What effect does inflation have on my savings?

What is inflation?

Inflation is the general increase in the price of goods and services over time. It means money loses value, because when inflation goes up, the same amount of money buys you fewer things than it could before.

Inflation is happening constantly and you may have noticed it by the increase in the price of basic items over time. For example, here is how the average cost of a pint of milk has gone up over the last 50 years:

1973: 6p
1983: 21p
1993: 35p
2003: 37p
2013: 46p
Today: 68p

As you can see, the cost of a pint of milk is more than 11 times greater today than it was 50 years ago.

Inflation affects the value of your savings and investments, because if they go up more slowly than inflation, they will be able to buy less than when you initially put the money away.

How is inflation measured?

In the UK, inflation is measured using the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). These both track the changes in the prices of a "basket" of goods and services that represent typical household spending.

The Office for National Statistics (ONS) considers around 180,000 prices of 743 items every month that are commonly purchased in the UK.

Consumer Prices Index (CPI): The CPI measures the average price changes of a wide range of goods and services that most households purchase. This includes items like food, clothing, housing costs, transportation etc.
Retail Prices Index (RPI): The RPI is an older measure of inflation that was more widely used in the past. Like the CPI, it tracks the prices of goods and services, but it includes a broader range of housing costs, such as mortgage interest payments and council tax.

Both the CPI and RPI provide valuable insights into changes in the cost of living and the purchasing power of money.

Who benefits from inflation?

Typically, those who have debts tend to be the ones who benefit when inflation is high.

That’s because, as prices rise, the value of debt goes down in real terms. Borrowers can effectively repay their loans with money that's worth less than when they borrowed it, reducing the burden of debt.

For example, homeowners with fixed-rate mortgages in particular can see an advantage during periods of high inflation.

As prices go up, the value of real estate assets tends to rise too, which increases the equity in people’s homes. So this can mean that homeowners with a fixed-rate mortgage see the value of their property increase while their repayments stay the same.

However, as inflation can result in increased interest rates, like we’ve seen in the UK recently, those that don’t have a fixed-rate mortgage deal are often hit with hefty increases in their monthly repayments once these end.

How does inflation affect my savings?

Where borrowers can be the winners from inflation, savers are often the losers.

Inflation can erode the purchasing power of your money over time. As prices rise, the same amount of money buys fewer goods and services, effectively reducing the value of your savings.

While the amount of money in your savings may remain the same, the real value of your money goes down during inflationary periods. This is especially true if the interest rate of your savings account doesn’t keep pace with the inflation rate.

For example, if inflation is at 5%, but your savings are only earning 2% interest, your savings will effectively be losing value.

Inflation can also make it harder for you to add to your savings and reach your financial goals. Whether you're saving for a house, your education, or retirement, how much you’ll need to save to achieve these will go up with inflation.

Also, as inflation increases the cost of everyday items, it may mean that you’ll have less money available to put towards your savings.

How can I protect my savings from inflation?

If you want to reach your financial goals it’s really important to take steps to protect your savings from inflation to help them maintain their value or even grow.

Here are some tips designed to help safeguard your savings against inflation:

Find the best interest rate: Make sure that any cash savings you have are earning the highest interest rate possible. The closer your savings interest rate compared to the rate of inflation, the less value they will lose.
Diversify your investments: Spreading your savings across different types of investments can help reduce risk. Diversification can include a mix of things like stocks, bonds, and property. Each investment may respond differently to inflation, which could provide some protection.
Review Your savings regularly: Try to stay on top of the latest inflation updates. As economic conditions change, you may need to adjust your approach to protect your savings.
Consider long-term fixed-rate investments: Long-term fixed-rate investments can protect you from inflation movements with a guaranteed return. They can also offer higher interest rates than easy access accounts. However, if inflation drives interest rates up, you could end up stuck in an account paying a lower rate than the rest of the market.
Minimise cash savings: While it's a good idea to have some savings in cash which is easily accessible for emergencies, holding too much can leave your savings vulnerable to inflation. Consider exploring other options that could deliver more growth over the long-run.

Are there safe investments to protect me against inflation?

While no investment is entirely risk-free, some options may be able to help protect your savings against inflation.

Equity investments like stocks and shares have historically outpaced inflation and offered some protection.

This is because companies you invest in can increase their share price to keep up with the increasing costs that result from high inflation. Although investing in stocks can beat inflation, it can also come with risk. The stock market can be volatile and unpredictable and you could lose part, or even all, of your investment if things go wrong. You may want to consider only investing in a diverse range of established companies and ensuring you don’t invest money you may need to access soon, so you don’t have to withdraw when the markets are down.

Another option could be choosing a long-term fixed-rate bond for your savings. This would mean your money will be protected against inflation fluctuations for the term of the account.

If you’re unsure what approach is best for you, and your specific financial situation, it is always worth seeking financial advice. An independent financial advisor can talk you through your options and give you personalised advice based on your financial goals and risk tolerance.

How can I protect my pension from inflation?

It’s worth remembering that pensions are designed to be long-term investments that can span your whole working life. They’re built to weather fluctuations in the market, including periods of high inflation.

If you have a workplace pension that you pay into every month through your earnings, it’s worth keeping your payments up, even when inflation is high.

That’s because with most workplace pensions, your employer pays into your pension too and you also get tax relief from the government. This makes it a really effective way to save for retirement.

If you have a private pension, be very careful before deciding to change your investments. Money invested in a pension may fall in value during high inflation, but it is likely to hold its value better than converting it to cash.

How often should I review my savings strategy?

Regularly reviewing your savings strategy is essential to staying on track with your financial goals and adapting to changing circumstances.

As a general guideline, try to review your savings strategy at least once a year. This allows you to assess your progress, adjust your goals if needed, and evaluate the performance of your savings.

However, it’s worth considering reviewing more frequently when inflation is high, especially when changes to the Bank of England base rate have been announced.

You should also always assess your savings if you’re going through any personal changes, like a new job, or when you need to change your savings goals.

Staying on top of your savings strategy ensures it is consistent with your objectives. It also gives you the best chance of protecting your savings from inflation and achieving long-term financial success.