cash clinic: ensuring savings and investments keep pace with inflation

28th August 2010

The Scottish private client and financial services team answer your queries, this week: how do you ensure savings and investments keep pace with inflation?

Q Over the years I have amassed a fairly substantial investment portfolio, which I hope will support me through my retirement years. However, the current economic climate makes me increasingly concerned about whether my savings and investments are actually making me money. Could you advise me as to how I can ensure my savings and investments keep pace with inflation?

A In the context of savings and investments, inflation is assessed in terms of the negative effect it has on returns. Essentially, inflation will erode the purchasing power of the funds invested, but the effect of inflation, unlike taxation and charges, is often not appreciated when choosing the most suitable investment or investment strategy.

Cash savings are impossible to protect against inflation because the interest rates available seldom match the rate of inflation. While the cash amount will appreciate in line with the interest rate, the underlying real value will be eroded.

Investment portfolios can incorporate vehicles that negate the effect of inflation. Traditionally, NS&I index-linked savings certificates offered investors an investment return that kept pace with inflation, but this option is no longer available after being withdrawn last month.

Another investment offering protection against inflation is index-linked gilts. Compared with conventional government gilts or corporate bonds, these tend to have a lower yield and their value moves in line with investors' expectation of inflation rate changes.

Therefore, while they factor in inflation, they can be volatile and do not offer any protection against loss in value. Typically, they could be used as a component part of a well-diversified portfolio.

Real assets such as commodities and property can also offer a hedge against inflation. These should be seen as longer-term investments only and as they tend not to move in synchronicity with inflation, they provide long-term protection only.

Historically, equity investments will offer returns ahead of inflation in the longer term. The investment term is crucial to achieving the average investment returns that will exceed the average rate of inflation over the same period.

A possible strategy may be to invest in stocks or funds that produce a high dividend yield. Dividend income can often be higher than the current rate of inflation, but in the long term this does nothing to protect the capital against inflationary effects.

The inflationary effect has hit pensioners particularly hard as their income becomes fixed and the majority of this income is spent on essential goods and services that have experienced huge price inflation, such as utilities and food.

There are products available that will provide inflation-proofing. Index-linked or escalating annuities increase either by a fixed amount or by the rate of inflation. Escalating annuities will provide the annuitant with a lower starting income when compared with their conventional counterpart - sometimes as much as a third lower.

As with any such products independent financial advice must be sought.

Christian Poziemski is a wealth manager within the private client and financial services division of HBJ Gateley Wareing.