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How to protect your savings from the ravages of 5% inflation

That old bogeyman of the 70s is back again – inflation – now running at 5.3% as measured by the retail prices index (RPI). Fortunately, National Savings has an answer.

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by Lorna Bourke on Jun 13, 2010 at 07:00

How to protect your savings from the ravages of 5% inflation

That old bogeyman of the 70s is back again – inflation – now running at 5.3% as measured by the retail prices index (RPI).

Some of us can remember when inflation hit a record high of 26.9% back in August 1975, having been in double digits from November 1973 when it stood at 10.3% right through to January 1977 when it fell to 9.9%.

If you were working during that time your wages probably went up roughly in line with rising prices. But as always, it was pensioners and others on fixed incomes who suffered and it was high inflation in the seventies that forced the government to produce Index Linked National Savings Certificates – initially dubbed ‘Granny Bonds’ because they were only available to pensioners.

There was another bout of double-digit inflation from April 1979 when the RPI moved up to 10.1% and it stayed in double figures until April 1982 when it fell to 9.4%. Virtually the first thing Margaret Thatcher (below) did when she came to office in 1979 was to slap 3% on Bank of England base rate in an attempt to choke off inflation. It took three years to work. By this time Index Linked National Savings Certificates were available to all – as they are today.

It's time to take another look at Index Linked Savings Certificates as a safe haven during what looks like an incoming storm. The beauty of these certificates is that not only do they protect your capital and spending power from the ravages of inflation, but the returns are also tax free – a big bonus for higher rate taxpayers in particular.

The current three-year 20 issue and the five-year 47 issue both offer index linking plus a guaranteed 1% a year interest which ensures that you are always ahead of the game. The index linking works by upgrading the value of your original investment by the rate of inflation as measured by the RPI.

Over the past five years a £100 investment would now be worth £123.77 or a simple interest annual return of 4.7% and the three-year bonds £114.13 – also a return of 4.7%. This is equivalent to a gross return of 5.8% to a basic rate taxpayer or 7.8% to a 40% taxpayer. With income tax rising to 50% from April of next year the benefits will be even greater for top rate taxpayers, equivalent to 9.4% gross.

Investing for children

Maximum holding of each issue is £15,000 so you can invest up to £30,000 per person if you buy both the three-year and five-year versions. You can also invest on behalf of children and if you prefer, put them into a trust fund until they are eighteen. So a family of four could tuck away a tidy sum of £120,000. You can also hold them in Sipps and SSASs – but there is not much point in doing so as the return is tax free anyway and you will retain control over your funds if you hold the certificates direct.

If you are investing for children, remember that most children are non-taxpayers anyway so you might be able to get just as good a return with greater flexibility from other investments. There are fixed rate bonds currently paying a guaranteed 5% a year for example. It all depends on your view of where inflation will settle and what alternative investments are offering.

It is also worth bearing in mind that a trust prevents the children from squandering the money – at least until they are 18 – but you will have the expense of running a trust which could greatly reduce the returns if the only investments are the NS&I certificates. The simplest way to prevent a child from spending savings – is not to tell them that you have invested on their behalf in the first place and just give them the money when you feel they are not likely to waste it.

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13 comments so far. Why not have your say?

if inflation does take hold will the B of E raise interset rates?

also what affect will it have on the housing market if houses are assets that rise in value with inflation vs the effect of potentially higher mortgage IRs if the B of E raise the base rate?

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Inflation is not 5%. Last month annualised it was 11.4% Index linked gilts or Certificates are the only investments worth making now.

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Anonymous 1: If inflation does take hold will the B of E raise interest rates?

It means nothing the BoE will announce whatever interest rate they feel like. BoE interest rates are related to short term bond interest rates (1 year bonds) which they don't sell many of. The BoE try to sell long term bonds (20+ year bonds) which get a much higher interest rate than the current BoE rate. If the BoE interest rate is not high enough then no one will buy short term bonds, in which case they will probably try to just keep selling long term bonds at a higher interest rate, I'm not sure why or if anyone is buying short term bonds because if they do they will just lose money by inflation eating it away.

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It has been obvious since Dec. that tax-free index-linked NS&I Certs have been the best short-term savings, if not cashed in before one year. The chances that rpi will reduce in the next year or so are negligible. That makes them better than any short or medium term fixed-rate bonds shown as best-buys on the financial web-sites.

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Take a look at the BT bond issue 3.5% plus inflation.

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I should have been clearer British Telecom bond 2025.

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Yikes, I hadn't realised how much the RPI has risen by just recently. Thanks for this advise, I had never looked into these certificates before nor realised they are available to all and are tax free so can earn a decent rate of interest.

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No one ever mentions what a good thing inflation is for those with huge mortgages. I remember what seemed like a killer mortgage in 1970 could be put on your credit card by 1980. Only works if you can hang on to a job and get decent pay rises. I think with all the debt about at the moment higher inflation might be okay for a year or two.

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Is the base rate set by Merv really done with an eye on reigning in inflation? I think not, the MPC see inflation as a way of watering down the public and private debt burden.

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I believe that the inflation rate applied annually to these certificates is based on the RPI for that particular month compared to a year ago rather than an annual average. Therefore to avoid the possibilility of hitting a dip on the anniversary date buying regularly through the year may be a good savings option. The graph of the last couple years of course certainly shows volatility. Please correct me if I have read this incorrectly.

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From National Saving website.

Calculating index linking

17. An index-linked value will be calculated as V x B/A where:

(a) 'V' is the value of the Certificate at the beginning of the index-linked period (this will be the purchase price or the value at an anniversary date);

(b) 'A' is the RPI start level and is the index figure applicable to the calendar month in which the first day of the index-linked period falls (this day will be the purchase date or an anniversary of it); and

(c) ‘B’ is the RPI end level and is the index figure applicable to the calendar month in which the day after the final day of the index-linked period falls. This will be the maturity date, an anniversary date, or the day after the last completed month for which index-linking is earned.

In the event of this calculation producing a negative value, no index-linking will be applied.

18. If the RPI is reset to 100 points the Director will calculate notional RPI figures designed to produce as closely as practicable the same effect as if the RPI had not been so reset. These will apply to Certificates bought before the revision.

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Unless the rules have changed recently the "in trust" option is not only available for children . Thus in each issue a couple can double their entitlement by buying the bonds "in trust" for one another. This assumes of course that you intend remaining a couple!

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Anonymous 7 needed this 'off the record'

Jul 14, 2010 at 12:59

In these financial climates, best option for all remains on sitting on cash. Even though that does not earn you a lot, its an option only those who have fore....fore sight will consider.

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