The second successive increase to the headline rate of inflation is far from welcome and it couldn’t come at a worse time, with millions of maturing fixed rate bondholders staring at sharp drops in the level of income currently available. We take a closer look at what this latest increase really means when making decisions around our savings and investments.
A quick round up
The Consumer Price Index (CPI) has risen by 2.9% in the year to June 2013, according to the latest figures from the Office of National Statistics, up from 2.7% in the previous month. Although the ONS has now largely abandoned the Retail Price Index, RPI stood at 3.3% for the year, also up 0.2% compared to the previous month.
The government statistics body says a rise in the price of motor fuels was the largest contributor while there was also a large upward contribution from clothing & footwear. There were other, comparatively modest, upward contributions from water, electricity, gas & other fuels.
Pensioners hit particularly hard
June’s increase takes CPI to its highest level since April 2012. Vince Smith-Hughes, a retirement expert at Prudential said:
“The rise in inflation will have a major impact on households throughout the UK. However, pensioners will be amongst the hardest hit since they spend higher proportions of their income on essentials like food and fuel, which have seen some of the biggest price rises.
The combined effects of falling retirement incomes and inflationary pressures make pensioners amongst the most financially vulnerable. This year, the average expected income for those in retirement hit a six-year low of £15,300, which is 18% down on 2008.”
Bank of England admits the outlook is not good
The Bank of England has also finally admitted that there is an ongoing problem here, commenting in its May 2013 Inflation Report: “CPI inflation remains above the 2% target and is set to edge higher over coming months. Inflation is likely to stay above the target for much of the next two years, bolstered by external price pressures.”
So the targeted measure of inflation has exceeded its target since December 2009 and even the Bank of England does not think that there is likely to be a change in this situation anytime soon.
Economists agree
Economists were quick to point out that while June’s rise was slightly lower than expectations, there were fears stubbornly high prices could eventually choke the recovery. Markit’s Chris Williamson said: ”There are growing signs of the UK recovery gaining momentum, but inflation clearly remains the UK’s bug-bear and calls into question just how long this strong growth can persist for.
He continued:
“High prices look set to continue to erode spending power, curbing the overall pace of economic growth. High inflation also looks set to persist for some time.” Echoing these views, Howard Archer, chief UK and European economist at IHS Global Insight concluded that: “oil prices have recently firmed to trade at a three-month high of $109 a barrel, which is likely to cause further rises in CPI inflation.”
Effect on real wages
Mr Archer commented further: ‘With inflation moving up to 2.9%, the squeeze on consumer purchasing power remains appreciable given that inflation is running at more than three times underlying annual average earnings growth of 0.9% in the three months to April. June is unlikely to mark the peak in inflation.”
On this basis, real wages continue to fall and the new inflation numbers mean that after taking away inflation from the average wages increase, they are now falling at an annual rate of 2.0%. For those who feel that the Retail Price Index is more realistic then real wages are falling at an annual rate of 2.4%.
Effect on savers
Savers continue to feel the effects more than anyone. Recent research from HSBC shows that almost 5.3 million fixed rate products worth nearly £93 billion will mature in 2013 with around 500,000 maturing every month for the rest of the year.
Of these, 2.8 million have matured over the last six months, but the recent fall in savings rates means it estimates that bondholders with accounts maturing this year will see £1 billion knocked off their combined income if they were to reinvest into a similar product.
3 year fixed rates hit worst
All fixed rate products have been affected by the drop in rates and now offer lower returns if savers were to reinvest their money into the best-buy products currently available. However, the biggest falls in income will be felt by 3, 5 and 2 year bond holders with eye-watering falls of 52%, 50% and 45% respectively. The average investment in a 3 year bond currently stands at £22,333 and if this were to be reinvested in the current best-buy products on offer, investors can expect a return of £3,037 – a fall of £1,576 compared to their last investment in 3 year bonds.
Worse hit still are those with £50,000 plus coming to the end of the three-year term this month. They have earned as much as 4.15% over the term with high street providers such as Lloyds TSB and Halifax paying 4.1% and 4.0% respectively. Now Halifax pays just 2.2% and Lloyds 2.1%, equivalent to a 49% drop in income. Even the best rate is almost 40% down on the top deal three years ago.
Don’t forget the impact of tax
Unfortunately the headline rate itself is not the only factor we should consider before parting with our hard earned money. When considering where to put our savings, it is imperative that we consider what the net return will be, i.e. the amount we receive back in our pockets after tax.
Since it is the gross rate that is usually advertised, all but non-taxpayers will have at least the basic rate of tax (currently 20%) deducted. For higher and additional rate taxpayers there is likely to be further tax to pay taking the total rate to 40% and 50% respectively. In a nutshell, in order to provide a positive return after both CPI and RPI (at their June 2013 levels) and tax, you would need to earn above the following headline rates:
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Tax status
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Minimum return (CPI)
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Minimum return (RPI)
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Non taxpayer (0% tax)
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2.9%
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3.3%
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Basic rate taxpayer (20% tax)
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3.63%
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4.13%
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Higher rate taxpayer (40% tax)
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4.83%
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5.5%
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Additional rate taxpayer (50% tax)
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5.8%
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6.6%
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What this also tells us is the importance of maximizing our ISA allowance whenever possible since the cumulative effect over time allows a significant sum to be protected against the effects of taxation. Please note that this information is based on current law and practice which may change at any time.
Future savings rates
Interest rates have fallen dramatically since the Government’s Funding For Lending Scheme came into effect in August 2012. This gives banks and building societies a cheap source of finance so they are not so reliant on savers to lend them money. Since then banks and building societies have delivered a series of cuts to new savers and often, once they find themselves at the top of the best buy tables, they lower their rates.
In April, the Bank of England extended this scheme for a further year — until January 2015. Interest rates are not therefore expected to rise anytime soon so there would seem to be no respite for these low rates in the foreseeable future.
Give serious consideration to all options
With rates falling by as much 2.47% on maturing products (5 year fixed rate), many will see their income virtually halve. For those investors in the millions of fixed rate products due to mature over the remainder of 2013, there is a serious need to consider what the best possible home for their savings is.
Bruno Genovese, head of savings at HSBC, commenting on the findings says:
“Many savers value the guaranteed income and security offered by fixed rate products. However, those who want to reinvest their savings from matured fixed rate products into comparable deals this year may find that their income drops significantly. Savers need to consider all available options and this may not be to simply reinvest their savings in a similar product.”
Fixed rate options
In years past it would have been commonplace for savings accounts to offer inflation beating returns, especially if you were prepared to tie yourself in for the medium term. But today the difference in annual interest offered between leading one year and five year fixed rate bonds is under 1% and with nothing currently offering above 3%, you are simply not going to be able to obtain a real return from your savings.
One option would be to not tie up your money for more than two years. Rates are not expected to rise significantly over this term and you will then be in a position to reassess what is on offer. However, this strategy does rely on the Funding For Lending Scheme not being extended further, as well as savings rates coming back relatively quickly in two years time – if the changes to the savings landscape in recent years is anything to go by, neither is guaranteed.
Risk warning for savers
If inflation continues at its current level of 2.9%*, a basic rate tax payer needs to achieve 3.63% and a higher rate taxpayer 4.83% just to keep pace. Perhaps the risk warning that should be made by every provider before a customer buys a fixed rate bond is to make it quite clear that they will lose money in real terms unless inflation falls sharply and remains at a much lower level.
If you have not yet done so, ask yourself the likelihood of this happening? The impact of inflation, especially over time, is something which not enough savers put sufficiently high on their priority list prior to taking action.
Alternatives available
Diversifying savings portfolios to have a variety of products can ensure that investors lessen the impact of falling interest rates. The combination of a wider range of options could offer a more stable way to provide the level of returns savers need over the longer term. Moneyfacts editor Sylvia Waycot says:
“Watching the spending power of savings diminish, especially if it is needed to supplement income, is today causing heartbreak for many and could lead to escalating risk in the search for a return.”
Capital protected with the opportunity for higher returns
As an alternative option to fixed rate bonds you could consider a structured deposit. Interest in these has continued to rise in the current economic environment since they combine full capital protection with the opportunity to achieve higher returns than would be available from a fixed rate bond of similar duration – therefore offering the potential to beat inflation but without putting your capital at risk.
Structured deposits are essentially a combination of a deposit and an investment product where the return is dependent on the future performance of an underlying asset, commonly the FTSE 100 Index or a number of shares listed within the FTSE 100. By linking your return to the stock market and thereby sacrificing a fixed rate of interest, you create the opportunity to receive higher returns. The downside is that if the index does not perform in the way required to produce the stated returns, you will only receive a return of your capital (unless there is a minimum return built in).
The Target Income Deposit Plan from Investec, for example, offers a potential return of 5% income each year. The closing level of the FTSE 100 Index is taken on 2nd September 2013 and if at the end of each year the value of the Index finishes higher than 90% of its value at the start of the plan (subject to averaging), you receive a payment of 5%. If the Index finishes below 90%, no income will be paid but should it meet the required level on any future anniversary, any missed payments will be added back.
Investing
For those prepared to put their capital at risk in order to provide the potential for higher returns, especially higher yields, then there is a wide range of income investments available.
The FTSE Income Accumulator Plan from Morgan Stanley offers up to 7% each year with income accrued for each week the FTSE 100 remains between 4,500 and 9,000 points – any income is then paid out to you each quarter. The investment also includes some protection against a falling market since your initial capital is returned in full unless the value of the Index on the final day of your investment is below 4,000 points.
If the Index is lower, your initial investment will be reduced by 1% for each 1% fall and so this plan should only be considered if you are prepared to lose some or all of your investment. The FTSE opened this morning at 6,623 and so if you are looking for a high level of income and think the FTSE 100 could remain above 4,500 for most of the next five years, this could be an option. Obviously you must consider the risk to your capital before committing your money to an investment and you should be prepared to lose some or all of your initial investment.
Weigh up all of the options
High inflation is one of the hardest challenges to face, especially during a period of record low interest rates. But always remember that tax, inflation and interest rates each bear an important part on the net return from your capital. We must be prepared for what might happen and not be frustrated by finding ourselves tied into something which ends up providing us with a negative return after tax and inflation, purely because we ignored those crucial factors which can affect our overall return.
Since there is the potential to achieve only a return of initial capital, structured deposits are not designed to meet the needs of every saver or to receive your entire savings and investment inevitably entails risk to your capital.
Ultimately, which option or blend of options will depend entirely on your individual circumstances however, these are unusual and challenging times and traditional savings accounts are currently falling short of meeting the pressures put on saver’s capital by the continuing economic situation. Above target inflation, record low savings rates, low wage increases and an uncertain future are all relevant factors when deciding what to do. As a minimum we should make sure that all of the options available are weighed up very carefully indeed.
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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.
The Investec Target Income Deposit plan is a structured deposit plan that is capital protected. There is 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 this event you may be entitled to compensation from the Financial Services Compensation Scheme (FSCS), depending on your individual circumstances. 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 and any of it shares is not a guide to its future performance.
The Morgan Stanley FTSE Income Accumulator plans is a structured investment plan that is not capital protected and is 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. There is 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.