Rising costs, rising concerns
Most people have an understanding of the term inflation, how it works and phrases such as cost of living, prices index and other similar terms. In basic terms, inflation is just understanding how prices change over time and how things are more expensive today than they have been in the past.
The Bank of England Governor is required to keep inflation around 2% per annum. If they miss this target by plus or minus 1%, they have to send a letter to the Chancellor of the Exchequer explaining why the target has not been achieved, and how they plan to change this going forward.
Inflation is one of the most common risks people face with their finances as the value of your assets can be eroded by rising prices. Cash is considered to be a safe asset but, in an environment where there is high inflation and low interest rates, the value of your cash savings can be eroded very quickly. Although there is no change in the value held within your bank account, the real value e.g. the spending power, is reduced by inflation.
Here is an example to demonstrate this:
| Account | Value | Interest rate | 1 year | 5 years |
|---|---|---|---|---|
| Current Account | £10,000 | 0.0% p.a. | £10,000 | £10,000 |
| Savings Account | £100,000 | 1.2% p.a. | £101,200 | £106,145 |
The value of the current account has remained unchanged over the 1-year and 5-year period due to an interest rate of 0.0%, but the savings account has increased in value by 1.2% per annum.
However, when we take inflation into account, the real values would be as follows:
| Account | Value | Inflation adjusted rate | 1 year | 5 years |
|---|---|---|---|---|
| Current Account | £10,000 | -2.0% p.a. | £9,800 | £9,039 |
| Savings Account | £100,000 | -0.08% p.a. | £99,200 | £96,063 |
This shows that although the amount of money held in the bank account isn’t changing or is increasing respectively, the real value and the spending power of the money has decreased. This is because inflation is higher than the interest rates received by the banks.
We are currently in a high inflationary environment where the UK inflation rate rose to 7% in the year to March which is up from 6.2% in February. This is the highest rate the UK has experienced since 1992. With inflation at this high level, everyone is seeing the cost of living going up.
The prices are being driven up by rising electricity and fuel prices leading to companies facing higher costs which are then being passed onto consumers.
Although it is easy to see the impact inflation has on your cash holdings, the impact it has on your future income is less obvious. When planning for retirement you may have a target income in mind to cover your essential and discretionary expenditure. However, people often think about this value in today’s terms rather than the value of money when they retire.
For example, you might think you have an income requirement of £20,000 in retirement. However, if you are still 10 years away from retirement, £20,000 in today’s terms will buy you less in the future. This means your income requirement is likely going to be higher than you initially anticipate.
By investing your surplus cash, it provides your money with greater potential for growth. This means it is given the potential to grow more than inflation. However, there are various risks that come with investing your money and returns are not guaranteed, meaning you may end up with less than you put in, even before taking inflation into consideration.
Inflation is something that we have all been made more aware of recently as the prices of everyday items are currently rising more than people’s wages. This means people can now buy less with their monthly income. Inflation can erode the value of your cash savings over time however investing can provide your money with the potential of keeping up or outperforming inflation, though this does come with other risks that need to be considered.
If you have any concerns about your financial position due to the current high inflationary environment or would like to consider investing, please contact me or your usual Johnston Carmichael Wealth Financial Planner.
Disclaimer: Johnston Carmichael Wealth Limited is authorised and regulated by the Financial Conduct Authority.
Please note: This communication should not be read as financial advice. While all possible care is taken in the completion of this article, no responsibility for loss occasioned by any person acting or refraining from action as a result of the information contained herein can be accepted by this firm.
This blog represents our interpretation of current and proposed legislation and HMRC practice as at the date of publication. These may change in future.
Figures refer to the past and past performance is not a reliable indicator of future results. You may not get back the full amount of your investment.
