The Office for National Statistics (ONS) announced earlier this week that inflation is back on the rise with an increase from 0.60% in August to 1% in September.
Inflation has been low in recent years but a weakening currency, amongst other factors, has however seen general prices begin to creep up.
I regularly discuss inflation with clients and while most understand the general concept, it becomes far more of a concern when we look at the way this materially impacts their wealth over the long-term.
As most will know, inflation is the rate at which the general price of goods and services is rising. This is an integral part of economic growth but consequently leads to a decrease in the purchasing power of your money.
Depending on your view of the world, the most common measures of inflation are the Retail Price Index (RPI) or the Consumer Price Index (CPI). These indices are based on the movements in price of differing baskets of good/services and you can argue the toss which of these is most accurate or relevant.
Inflation in action
One of my more reluctant chores is the weekly food shop. Let’s say that today my trolley full of food (and male facial moisturisers) comes to £100.
If I return to the supermarket in one year’s time to buy the exact same items and the rate of inflation in the intervening period has been 5%, it will now cost me £105 to purchase that same trolley of goods.
Simple to understand in this scenario but what about the long-term impact?
5% might seem like a high figure to use in the above example as we’ve become accustomed to a low rate of inflation.
While we’ve never seen anything like 1920’s German hyperinflation in this country (when the price of a loaf of bread went up from 1 to 1.5million Marks in just 5 years), inflation can and does spike. Take a look at RPI levels in the UK over the last 30 years:
How does this affect your investments?
First off, an investor needs to take a view on the average rate of inflation (4% is a reasonable starting point).
They then need to consider how their money is currently invested and the potential range of returns this can realistically achieve over time. They also need to consider their income tax position, as tax will also take a bite out of their investment returns.
The best way to illustrate how inflation can materially impact your wealth and lifestyle is to use a simple example:
- Donald has prudently put money aside over the years and has now reached retirement.
- He’s amassed a pot of £1m in savings, investments and pension funds.
- He needs £40,000 each year (after tax) to enjoy a comfortable lifestyle and to travel.
- He expects inflation to average out at 3% per year.
Donald would like this money to last at least 30 years, and if possible leave some money to his wife Melania and his five children. This is how much of his £1m would be left after 30 years based on different rates of investment growth (or interest):
This might be uncomfortable reading for Donald, particularly as it doesn’t take into account other possible outlays, such as helping children buy a house, later life care costs, etc.
You can see why it’s so important to (a) put enough money away in the first place, and (b) give it the best opportunity to generate strong returns over time.
Where should you invest?
Savings accounts have their place in financial planning, but will do you no favours in the long run.
Interest rates have been in the doldrums for the last seven years (the base rate was recently cut to just 0.25%), so you won’t find many savings accounts paying enough interest to cover the rate of inflation and the tax you pay on that interest.
If you feel it’s important for your money to have any chance of lasting your lifetime, you have little choice in today’s world but to step out of cash and accept some level of risk.
Property will always be an attractive proposition but this comes with considerations. You need to weigh up if you’re comfortable with potential management headaches, high set-up costs and its tax inefficiency.
Managed portfolios or funds containing Stocks, Shares and Bonds can certainly do as good a job as property over time and are far more flexible and tax friendly.
You may already have money in managed investment and pension funds but don’t get complacent. Investment performance between fund managers can vary widely, so it’s important that you or your financial adviser objectively assess whether the managers are delivering returns in line with your risk profile and where these sit relative to inflation.
Beyond these conventional approaches, you’re venturing into investments that involve more speculation and more risk e.g. currency and commodity trading, investing in start-up companies/your own company, etc.
Ultimately, you need to decide what type of investment strategy is right for you given your level of knowledge, available time and most importantly, how you want to live your life today and in the future.
Sound financial planning isn’t about plonking money in an investment and hoping for the best. It’s understanding what you’re aiming for in the future, the impact of silent enemies (like inflation) and then deploying your resources as efficiently and effectively as possible.
Please get in touch if you need help understanding how you can inflation-proof your wealth more effectively.
Thanks for reading.