Inflation is one of the most significant financial challenges individuals face in today’s economy. As prices for goods and services rise, the purchasing power of money declines, which can have a significant impact on personal savings. While inflation might seem like a distant or abstract concept for many, its effects on savings are very real and can erode the value of your hard-earned money over time. In this blog, we’ll explore the damage inflation can do to savings, provide examples, and discuss how you can protect your wealth from its harmful effects.
What is Inflation?
Inflation refers to the rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of a currency. In simple terms, as inflation increases, each unit of currency buys fewer goods and services. For example, what you could purchase for £100 today might cost £105 a year from now, assuming inflation is around 5%.
Inflation can result from various factors, such as an increase in demand for goods and services, a reduction in supply, or expansionary monetary policies that increase the money supply. While a moderate level of inflation is considered normal and even necessary for economic growth, high inflation can lead to significant challenges for consumers and savers.
The Impact of Inflation on Savings
- Erosion of Purchasing Power. The most immediate impact of inflation on savings is the loss of purchasing power. If your savings are not growing at a rate that outpaces inflation, the real value of your money decreases. For instance, let’s say you have £10,000 saved in a bank account with a 1% interest rate, while inflation is running at 3%. Over time, the purchasing power of your savings will decline because the interest you earn on your savings will not be enough to keep up with rising prices. For example, if inflation is 3%, the same £10,000 you’ve saved will buy fewer goods and services in a year. In practical terms, you might find that your money no longer stretches as far when it comes to making purchases. This means that the value of your savings, in terms of what you can buy, diminishes.
- Savings Accounts Provide Insufficient Returns. One of the most common places people put their savings is in a traditional savings account, which offers a relatively low interest rate. In recent years, many savings accounts have paid low interest rates . While these accounts provide safety and liquidity, the interest rate after income tax that’s generated typically fails to keep up with inflation, meaning the value of your savings is eroded over time. So, despite earning interest, your savings have actually lost value in real terms.
- Long-Term Effects of Low Returns. Over time, the damage inflation does to savings compounds, especially if inflation is persistent. Let’s say you have a personal pension and you’re putting away money for the long term. If the return on investment in your account is lower than the inflation rate, the money you are saving today will have less value when you retire. Consider this example: you put £100,000 into a personal pension, and the return is 2% return annually, while inflation is 3%. After one year, your £100,000 would have grown to £102,000, but the cost of goods and services would have increased by £3,000 in real terms. Despite earning a 2% return, the real value of your savings has decreased, and you are falling behind in terms of purchasing power.
- Impact on Fixed-Income Investments. Inflation can also be particularly damaging to fixed-income investments, such as bonds, which provide a predetermined interest payment. As inflation increases, the real value of the fixed interest payments you receive decreases. This is especially problematic for individuals who are living off their savings in retirement, relying on fixed-income investments to provide regular income. For instance, suppose you own a bond that pays a fixed interest rate of 3%. If inflation rises to 5%, the purchasing power of your bond’s interest payments has effectively been reduced by 2%. While you’re still receiving the same nominal amount, your ability to purchase goods and services with that money is diminished.
Real-World Examples of Inflation’s Impact
Let’s look at a few real-world examples of how inflation can erode savings over time:
- The £100,000 Example. Imagine you’ve saved £100,000 over a period of years, with the goal of using it to purchase a home. If inflation averages 3% annually over the next decade, the cost of a home you’re looking to buy could rise significantly. What you could afford today for £100,000 might cost £134,391 in 10 years due to inflation. In this case, the value of your savings hasn’t kept pace with the rising costs of housing, which could affect your ability to purchase the home you want.
- The University Fund Example. If you’re saving for a child’s education, inflation can be a huge factor. University costs has historically outpaced inflation, meaning the amount you save today may not be enough to cover the costs in the future. If you save £20,000 for your child’s university education and inflation causes tuition to increase by 5% annually, in 10 years, the cost of tuition might exceed £30,000—rendering your £20,000 savings insufficient.
How to Protect Your Savings from Inflation
While inflation can have a damaging impact on savings, there are strategies you can use to help protect your wealth:
- Invest in Assets that Outpace Inflation. Other investment vehicles often outperform inflation over the long term. By investing in assets that tend to appreciate, you can potentially protect your savings from the eroding effects of inflation. For example, the stock market has historically outpaced inflation by a significant margin over long periods of time.
- Diversify Your Investment Portfolio. A diversified portfolio can potentially provide better protection against inflation than holding cash or low-yield savings accounts. This helps spread risk while potentially increasing your returns.
- Consider Inflation-Protected Securities. Some government bonds are specifically designed to protect against inflation.
Final Thoughts
Inflation is a silent but powerful force that erodes the value of your savings over time. Without careful planning and investment, the money you save today may not be enough to meet your needs in the future. By understanding the risks inflation poses to your savings and taking proactive steps to invest in assets that outpace inflation, you can protect your financial future and preserve the purchasing power of your hard-earned money.
- To find out more about how you can invest your money for your future contact us today or take a look at the services we have on offer.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested.