How inflation hurts your savingsNovember 15th, 2013 by Dan Woodruff
Latest posts by Dan Woodruff (see all)
- How you could save £226,436 just by maxing out your ISAs - February 21, 2017
- 5 ways to guarantee retirement insecurity - November 24, 2016
- Pension withdrawals – 12 crucial considerations - November 2, 2016
I was in my bank the other day so I took a look at the interest rates they were paying on savings accounts. It was not great reading – 1.59% for a cash ISA.
You are probably well aware that bank accounts are not paying much interest at the moment. If you have money in savings accounts, you may have received a relatively decent level of return in the past. The chances are that your interest rates are tumbling at present. This article examines the real danger posed by bank accounts vs inflation, and explains why your bank accounts are probably losing you money.
- Why is inflation important?
- How are bank accounts performing vs inflation?
- How inflation hurts your bank savings
- What can you do about inflation if you have bank savings?
Why is inflation important?
Inflation is the change in the cost of living measured over time. Generally, prices tend to rise, but this is not always the case. This is important when looking at bank accounts (or any savings) since if your bank accounts are not growing in value as much as the rise in the cost of living then you are really losing money. If the cost to buy goods is rising, and your asset is not rising as much then the purchasing power of those bank savings is dropping in value. This has been a real problem in the last 5 years, as this article examines.
Measures of inflation
The 2 main measures of inflation in the UK are the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). CPI is the preferred measure of the UK Government.
Both measures take a theoretical basket of goods and measure the increase in the cost of purchasing those goods each month. Over time, this creates a measure of the increase in the costs of living. The main difference between the 2 measures is that CPI does not include housing and mortgage costs. There are other more complex reasons why they are different, based on the ways they are calculated. In general, CPI comes out to be lower than RPI, which is why the Government prefers this measure to base pensions and other costs on.
Bank accounts vs inflation
I have taken a look at the statistical evidence surrounding bank accounts and inflation in the last 5 years. If you’re reading this after November 2013 please bear in mind that these statistics will change over time, so this is only a snapshot of the current situation. We have used the Moneyfacts index of 90 day notice bank accounts for £10,000 or more, to demonstrate the performance of bank accounts.
The raw data
|1yr||Ann. 3yr||Ann. 5yr|
The figures above have been annualised over the terms shown. This means that the measure shown would have needed to grow by the figure quoted each year to reach its current result.
This shows that in the last year the average bank account by this measure grew by 0.95% (before tax) – hardly impressive. By contrast retail prices grew by 2.57%. Over 5 years, which is perhaps more reliable, a bank account grew by 1.19% per year before tax. Consumer prices grew by 4.75% per year and retail prices by 2.96% per year. The general trend is that comparing bank accounts vs inflation shows that your savings are losing you money.
Comparing bank accounts vs inflation over 5 years
Here is a chart showing the growth in an average bank account against these 2 measures of inflation over 5 years. As you can see, bank accounts are losing money to either measure of inflation.
So, over 5 years your bank savings would have grown by 6.10%. Consumer prices grew by 26.1% and retail prices by 15.7%. Whichever way you look at it, when you compare your bank savings vs inflation, they lost money.
Let’s look at this another way
In the above chart, the purple line shows inflation (retail prices) as a constant, and shows how a bank account performed against this. The evidence is clear – your bank account lost money to inflation. In the above example, your bank accounts lost 8.3% in value compared to retail price inflation over 5 years. Tweet this.
In the above chart, the green line shows inflation (consumer prices) as a constant, and shows how a bank account performed against this. The evidence is clear – your bank account lost money to inflation. In the above example, your bank accounts lost 15.8% in value compared to consumer price inflation over 5 years. Tweet this.
Why is this important?
We are concerned that many people are risk averse, and so naturally seek the safety and simplicity of bank accounts. This is usually fine if you have a short-term need for this money, are completely risk averse, or do not need to take risks with your money. However, for most people this is not the case. If you have a use for your savings – perhaps to create an income in your retirement – then you should at least consider the long-term effects of keeping this money in cash. Over time, the value of your savings, and the income you get will increase gradually in actual terms. However, after taking into account the effects of inflation your savings and income will actually be losing you money.
How inflation hurts your bank savings
Using the data above, an average bank account currently provides you a 0.95% annual return. If you have £10,000 in savings that’s going to give you an annual return of £95. Hardly anything to get excited about. If you’re a basic rate UK taxpayer, you could pay 20% tax on the interest, leaving you with £76.
If you saved your interest for 5 years, your £10,000 would have grown to be £10,609.90 (ignoring tax). If we compare this to inflation (consumer prices), your £10,609.90 would compare to the purchasing power of £8,411.77 5 years ago. In other words, inflation would have made you feel like you had lost 15.88%, or £1,588.43. You can imagine that over time this would feel worse. If we added in tax, the situation would be even worse.
What can you do about inflation if you have bank savings?
Usually, we advise clients to keep an emergency fund. This is an amount of money in a bank account that you can access easily when you need it. You should then save separate amounts for other short-term projects like holidays, tax bills etc. After that, unless you do not need to take risks, or you are completely worried by them, you should put your money to work for you. By this, we mean investing in a portfolio designed to beat inflation after investment charges. You may be surprised to learn that just by investing in a cautious investment portfolio you have a much greater chance of beating inflation over time (although this is not guaranteed). By doing this, you allow your savings to grow in actual value over time. You also give yourself a chance to beat inflation, thus growing your savings in real terms too.
There are many different options open to you if you want to beat inflation. There are even some investments available that guarantee to beat inflation over time. Unfortunately, bank accounts do not do this.