Inflation and how this impacts you

What is inflation?

Inflation refers to the way that prices for goods and services increase over time.

An easy way to measure inflation is to compare the cost of things today with how much they cost in the past. So, if inflation is 2%, it means prices are, on average, 2% higher than they were a year ago. If a loaf of bread cost £1 a year ago and it now costs £1.02, its price has risen by 2%. That doesn’t sound like much, but it adds up over time.

The effect of inflation is more pronounced over longer periods of time. According to the Bank of England’s inflation calculator, goods and services costing £10 in 1980 would cost £43.85 today. This is because inflation averaged 3.8% over the last 40 years.

How does inflation affect me?

Higher food and household bills are the most noticeable effects of inflation. If your salary hasn’t kept up with inflation, you might find your household finances are squeezed. Home energy and fuel prices are a large expense for many households and it seems that they have a rate of inflation all of their own right now, so without some disposable income or savings to cover the shortfalls, households may need to do some serious budgeting to afford the increases.

A less obvious effect of inflation is the way it erodes the value of your savings. Let’s imagine you have £100 sitting in a zero-interest bank account. Over time, inflation will reduce the ‘real’ value of your £100. After 5 years, you’ll still have £100, but you’ll be able to buy significantly less with it than you could at the start. Although interest rates have been rising, they are still historically low, with the Bank of England base rate currently at 1.25%. It was 17% in June 1980! We rarely see banks passing on base rate rises via their savings accounts, therefore there are still a lot of accounts paying less than 0.5%. Although it is important to retain an emergency fund in a deposit-based account (Savings) anything over that (providing you have appetite for risk and can invest for at least 5 years) has more chance of keeping pace with inflation if invested in a market-based investment aligned to your risk profile and objectives.

But haven’t market-based investments performed terribly recently?

No, not in the long term. A medium risk portfolio has averaged 19% growth in the last 5 years and 97% in the last 10 years. Depending on what time frame you take that is between 3.8% and 9.7% per annum. That 10-year period now includes this most recent drop, Covid and Brexit, and the portfolios still have incredibly strong performance. If you took the last 6 months on its own then yes, markets have fallen, as they did during covid (recovering quickly) and numerous other times, but the markets have always recovered. Covid is an excellent recent example of this but there are other times it has recovered too such as, after the financial crisis and even the second world war.

If you’re saving for a long-term goal, like retirement, then it’s really important to factor in inflation. You might think saving up £600,000 will set you up for a comfortable retirement but, in 20 years’ time, that £600,000 won’t go as far as it does now. You need to seriously consider investments that give you a much better chance of keeping pace with inflation.

Pension freedoms have also helped here. Historically you had to ‘de- risk’ your portfolio just before retirement, as most people used their whole pension pot to buy an annuity. Therefore, if the pot was considerably smaller at your chosen retirement date, due to a market fall, this would impact your income for life. With flexible access drawdown, introduced in 2015, you can keep the majority of your pension invested for recovery and only take out what you need on a monthly basis.

How do I protect myself from inflation?

To prevent inflation from eroding your savings, you need to ensure that your money grows at or above the inflation rate. The rate of inflation changes from year to year, and even month to month. Ten years ago, the rate was above 5%. You cannot assume it will stay as high as it is now, equally you cannot assume it will always be low, even though governments target low inflation rates.

Over the last 40 years, inflation has averaged 3.8%, which means that unless your money has grown by at least 3.8% each year, its real value will have fallen.

Interest rates on cash are typically below inflation and currently very low. The highest rate on an easy access savings account is around 0.6%, while the highest rate on a five-year fixed-rate savings account is 1.8% (as of 23/06/2022)

If you keep all of your money in cash, there is a high chance it will lose value over time, which could put your financial plans in jeopardy.

Is it possible to beat inflation?

Investing in the stock market gives your money the opportunity to beat inflation and grow in value. Equities carry investment risk, but history demonstrates that, over the long term, they tend to outperform cash and produce an above-inflation return.

The important thing to remember is that equities go up and down in value. This means you should invest for the long-term – at least five years – and spread your money across different asset classes, sectors and regions. By diversifying your money, you can reduce the impact of one asset or a particular sector falling in value. Our advisers can help you with this.

Why is financial planning important and why will this help with inflation?

Financial planning doesn’t concentrate on products and specifics. It concentrates on you and your income, outgoings, assets and liabilities. It concentrates on your objectives and whether you have enough financial resources to achieve what you want to do.

Financial planning software can include inflation and we can change that rate of inflation to see how higher inflation will impact your long-term plans. This can also highlight gaps that you have and give your adviser the information they need to be able to recommend the most appropriate solutions for you. We can also illustrate volatile markets and variable market conditions to stress test your plans.

Recently we have been modelling higher rates of inflation for our clients to see how that impacts their long-term planning and if higher inflation has created gaps, we can then advise the best way for our clients to navigate the situation. There is often a solution for the majority of problems.

Higher inflationary times are a great time to revisit your expenditure. We are living in times where we have a record number of subscriptions from Netflix and Sky to Spotify and Audible. Spending on takeaway coffees, lunches and dinners is at an all time high. If there are gaps in your planning, there are usually spaces in your budget where savings can be had. Equally if there are no gaps in your planning, budgeting is still a great idea, however, if you know (through financial planning) that you can comfortably afford that trip to the restaurant no matter what, then why not!

Checking your budget will let you know what your true expenditure is and with energy prices increasing chances are your monthly outgoings will increase. Unless you have other areas where you can cut back you will need to include these new figures in your new financial plan with your adviser and then we can build inflation into that for the future to reflect how that will look in the long term.

Inflation is an issue and the increasing cost of living is never going to be an area that we are happy about but it is happening. The government have various tools at hand to reduce this and they are targeting to bring the inflationary rate down within 2 years, but will prices decrease then? Unlikely. Making it very important to consider investments with more of a chance to keep pace with inflation.

Our advice throughout an inflationary rise, interest rate rise, recession, war, financial crisis, property crisis etc is to stay calm, stay away from the headlines, stay invested and stick to the plan you made with your adviser. They can advise on any corrections you need to make to still hit your financial goals.

Remember it is our job to help you achieve financial peace of mind so if you are ever concerned, we are here to help.

For anyone that hasn’t considered financial planning please do. It can help hugely with financial peace of mind and the advice that often follows planning can make sure you are using all available tax allowances and are invested in the most appropriate investments to meet your goals.

If you would like to speak to one of our fully qualified advisers and planners please get in touch.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.