Beware investing in inflation-linked bonds
National Savings and Investments has reintroduced its index-linked savings certificates paying inflation plus 0.5% a year for five years.
The news came just 24 hours after the governor of the Bank of England gave a heavy hint that the rise in inflation - which the Bank said could hit 5% in the final months of the year - has tilted the balance of opinion towards an early increase in interest rates.
Inflation of 5% - as measured by the government's preferred Consumer Prices Index - would be double the government's target. Just three months ago, the Bank said inflation would only hit 4.5% this year.
NS&I withdrew its index-linked savings certificates in July last year. Ever since, banks and building societies have been filling the gap in the savings market by offering bonds where your return is linked to inflation. But these bonds have been described as "complicated" compared with the NS&I product.
Their launch comes at a time when the cost of living as measured by the RPI is already running at 5%. The top rate you can earn on an easy-access account is 3.35% before tax, while the top five-year bond pays 4.65%.
The new deposit accounts from banks and building societies pay the equivalent of the rise in the RPI over three or five years plus a little bit extra. If inflation falls during the term you will get your money back, plus the small amount of interest on top.
But while they seek to mirror the NS&I version, they are not as simple as they might first appear. Savers need to study the terms and conditions carefully before signing up.
Watch out for tax
Some accounts are taxable - so you can find that your money will not keep pace with inflation once you have paid tax.
Others you can wrap in an ISA, so the returns are tax-free. You have to tie your money up for three or five years and can't make any withdrawals during that time. If you want your money back early, you could also face a charge.
At data analyst Defaqto, banking expert Kevin Bray says: "These accounts are complicated. They may look attractive now in the light of high inflation, but might not be so in the longer term. You also need to look at when the RPI is calculated. If inflation falls sharply and you fall into the wrong month, you could lose out."
They are made all the more complicated as banks and building societies offer different "issues" of the accounts with different interest rates and start dates. And you can find that the bond will not start running for weeks after you hand over your money, meaning that you earn a pittance before the start of index linking.
For example, with the Yorkshire Building Society Protected Capital Account Inflation Linked 4 plan, you can hand over your money now, but the bond does not start running until 29 June, so your money will be tied up until then. And during that time it pays RPI plus just 0.29% a year. Your interest is linked to the RPI April figure, announced in May each year.
These bonds generally roll up for savings and interest over the term. But BM Savings pays the interest out each year. You cannot have the taxable income added to your account. Yet this is one of the most generous schemes on the market, paying 1.5% a year before tax - worth 1.2% to basic-rate payers - on top of inflation.
Of course, how well you will actually do with these bonds depends on the future course of inflation. The rise in the cost of living may be set to increase in the near term, but experts expect it to fall back sharply within a year.
The Centre for Economic and Business Research forecasts the RPI down at 3.3% in the first quarter of next year and to average 2.7% between 2012 and 2015.
Scott Corfe, economist at CEBR, says: "We expect inflation will start to fall as the pressures of rising commodity prices recede. The weak economy puts constraints on price growth. And the rise in VAT, which came into effect at the start of this year, will fall out of the index next January. We expect a significant fall in inflation by the start of next year."
If this happens then the return of your index-linked bond will also fall.
The BM Savings bond will pay 6.5% a year before tax with inflation running at 5%. After tax, this is worth 5.2% to basic-rate taxpayers - marginally ahead of inflation. But for higher-rate taxpayers, the return after tax is 3.9% - less than the inflation rate.
When interest rates rise...
If inflation averages 3% over the next five years, your return will drop to an average 4.5% a year before tax. But BM Savings currently offers a five-year fixed-rate bond paying 5.05% before tax.
And as interest rates can surely only go one way - upwards from their historic 0.5% low - you could do better by sticking to a shorter fixed-rate bond and then picking up higher rates in a year or two's time if they materialise.
Another option is to stick to top-paying easy access accounts, such as ING Direct's Direct Savings account. You will then be ready to make the most of better savings rates when interest rates do rise.
Questions to ask
1: What will I earn a year on top of inflation and is it taxable?
2: Who is the deposit taker and will I breach my £85,000 limit under the Financial Services Compensation Scheme?
3: Does the interest roll up or is it paid out each year?
4: When does the term start and how much interest do I earn between handing over my money and the start of the bond?
5: Which month's annual rise in the RPI counts?
6: Will I lose some of my capital if I cash in my bond in early?
This article was taken from the June 2011 issue of Money Observer.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.