Accountant Danny Cox looks at how to make the most of your savings during a time of low interest and high inflation
The interest rate on cash savings continues to make depressing reading. Even if the Bank of England quadrupled rates from here, the base rate would still just be 2%.
Those retaining excessive cash savings often suffer from money illusion – the tendency to think of money in nominal, rather than real, terms. In other words, the face value of their savings is mistaken for its purchasing power. For instance, the same £1,000 of goods bought in May 2001 would cost £1,316 today.
Interest rates on immediate access cash accounts are currently around 3%. However, rising food and fuel prices are stoking retail price inflation (RPI) above 5% (source ONS: RPI April 2011). Therefore, the real value of cash is falling, particularly after tax.
Shopping around for good deals is straight forward using price comparison websites. Fixed-term bonds currently pay up to 5% gross over terms up to five years. However this return may look unattractive in a couple of years' time if interest rates do take off. My preference is to not tie up cash for too long; two years is probably the limit.
You might be able to improve the net returns either by investing in your spouse's name, if they pay a lower rate of tax than you, or use Cash ISA which provides tax-free interest.
Beyond this the best inflation busting cash investments are National Savings Index Linked Certificates, guaranteed to beat the rate of inflation over the year from investment. Check for their availability at www.nsandi.com.
To maintain and grow the real value of your wealth in the current climate I think you should take another look at the stock market and specifically equity income investing.
Consider equity income
Equity income has been somewhat out of favour in recent years, but in the current climate it is worth considering. Equity income provides the potential for not only a growing income but for some capital growth, giving investors a hedge against the effects of inflation on their savings and investment capital.
Equity income is about investing in profitable companies that distribute their profits in the form of dividends. When these types of companies attract investment, the price is pushed up and the yield down. At this stage an equity income manager will often sell, looking to reinvest the proceeds in the next high yielding opportunity. This discipline means the equity income manager often buys shares when they are cheap (undervalued) and sell them when they are expensive (overvalued) - the best principles of buy low and sell high.
A company which is paying a good and rising dividend often communicates strong financial wellbeing, since dividends ultimately come from earnings and profit. As the dividend increases, the value (andtherefore the price) of each shares should also rise, so as well as a healthy level of income, investors could also benefit from capital growth.
Dividends are often ahead of the rate of inflation and dividend growth overtime supports share price rises. Shelter these equity income funds in ISA and there is no further income tax or capital gains tax to pay (ISA limit £10,680 2011/12, £21,360 for a couple).
Income investors can withdraw the income, growth investors can reinvest the income; it works for both scenarios.
Please remember past performance is not a guide to future returns and income is variable and not guaranteed. It's important to note income yields could be lower or higher in the future. Higher rate taxpayers are subject to additional tax on the dividend yield unless held in an ISA or SIPP.
Danny Cox is head of advice at Hargreaves Lansdown, www.hl.co.uk/news/expert-commentInflation-proofing your investments