Last month, the Bank of England raised their base rate for the first time in more than ten years, and by doing so opened the door to increased monthly costs for many homeowners. What’s more, at the time of writing inflation continues to sit at a five year high of 3%, which means that the cost of living has more than trebled in the last 12 months. These two factors alone combine to create additional strains on the average UK household, and a situation which may influence some to reconsider their financial position. We take a look at what the latest Bank of England base rate and inflation might mean if you are looking to re-think your savings and investments.
Inflation
UK inflation, as measured by the Consumer Price Index (CPI), remained at its five year high of 3% for the second month in a row, according to the latest report released by the Office of National Statistics. And despite this being a full one per cent over the Bank of England’s target of 2%, it is also widely predicted that inflation will increase again before the year’s end.
Base Interest Rate Hike
Approximately 15 months after cutting their base rate of interest to emergency levels, the Bank of England’s Monetary Policy Committee voted on November 2nd to increase the interest rate from 0.25% to 0.5%. The move represents the first increase for ten years and has had a knock-on effect with homeowners, as a number of high street banks have since increased their standard variable and tracker rates, thereby increasing the cost of living for many.
No doubt we will see more lenders follow suit this month, and the combination of increased mortgage interest rates and high inflation means less disposable income for households, making it harder for the average UK household to make ends meet, let alone put enough money into their savings.
Not Passed On To Savings Accounts
There was a general consensus among economists that the Bank of England would raise their base rate before the end of the year, and so even before the Monetary Policy Committee voted in favour, there had been much discussion on both the advantages and disadvantages of a potential increase.
The most common advantage given in support of an interest rate hike was that it would likely increase the savings rates offered by banks, a welcome change for savers who have had to face year after year of some of the lowest savings rates on record. Unfortunately, although banks have been quick to raise their mortgage interest rates following the hike, the majority of banks have not done the same for their savings accounts – a real ‘lose / lose’ for both borrowers and savers alike.
Savings Accounts At A Glance
Savings rates therefore continue to under-deliver. A review by Simply Savings of the savings rates currently on offer shows rates of around 1.30% AER on instant access; 1.80% AER and 2.05% AER for one and two-year fixed rates respectively, around 2.25% AER for a three-year fixed rate and 2.37% AER if you fix for five years. Therefore, savings accounts do not come close to matching inflation, let alone beating it, meaning savers are still losing money in real terms, even if you are able to tie your money up for five years.
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Do your homework
Whenever considering changing strategy, it is important to do your homework. This means comparing the amount of interest you already receive with what is currently available in the market. If you are not receiving anything close to the above rates, a change may be worthwhile, and remember, despite the fact that savings accounts do not provide rates that counter the effects of inflation, they do offer full capital protection.
If you are not prepared to take on more risk to potentially access higher interest rates, then there are not many alternatives available on the market.
Taking On Risk Or Losing Money In Real Terms
For the entire time that the interest paid on your savings is less than the prevailing rate of inflation (and that’s after any tax has been taken into account), the value of your money is going down in real terms, and the longer this goes on, the more an impact it will have. It may well therefore be time to start re-evaluating your strategy when it comes to savings, as you would have to receive a significant return in the current climate just to match inflation.
With the added financial pressure brought about due to higher inflation, it may force us to consider investing in order to try and keep up with the cost of living. We are then faced with the conundrum of whether to take on more risk in order to achieve potentially higher returns, versus record low interest rates but without the risk to our capital.
Capital at Risk Products
Capital at risk investment plans offer a defined return for a defined level of risk. Combined with a fixed or maximum term, they therefore offer potential investors a clear trade-off between risk and reward, hereby enabling them to be compared with alternative options.
When you invest in a capital at risk investment plan, although your capital is not directly invested into the stock market, their returns are generally linked to the performance of the FTSE 100 Index (‘FTSE’ or ‘Index’). The returns for a capital at risk product are often dependent on whether the FTSE stays or ends above a certain level, for example a fix growth or income payment provided the FTSE ends a plan year higher than its value at the start of the plan.
Income Investment Plan Example
An example of one of the most popular income investment plans is the FTSE 100 Defensive Income Plan from Investec Bank, which provides investors with the opportunity to receive 7.25% interest each year provided the FTSE has not fallen by 20% or more at the end of each quarter. The plan has a second investment option offering 5.50% per year provided the FTSE does not fall by 40% or more.
Unlike deposit based savings products, this plan puts your capital at risk and if the FTSE has fallen by more than 40% at the end of the six-year term, you could lose some or all of your initial capital. Also, since it is an investment rather than a deposit-based plan, your initial capital is not covered by the Financial Services Compensation Scheme for default.
Risk v Reward
As with any investment, it is important to give full consideration of the risk versus reward on offer. A good benchmark for assessing your investment is to compare what you could get from a fixed rate deposit over a similar timeframe, and then consider whether you are prepared to accept the level of risk to your capital in return for either a higher fixed rate, or the potential for a higher variable income.
In the example above, the potential income on offer is either 5.50% or 7.25% depending on how much the FTSE can fall each quarter. The best fixed rate on offer over a similar timeframe is in the region of 2.50%, so one of the questions to ask is whether the ability to receive around 2 to 3 times more interest is sufficient potential reward for putting your capital at risk if the FTSE falls 40% or more?
Conclusion
There is little doubt that higher inflation and an increase in the Bank of England’s interest rate has put increasing financial pressure on households in the UK. With a reduction in the amount of disposable income for many, uncertainty around future wage growth and no direct uplift in savings rates, one could argue that for those with mortgages, unless you can secure a savings rate higher than your mortgage rate, you should be paying off your mortgage as a priority, unless there are higher interest rates being paid on other debt such as credit cards, etc. which should be paid down first.
Although savings accounts do offer protection to your capital, since the banks have not passed on the interest rate rise to their savings accounts, the interest paid is likely to fall well short of inflation. Therefore, the fact that savers are losing money in real terms is a harsh reality of where we are right now, with some uncertainty of what this may look like in the coming months and years.
For those looking to secure a higher level of income and/or growth over and above the rise in the cost of living, then investing may be the only option since there are no savings products paying anything close to the current rate of inflation. You may want to explore the investment plans we have on offer, as they may provide the opportunity for returns to counter the adverse effect of inflation. However, if you are looking to invest in a plan, it is important to do you research, and make sure you fully understand the risks involved before putting your capital at risk.
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular plan. If you are at all unsure of the suitability of a particular product, both in respect of its objectives and its risk profile, you should seek independent financial advice.
Tax treatment of ISAs depends on your individual circumstances and is based on current law which may be subject to change in the future. ISA transfer charges may apply, please check with your provider.
The investment plans referred to in this article are structured investment plans that put your capital at risk and are not covered by the Financial Services Compensation Scheme (FSCS) for default alone. There is a risk of losing some or all of your initial investment due to the performance of the FTSE 100 Index. There is also a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index is not a guide to its future performance.