Investment risks – the basics
Inflation risk explained
By Michael Trudeau
Article 3 of 6
Inflation risk explained
Learn how inflation can erode your savings and how to beat it.
Inflation risk is the threat of rising prices eroding the buying power of your money.
Until it was cut to 0.25% in August 2016, the Bank of England base rate had stayed at the historic low of 0.5% since 2009, meaning savings rates have also been at rock bottom. In many cases, they have been lower than inflation, meaning that the returns savers are making on their money are not enough to keep up with the rising cost of living.
Inflation risk to savings
Unless your money is in an Isa, or you are a non-taxpayer, you could pay tax on your savings, which means you need to earn an even higher interest rate to keep pace with inflation after tax has been deducted.
If, for example, inflation is at 2% and you pay basic-rate tax of 20% on your interest, your money would need to be in an account paying 2.5% for the real value of your money to remain the same, and higher than 2.5% for it to go up. Note that this calculation does not take account of the savings allowance, by which basic rate taxpayers don't pay tax on the first £1,000 of savings interest, while higher rate taxpayers avoid tax on the first £500 of savings interest. Given that rates are low, it's quite possible the amount you earn on your savings falls well within these allowances.
What this tells us is that keeping all of your savings in cash is not actually the 'risk-free' solution it's sometimes assumed to be. If the returns you get on your money are unable to at least match inflation, then your money will effectively be losing value each year.
Find out more: Finding the best savings account – seek out an inflation-beating return.
Inflation risk in retirement
Inflation can be a risk at any stage of your life, but it can be particularly damaging when you're retired, as you would typically not want to expose too much of your money to riskier assets such as shares. And if you're living off income from an annuity that is not linked to inflation, you could see your real income drop over time as the buying power of each payment diminishes.
There are several index-linked savings accounts and investment products available, which are built to beat the risk of inflation, although they often require you to lock your money up for a number of years. These can work well if inflation remains high, but if it drops during the term of your agreement then you might miss out on higher returns elsewhere.
Find out more: Planning for retirement – the Which? guide.
How to beat inflation through investing
Investing your money on the stock market is often seen as the best 'hedge' against inflation. Taking on additional risk with your savings can potentially provide returns that outstrip the rising cost of goods and services. However, taking on this additional risk means you could also lose money.
Find out more: Which? investment portfolios – we've created a unique set of investment portfolios that can help you decide where to invest your money, balanced with how much you're willing to put at risk.
- Last updated: June 2017
- Updated by: Michael Trudeau