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How do inflation-linked savings accounts work?

How do inflation-linked savings accounts work?

Category: Savings

Updated: 01/05/2014
First Published: 18/08/2011

MONEYFACTS ARCHIVE
This article was correct at the time of publication. It is now over 6 months old so the content may be out of date.

If you're a saver, it's all about inflation at the moment. As of 16 August 2011 inflation is sitting stubbornly high – the Consumer Prices Index (CPI) at 4.4% and the Retail Prices Index (RPI) at 5.0%.

The savings rate you'll need to beat these figures will be difficult to find – especially with the Bank of England Base Rate remaining resolutely at 0.5%.

You need to earn 8.33% to keep pace with inflation!

Depending on what type of taxpayer you are, you might need to earn a gross interest rate of 8.33% to keep up with RPI inflation. If you save into a cash ISA – you'd need to earn 5.00% to beat RPI.


Non-taxpayers and Cash ISA savings Basic Rate Taxpayers Higher Rate Taxpayers
Consumer Prices Index (CPI) 4.40% 5.50% 7.33%
Retail Prices Index (RPI) 5.00% 6.25% 8.33%
Information correct as of 16.08.11

There are no normal savings accounts that will beat CPI or RPI inflation – the only accounts that beat this are a couple of 5 year fixed rate cash ISAs… and, of course, the inflation-linked accounts.

Meet the inflation-linked accounts

High inflation and low interest rates have prompted a flurry of inflation-linked accounts to be released. These are complicated products – and work in different ways. Here's a brief outline of the products currently available:

Provider
Account
Rate
Term
Minimum Investment
Cambridge BS
Inflation-linked Bond 1.00% plus RPI 16.9.16 £5,000
Post Office
Inflation-linked Bond Issue 2 0.50% plus RPI 10.10.14 £500
Post Office
Inflation-linked Bond Issue 2 1.50% plus RPI 11.10.16 £500
Santander
Inflation-linked Bond Issue 4 110% of the growth in the Retail Prices Index (RPI), or a guaranteed minimum return of 12%, plus original investment returned 1.4.17 £1
Yorkshire BS
Protected Capital Account – Inflation-linked 8 100% of the growth in the Retail Prices Index (RPI), or a guaranteed minimum return of 16%, plus original investment returned 17.10.17 £3,000
Yorkshire BS
Protected Capital Account – Inflation-linked 7 100% of any annual growth in the Retail Prices Index (RPI), or a guaranteed minimum of 0.25%, plus original investment returned on maturity 17.10.17 £3,000
* Interest earned tax-free
Source: Moneyfacts.co.uk 07.09.11


How do inflation-linked accounts work?

So how do these accounts work – and more importantly, what might you get back if you invested in one?

1. The account that pays a percentage of growth in RPI
These inflation-linked accounts work by paying the percentage of the growth in RPI over the term of the product. If RPI does not increase by a minimum amount within the term, then a minimum percentage return will be applied to the account.

For example, you take out an inflation-linked product that guarantees to pay 100% of the growth in RPI in the next 5 years or a guaranteed minimum return of 15%. So if RPI does not increase by at least 15% in this time, then you are guaranteed to get 15% back on your original investment.

Between July 2006 and July 2011 the Retail Prices Index increased from 198.5 to 234.7 – that's an 18% increase over the 5 year period. So if you invested £10,000 and RPI increased by 18% over the next 5 years, you'd earn £1,800 in interest at the end of the term.

2. The account that pays RPI plus a set amount of interest
This type of inflation-linked account works by paying the percentage of growth in RPI over a set term, plus a little bit of interest on top. Unlike how RPI is paid in the previous example, this type can be paid on increases each year – allowing you to also benefit from compound interest.

For example, you take out an inflation-linked product that pays growth in RPI plus 0.5%. So, between July 2010 and July 2011 the Retail Prices Index increased from 223.6 to 234.7 – that's nearly a 5% increase. So if you invested £10,000 you'd earn £496 in year 1, plus £50 (the extra 0.5% interest) making a total of £546.

For the second year you would earn interest and inflation-linked based on your new balance of £10,546, and so on until the end of the term.

Do inflation-linked accounts beat inflation after tax?

Most inflation-linked accounts will all be subject to income tax, just like a normal savings account.

The exception to this rule are the Yorkshire BS Projected Capital Accounts, which offers the option for you to invest cash ISA funds (they also allow ISA transfers) and benefit from paying no tax.

Are inflation-linked products better than normal savings accounts?

That's the million dollar question isn't it? The simple answer is that it's impossible to say.

It all depends on whether inflation remains consistently higher than interest rates over the term of the account. If they do then it's quite likely that you will get a better return with an inflation-linked account.

However, the Bank of England expects inflation to actually go down at some point in the next year or two. Of course if there's one thing to be gleaned from the last few years it's the fact that experts can be wrong. But the consensus seems to be that inflation will return to heel at some point. If that happens, rates will rise. This could mean that your investment in a long term inflation-linked product could earn you less than had you left your money in a normal savings account.

Ultimately it depends on what you think will happen to inflation and interest rates over the next few years, but it's important to make sure you understand the inflation-linked product you are taking before deciding.

Disclaimer: Information is correct as of the date of publication (shown at the top of this article). Any products featured may be withdrawn by their provider or changed at any time.

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