Eroding the purchasing power of your money
The impact of the cost of inflation on savings and investments, especially of those retirees living on a fixed income, is an important issue. But it’s also not good news for other savers and investors, as it can erode the purchasing power of money.
Inflation is officially defined as the sustained rise in the general level of prices of goods and services in the economy. On a basic level, the buying power of an individual pound decreases when the price of everything has increased. Low interest rates also don’t help, as this makes it even harder to find returns that can keep pace with inflation and rising living costs.
If inflation becomes too high, the Bank of England may increase the bank rate to encourage us all to spend less and to save more. They can use the bank rate (the interest rate it sets) to control inflation. The higher the rate, the more incentive individuals and businesses have to save rather than borrow money, meaning they’ll receive higher returns from their savings but have to pay more for any loans.
There are a number of different factors which may create inflationary pressures in an economy. These include rising commodity prices that can have a major impact, particularly higher oil prices, which translates into steeper petrol costs for consumers.
Investments are usually a better option than cash savings if you want to protect or grow the real value of your money, although it is still worthwhile holding some of your assets in cash as opposed to investments, as this will help to protect your money during more volatile periods.
Historically, investments such as shares and bonds have outperformed cash – particularly over long periods, although remember that past performance isn’t a guide to future performance. So if you’re saving for your retirement, investing can put you in a stronger financial position and put you on track towards your dream retirement.
Different asset classes provide varying degrees of protection against inflation. Equities are often cited as being one of the best long-term defences. Intuitively, this makes sense. On a basic level, by investing in shares of companies, as the price of goods rises so too do the profits the companies earn on those goods, and in turn the returns to shareholders.
So although they have the potential to be more volatile, stock market investments have historically performed well, benefiting from the earnings of companies usually rising along with inflation and reinvesting dividends. It is these dividends that help in the battle to beat inflation, particularly when returns compound.
Changes to pension legislation in more recent years have given us all more freedom about how we use our pension pot and when we take that money. This means you can leave your money invested until you’re ready to take it, and then release it gradually, rather than being at the mercy of stock market performance on the day of your retirement.
This also means that you’re giving your money more opportunity to grow in value and to beat the cost of inflation.