Over the last few months, inflation has never been far from the headlines. As of March 2023, the Office for National Statistics reports that inflation stood at 10.1%, meaning that the cost of goods and services had risen by more than a tenth in the previous 12 months.

The main drivers of inflation have been:

• Food and drink (up 19.2% in the year to March 2023)
• Housing and household services (up 11.6%)
• Restaurants and hotels (up 11.3%)
• Furniture and household goods (up 8%).

In simple terms, inflation means that the value of your money is reducing in real terms. You can’t buy the same quantity of goods and services as you could this time last year.

However, this is not something everyone fully understands. A recent survey by Aviva has revealed that more than half of Brits don’t understand the impact of inflation on their cash savings, and consequently their buying power.

Read on to find out more, and to fully understand why inflation can have such a detrimental effect on cash savings.

Just 44% of Brits understand the impact of inflation on savings

The recent study by Aviva asked a series of questions to explore people’s understanding of some basic financial principles, including the impact of inflation and compound interest, and the concept of risk and reward.

Worryingly, the insurer found that only 44% of the respondents correctly identified the buying power of money when savings interest rates and inflation rates are taken into account. Even among those who described their financial knowledge as “very or moderately good”, only half got the answer right.

Sam Mirehouse from Aviva says: “Understanding […] the way inflation can eat into the buying power of our savings [is one of the] basic building blocks for making good financial decisions, and yet our research showed a significant proportion of consumers are not clear on the difference they can make.”

One of the reasons that confusion may exist is because the high inflation rate has led to much higher interest rates. The Bank of England (BoE) has increased interest rates 12 times between December 2021 and May 2023.

The theory goes that, if people have less money to spend as the cost of borrowing such as mortgages rises, they typically purchase fewer items. This can reduce the demand for goods and, as a result, helps to slow price rises.

So, it may be logical to think that inflation is a good thing, as it means the interest you’re earning on your cash savings may be increasing. However, there still exists a significant gap between the interest you earn and the rate of price growth.

Inflation eats into the real value of your cash savings

Here’s how inflation affects cash savings:

• An inflation rate of 10.1% means goods and services that cost £100 a year ago cost £110.10 now.
• As of 10 May 2023, Moneyfacts say the best interest rate on an easy access savings account is 3.71%. If you invested £100 a year ago at this rate, you’d have £103.71 now.

Over the year, the value of your savings has fallen in real terms. That is, you can buy less with your cash than you could a year ago.

In time, inflation can have a significant effect on the value of your savings.

Research by pension provider Royal London goes one step further to show the effects of inflation on £10,000 in savings.

If these savings were kept in a high street savings account for 10 years against a 4% inflation rate, the purchasing power of the savings would decrease by more than a quarter to £7,224.

Investing can help your wealth to keep pace with inflation

In a world of elevated inflation, it’s likely to be difficult to find savings accounts that pay interest that will see the value of your wealth keep pace with inflation.

Of course, it is important to retain some cash. Having three to six months of expenses in an emergency fund ensures you always have cash available when you need it in a pinch. Plus, if you’re planning to retire in the next few years, holding some cash can protect you in the event of market volatility.

However, if you are looking at a time horizon of five years or more, investing can give your wealth the potential to keep pace with rising prices.

Using the example above, Royal London considers what would happen to the purchasing power of your money if you’d invested £10,000 into a pension instead of in cash savings.

Assuming a projected annual growth rate of 4.56% (the current mid-rate assumption for Royal London’s GP4 ‘low medium risk’ investment approach) and with an annual charge of 0.45%, after 10 years your savings would be worth £10,650 (assuming a 4% inflation rate).

Unlike cash savings that have fallen in value in real terms, investing would have seen a real return on your wealth.

Get in touch

If you’re worried about the effect of inflation on your wealth, talk to us.

To find out how we can help you, please get in touch. Email info@blueskyifas.co.uk or call us on 01189 876655.

Please note

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.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.