Ashley Reeves, financial adviser writes;
While money held in a regular bank account or cash ISA is guarded from many risks that other financial instruments are exposed to, it is subject to one often overlooked factor, inflation risk.
You may well have seen reports in the press recently that the cost of living is rising. After many years of very low levels of inflation, this is certainly an issue that’s starting to cause concern with our clients.
There are many factors that can affect the rate of inflation, which I won’t go into here, but essentially it leads to a rise in the cost of goods and services over time.
The Office for National Statistics uses a metric called CPI (Consumer Price Index) to measure the rate of inflation. This looks at the average cost for a ‘basket’ of goods and services that the average UK resident will use. It does not include rent or mortgage costs. To take an example, while utility prices have increased by up to 12% at the end of 2021 (bbc.co.uk), the other items in the basket have increased by a smaller amount, leaving the CPI inflation measurement at 5.4% (Dec 2021) (ons.gov.uk).
At the current level of 5.4%, this is already much higher than we have been getting used to, and particularly with rising energy prices, we may well see even higher rates of inflation in the coming months. On the flip side of this, we haven’t seen any significant rises in the interest that is being paid out on bank and savings accounts, including funds held in cash ISAs.
For many people living on a fixed income, these will be worrying times. But if your wages rise roughly in line with inflation, then immediate costs, such as food, rent or mortgage, bills and car costs aren’t particularly affected by inflation. As the money is paid out very close to the time you receive it, then inflation doesn’t have time to increase the costs in the time between receiving and spending.
However, let’s look at a scenario where a couple are aiming to earmark some funds for future spending on a special holiday.
Peter and Mary are due to celebrate their 25th wedding anniversary in five years’ time and have recently received a lump sum of £15,000 from a relative. The holiday they are looking at would cost exactly £15,000 today, so they put the money into a cash ISA with a view to holding it to pay for the holiday in five years.
They find a relatively good deal on a cash ISA, which offers 0.96% interest per year (Oak North Bank, Jan 2022). In five years, their £15,000 will be worth £15,733.96, assuming the interest rate remains unchanged throughout the period. At first sight, Peter and Mary are pleased with the increase in the value of their money and look forward to splashing out on their holiday.
However, sadly the cost of the holiday is likely to increase over the five years. Let’s assume no factors other than inflation will affect the cost of the holiday. Inflation currently sits at 5.4%, so let’s assume that rate will remain stable throughout the five years. The holiday will now cost £19,511.66.
Peter and Mary find themselves £3,777.70 short for their holiday of a lifetime and will now have to make the unpleasant decision whether to buy a cheaper holiday or use funds from elsewhere to make up the difference.
So, what if Peter and Mary had come to speak to me at Four Oaks when they first received the £15,000?
After deciding that we can work together, we would have undertaken an in-depth fact find, where we discover all of Peter and Mary’s incomings and outgoings and find out what their goals are.
Now that we know that Peter and Mary are looking to use their £15,000 to pay for a holiday in 5 years’ time, we can advise on the best course of action. Knowing the effect that inflation may have over the investment period, we can choose a fund that will suit Peter and Mary’s attitude towards risk and reward, but that will also offer the potential for growth that will match the rate of inflation.
If that fund performs better than expected, Peter and Mary will have some surplus funds which they can leave invested or use elsewhere.
If the fund performs worse than expected, they may still be left short on their holiday, but with regular reviews through the investment term, they will have been kept updated on the progress of their funds and will have been able to prepare for the shortfall.
Offsetting inflation is important for any funds that are earmarked for use in the future, so contact me for a free initial meeting and find out how I can help.
- Investors do not pay any personal tax on income or gains, but ISAs do pay unrecoverable tax on income from stocks and shares received by the ISA managers.
- Tax treatment varies according to individual circumstances and is subject to change.
- Stocks and Shares ISAs invest in Corporate bonds; stocks and shares and other assets that fluctuate in value.