Why your personal inflation rate is important.jpg

Why your personal inflation rate is important


Financial Correspondent, Blevins Franks

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THE COST of living rises year after year without fail. We all notice this, so why do so few people consider inflation to be a threat? Why do some people go out of their way to avoid taxation but don’t bother to protect against inflation? Inflation reduces your income and capital as surely as taxation does.

Perhaps it’s because they are used to their salaries rising along with inflation and don’t appreciate that inflation is much more detrimental once they are retired and that they now need to take steps to protect their income and capital. Perhaps it’s because two per cent (the official target) doesn’t sound dangerous but you’d be surprised what effect it will have on your spending power when compounded year after year.

And very likely it’s because it’s easy to brush off an apparently low figure like two per cent without realising that this is just a general, average figure and that your personal rate could be four per cent, or six per cent or more. Data shows that the inflation rate for retired people in the UK was as high as nine per cent a few months ago!

Basket of goods

Governments measure inflation using a ‘basket of goods’. Each month they check the price of a range of goods and services to establish how much they’ve gone up. The result is a general, national figure. To establish how much your cost of living is rising, you need to look at the goods and services you spend your money on. There are likely to be key differences to the national basket.

To give an example, in the UK the price of food rose by 16 per cent over the last 10 years, while restaurant meals rose 40 per cent. If you go out to eat often, your rate of inflation will be higher than someone who eats at home.

Recent additions in the UK basket include DVD recorders, satellite navigation systems and mobile ring tones. Are these items you’ve bought recently or intend to buy? Brussels sprouts and vegetable oil have been replaced by broccoli and olive oil in the basket but perhaps good old sprouts are still your favourite.

The official data takes no account of different groups of people. There is no separate official measure for pensioners, even though their inflation rate is usually the highest of all groups and they are most vulnerable to the eroding effects of inflation on their income and savings.

Taking an average personal inflation rate of four per cent, if you had 100,000 euros in the bank (withdrawing the interest), after five years inflation would have reduced its spending power to 81,537 euros. Your money would have lost 18 per cent of its value in this short space of time.

After 10 years, its value would be 66,483 euros (a fall of 34 per cent from the original 100,000 euros) and in 20 years, you’ll be looking at a loss of spending power of 56 per cent. The 100,000 euros will be worth just 44,200 euros.

Inflation also reduces the amount of ‘real’ return you receive from your savings. Headline rates of return are of little value, you should only be concerned with the real rates of return, i.e. the return above inflation.

For example, last year UK interest rates were considered to be fairly attractive compared to earlier in the decade. And yet, according to the reputable annual study by Barclays Capital, cash only offered an annual real return of 0.4 per cent!

To make matters worse, these real returns are calculated using the official rate of inflation and don’t take your personal rate into account. And of course, your returns are also significantly reduced by taxation, and they are taxed on the interest you earn on paper, not on your real returns.

Everything considered, a retired person is more than likely to be receiving a negative real rate of return from their bank deposit account.

The only way to defeat inflation in the longer-term is to be invested in a well diversified portfolio of real assets like property, equities and bonds. You need to plan for the longer-term and the prospect of higher inflation or you’ll find that your spending power has eroded. If you do not beat inflation, your living standards will decline.

Protect yourself

When considering savings and investments, you need to look beyond the current returns. You may currently find that returns offered by some investment funds are similar to those offered by some bank deposit accounts. However, in a few years time, the investment fund is very likely to be returning much higher income and growth than the building society.

Interest rates are not set to help savers earn money. While Central Banks do want to encourage people to save, their primary aim is to keep inflation low, protect the currency and maintain a stable financial system.

High interest rates can have a negative affect on the economy. Six per cent rates may be available today but they will fall again over the coming years, possibly in the near future.

However, if you opted to invest in a bond fund, for example, then you can expect rates of over six per cent to continue over the coming years, plus earn some capital growth. You can also set up your fund to be tax efficient, something you can’t do with cash in the bank.

Whether you need to ensure your money lasts for the rest of your life and is sufficient to meet all future expenses, or you want to leave as much as possible for your heirs, there are steps you can take to help protect your income and capital from inflation, and from taxation too!

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