BBC News

Guide to inflation-linked savings

By David Black
Banking specialist, Defaqto

image captionSavers and borrowers have seen contrasting fortunes as a result of the low interest rates

We are in an era where the Bank of England interest rate is languishing at a historic low of 0.5%, while the rate of inflation is significantly higher.

While this is clearly great news for borrowers, it creates very real difficulties for those reliant on income from their savings.

The sad fact is that for the vast majority of people, money saved in deposit-based accounts is actually getting a negative return in real terms.

The average easy access savings account currently pays 1.16% gross on a £1,000 balance - although some pay as little as 0.01% and the highest paying account pays just above 3%.

The pain does not end there, because if you are a taxpayer, then HM Revenue & Customs also takes a bite out of the interest for all accounts except cash Individual Savings Accounts (Isas) and selected National Savings & Investment (NS&I) products.

To get the best returns on your money you really need to be proactive and review your current deal, and, if appropriate, transfer to a better account elsewhere.

You may want to take advantage of things like introductory bonuses, guaranteed minimum rates or fixed rates.

So, is there anything you can do to inflation-proof your savings?

Let's start with some good news. All the deposit-based inflation-linked bonds are linked to the Retail Prices Index (RPI) rather than the other widely-used inflation measure known as the Consumer Prices Index (CPI).

This is beneficial because the methods of calculation used to determine the two inflation rates mean that the RPI is usually higher than the CPI.

For inflation-linked deposit-based accounts, if you are a taxpayer you really need to confine your attentions to inflation-linked cash Isas because you will have to pay tax on interest from non-Isa savings accounts.

Six-year inflation-linked cash Isas paying a minimum of the increase in RPI or 2.5% AER are available from Barnsley Building Society, Chelsea Building Society and the Yorkshire Building Society for a minimum balance of £3,000.

They will accept transfers in of cash Isas from previous tax years. They are also as non-Isa accounts

Do bear in mind that these three building societies count as one institution as far as investor protection is concerned and have an overall limit of £85,000 that is protected under the Financial Services Compensation Scheme.

Cambridge Building Society's Inflation Linked Bond issue 1 has a five-year term and pays a return of the increase in RPI plus 1% AER. It is not available as an Isa and requires a minimum investment of £5,000.

Sadly a number of other inflation linked bonds have recently been withdrawn from sale.

If you are thinking of opening one of these accounts do remember you should only deposit money that you are sure you will not need to access for the entire term of the bond.

Early withdrawals or closure may not be permitted but, where they are, penalties would be imposed that would dramatically reduce any return.

Burst bubble

What happens if inflation is negative?

It is worth checking the small print to see whether a negative inflation rate will result in a reduction of your capital. None of the accounts mentioned above will deduct money from your investment in the event that RPI is negative.

Looking at the alternatives, index-linked gilts - which are bonds issued by the government - have been available since the 1970s.

However, the prevailing purchase prices of existing UK government issues mean that the real yields are now below 1%.

You can buy gilts through a stockbroker, or when new stock is issued, through the government's Debt Management Office.

Index-linked corporate bonds - which are issued by companies - are a newer phenomenon and currently have real yields of about 1.5% to 2%. You can buy existing issues of corporate bonds through a stockbroker.

You can also invest in Open Ended Investment Companies (OEICs) or unit trusts that have funds investing in inflation linked and/or other fixed rate investments that are targeted to have a return that matches or betters inflation.

Clearly there is no guarantee that they will meet their targeted performance and there is also capital risk in that the price of the units can fluctuate.

Most of these funds invest in gilts rather than corporate bonds.

However, M&G Investments has recently launched its UK Inflation Linked Corporate Bond Fund that invests in index-linked corporate bonds, Floating Rate Notes, index liked gilts and other fixed income instruments. It aims to achieve a return that beats CPI over the medium to long term.

Kames Capital's Inflation Linked Fund specifically aims to outperform the FTSE Index-Linked Gilts over Five Years (total return) Index - for which the underlying securities are linked to UK price inflation.

Fund managers offering a fund that invests primarily in UK index-linked gilts include AXA Sterling Index Linked Bond Fund, Baring BAM Index Linked Bond Fund, Henderson Index Linked Bond, LV= UK Index Linked Fund, M&G Index-Linked Bond Fund A, and Royal London Index-Linked Fund.

Bear in mind that you may have to pay an initial charge to buy an OEIC - or a bid/offer spread in the case of a unit trust - and that there will also be an annual management charge.

You can hold these funds in a stocks and shares Isa which would remove much of any potential tax liability. If held outside an Isa you may be subject to income tax on interest received and capital gains tax on any gain when you sell the units.

If you want to invest in an OEIC or unit trust you can do so either directly through the provider or through an independent financial adviser.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Links to external sites are for information only and do not constitute endorsement. Always obtain independent, professional advice for your own particular situation.