Guard yourself against the dangers of biting inflation

INFLATION is a silent thief that can rob the value of your investment capital. The consumer price index rose by 2.7 per cent in the year to October, up from 2.2 per cent in September. Though some argue that it will come down again, it has overshot the Bank of England’s 2 per cent target for 35 months. Some, like investment manager Henderson, forecast that it will exceed 3 per cent in 2013.

Inflation erodes the purchasing power of your money. “Most investors don’t realise the impact that it has on their investments over the long-term,” says Ben Yearsley of Charles Stanley. A £2 purchase today would only have cost £1 in 1992. And investors shouldn’t forget that if your investments grow by 2 per cent, and inflation is 3 per cent, you will have lost 1 per cent in real terms.

Investors often put money into cash Instant Savings Accounts (Isas), believing them to be a safe store of wealth. They allow you to earn interest tax-free, but make sure you consider their returns against inflation.

According to MoneySupermarket, Buckinghamshire Building Society’s Chiltern Gold Nuggets cash Isa is the highest paying Isa, offering 3.50 per cent annual equivalent rate (AER). However, it doesn’t allow transfers in, and the maximum monthly contribution is only £470. There are other restrictions: only one penalty-free withdrawal is allowed per tax year; any more and you’ll only receive a woeful 0.1 per cent AER. If inflation spiked, it would also offer little cushion to ensure a positive real return. Other Isas have smaller cushions and more restrictions, like locking your capital away for long periods.

But Isas still offer better real returns than an ordinary savings account. MoneySupermarket suggests that there are only 11 ordinary savings accounts that allow basic rate taxpayers to beat inflation, and they are all fixed rate bond accounts (crucially for City A.M. readers, there aren’t any for higher rate taxpayers). Inflation proofing your portfolio with bond accounts is not wise, says Yearsley: “You are buying a fixed-stream of income, and inflation is the worst thing for that.”

Paying tax on your interest will eat further into your investment’s real value. You will need to earn 3.39 per cent AER to gain any real saving benefit, higher rate taxpayers will need 4.51 per cent, and top rate taxpayers will need 5.41 per cent.

Jason Witcombe of Evolve Financial Planning says that while investments like cash Isas and bonds are important, you will need to look further to beat inflation. Much depends on your objectives. Identify why inflation is a problem and concentrate on the medium term. Those closer to retirement, typically with higher fixed-income allocations, could focus on inflation-linked products, which aim to protect capital and income in real terms. Some advisers recommend corporate bonds, but their popularity has made them expensive. For example, the M&G UK Inflation Linked Corporate Bond fund, which can be held in a stocks and shares Isa, has grown income by 4 per cent over the last 12 months, but it has an initial charge of 3 per cent.

Those with a longer timeframe could consider equity-income funds, which invest in high-quality companies with strong track records of dividend growth. “Equity income should be the bedrock of most investor’s portfolios,” says Yearsley. One popular option is the Invesco Perpetual High Income fund. It has grown at an annualised rate of 11 per cent over the last five years, and currently yields 4.24 per cent. It can also be held in a stocks and shares Isa.

Of course, these funds can be risky, offer less certainty and don’t guarantee returns. But inflation means that cash sitting in your bank account isn’t safe either. “Take risk, and accept that cash isn’t safe itself,” says Witcombe. He also advises being mindful of costs associated with investing. “Just as the compounding effect of inflation is important, so is the compounding effect of costs.” He favours low-cost equity trackers, such as the Vanguard FTSE UK Equity Index fund, tracking the FTSE All-Share Index.

The investment environment demands that investors step outside of their comfort zone if they want to beat inflation. This certainly won’t suit everybody. But catching the inflationary thief will never be without risk.