As a source of comfort in times of economic uncertainty, a savings account may appear to be a haven for your money. However, against inflation, which is an overall increase in the prices of goods and services, the sanctity of the savings account is not that great. Again, inflation at higher levels erodes the purchasing power of your savings over time. With inflation still a main issue in the UK, a savings account is unlikely to be enough to protect your savings from the future.
Below, we shall find out why savings accounts lack the wherewithal at times of inflation as well as what alternatives can be executed by UK savers to save and expand their wealth.
The Fundamentals of Inflation and Its Effects on Savings
What is Inflation?
Inflation is the rate at which the general price level of goods and services rises in the economy over time and the higher it rises, the lower the money’s purchasing power will be. Therefore, £100 today would not get the same quantity of goods and services tomorrow if the rate of inflation is high.
The Bank of England aims to maintain an inflation rate of around 2% to ensure economic stability. However, several recent factors have pushed UK inflation rates above this target, exceeding 7% in 2023. These factors include the disruption of global supply chains due to COVID-19 lockdowns, an energy crisis driven by geopolitical tensions, and the sharp rise in food and commodity prices. Together, these issues have contributed to a surge in inflation, putting additional pressure on savers and their financial security.
How Inflation Affects Your Savings
A savings account sounds safe, in that your money remains safe, growing with interest. However, there’s a catch: most savings accounts in the UK charge interest at a rate well below inflation. Even high street banks or many online savings platforms offer interest rates at their best as merely below 1.5%-2% of inflation.
Thus, if inflation stands at 5% but your savings account offers just 1.5%, the value of your money is being eroded. As the rate of price escalation outpaces the growth in the balance of your account, your real purchasing power is going down.
The Limitations of Savings Accounts in a High Inflationary Era
Low Rate of Interest
Savings accounts in the UK have perhaps the most obvious limitation-around historically depressed interest rates. Even since the Bank of England increased the base rate in its efforts to reduce inflation, many savings accounts have not been competitive in such regard. So the average saver is earning much less in interest than losing through loss of purchasing power by inflation. The sad reality is that, although your money might be “safe” in that savings account, it is slowly and painfully eroding.
The rate at which inflation outpaces savings growth is alarming.
In other words, when inflation is high, the cost of essentials like food, housing, and utility services rises, which means that the money in your savings account loses value. For instance, if you save £10,000 but the inflation rate rises to 5%, and your savings account only earns an interest rate of 1%, the real value of your money will have effectively decreased. After one year, your £10,000 will only have the purchasing power of approximately £9,500 in today’s terms. This illustrates how, even though the balance in your savings account increases slightly, it may not keep pace with rising costs.
The Psychological Comfort Trap
In the UK, many people feel secure keeping their money in a savings account because it offers liquidity and a sense of safety. However, with inflation rates consistently outpacing the interest rates offered by most savings accounts, this seemingly “safe” strategy may actually be eroding the value of your money. While the risk of losing money through investment can feel intimidating, leaving your savings in a low-interest account during times of high inflation can be riskier in the long run. Diversifying into higher-yielding assets not only helps preserve your purchasing power but can also provide the potential for growth that keeps pace with or even exceeds inflation.
Alternatives to a Traditional Savings Account
1. Stocks and Shares ISA
One other alternative to a traditional savings account is the Stocks and Shares ISA. Unlike most saving accounts, money placed into a Stocks and Shares ISA will gain value due to equities, bonds, and other investments in which you are investing. In the long term, equities have traditionally gained value at a higher rate than inflation, so this is another excellent place to put your money during periods of high inflation. ISAs also offer tax-free returns in the UK, another tier of financial savvy.
While investing in the stock market does involve risk, some of that risk can be mitigated through a diversified portfolio. Over time, investments in a well-balanced portfolio comprising stocks, bonds, and other instruments have a possibility of growing at a pace higher than that of inflation.
2. UK Index-Linked Gilts
If you’re not keen on investing in stocks but still want protection against inflation, UK Index-Linked Gilts offer an attractive option. These government-backed bonds adjust both the principal and interest in line with inflation, ensuring your investment retains its value as the cost of living rises. Unlike traditional savings accounts, where interest rates are fixed regardless of inflation, index-linked gilts help maintain the real value of your money over time.
3. Real Estate
Real estate can make an excellent hedge against inflation due to increases in property values and rental income arising from inflation. Property has been an investment product that has given a sound return for centuries in the UK, and demand for housing is still exceeding supply, making it a good long-term investment. You can invest directly in property or through Real Estate Investment Trusts, which enable you to invest in portfolios of property without having to get your hands dirty managing physical property.
4. Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS)
For those willing to take on more risk in exchange for higher potential returns, the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS) offer significant tax incentives for investing in early-stage or high-growth UK companies. These schemes are designed to encourage investment in start-ups and smaller businesses by offering tax relief, making them appealing options for UK investors.
- SEIS: Investors can claim up to 50% income tax relief on investments up to £100,000 per tax year, along with exemption from Capital Gains Tax (CGT) if shares are held for at least three years.
- EIS: Investors can receive up to 30% income tax relief on investments up to £1 million (or £2 million for knowledge-intensive companies) per tax year, along with deferral of CGT and no inheritance tax on shares held for at least two years.
These schemes not only provide the opportunity for high returns by investing in innovative UK businesses but also offer robust tax benefits that help mitigate some of the risks associated with start-up investments.
5. Commodities and Precious Metals
Commodities such as gold, silver, and others have always been considered havens for inflation. Although they produce no fixed incomes like a savings account or equities, commodities retain value because the buying power of money declines. More particularly, gold has been a growing UK hedge against inflation because it tends to increase in value while the pound declines.
6. High-Yield Savings Accounts and Fixed-Term Bonds
If you just want to keep some savings in safer, easily accessible forms, high-yield savings accounts or fixed-term bonds may be better than the basic savings accounts. While neither of these is a sure bet to grow faster than inflation, you might do better with fixed-term bonds or Cash ISAs if you lock your money away for a set term.
Creating an Inflation-Fighting Investment Plan
Diversify Your Portfolio
The best way to save your money from inflation is through diversification. Do not put it all in one call, such as with a savings account, and expect that to save you. The best way to minimise the risk of inflation, with its erosion of your total savings, is to disperse your money among a mix of assets- stocks, bonds, real estate, and commodities.
Rebalance Your Portfolio Periodically
The economic situation changes and inflation will never be constant. One has to review his financial portfolio periodically so that returns are optimised and risks are minimised. If inflation shoots through the roof, one may want to increase his investment in inflation-protected assets such as index-linked gilts or real estate.
Maintain Current with Economic Trends
Staying abreast of inflation trends, interest rates, and the UK economy may keep you best positioned on your financial decisions. The Bank of England continually publishes inflation reports and forecasts, which can serve as working blueprints for your next steps in financial matters.
Equilibrium between Emergency Funds and Investments
Although inflation can burn a hole in your savings pot, an emergency fund is still a good place to keep money handy for immediate expenses. Meanwhile, short-term savings in terms of liquidity should be set aside in some kind of accessible account for covering 3-6 months’ worth of your living expenses. To combat inflation, however, it has to be balanced with investments that give better protection against it.
Safeguarding Your Wealth during High Inflation
While depositing your money in a bank savings account may seem like the safest choice, high inflation could mean your savings are losing value more quickly than you realise. Although these accounts offer short-term security and liquidity, their low interest rates often fall far behind inflation, diminishing your purchasing power over time.
To protect and grow your wealth during periods of high inflation, consider exploring other financial solutions like Stocks and Shares ISAs, index-linked gilts, real estate, and commodities. A diversified portfolio, combined with regular reviews of your financial strategy, can help mitigate the adverse effects of rising prices and ensure your money retains its value.
The Time to Act is Now
Review your financial strategy, consider diversifying your portfolio, and consult a financial advisor who understands the UK market to develop a plan that safeguards your savings against inflation. By taking these steps, you’ll build a robust financial foundation that not only withstands inflation but helps your wealth grow over time. Remember, your savings are one of your most valuable assets—don’t let inflation eat away at them.