Burst your inflation bubble

Chances are you’ve noticed prices creeping up in most areas of your life lately, from your weekly grocery shop and council tax, to travel costs and fuel bills.

Although inflation remains low, it is rising. Following VAT returning to 17.5% in 2010, the Consumer Prices Index (CPI) - the official rate of inflation - jumped from 2.9% to to 3.5% in January. This is a 14-month high. 

Meanwhile, the Retail Price Index (RPI) - which some economists say is a more accurate measure of inflation as it includes housing costs - has risen from 2.4% to 3.7%.

However, for many people the government’s ‘official’ rate of inflation is meaningless. Just how much inflation hits you will depend on a number of factors such as your age and circumstances and the way you spend your money.

“We really should ignore the ‘official’ inflation rate,” says Francis Klonowski, director of financial planners, Klonowski and Co in Leeds. “Because most of the things that we can’t run away from are going up by more than the rate of inflation, such as council tax and gas and electricity.”

The general rule is that the less wealthy suffer the most, because they don’t have surplus income to absorb rising costs. Retirees are the hardest hit of all because most pensioners’ incomes are fixed and a large proportion of it is spent on necessities such as utilities and food – which are rising the fastest.

“Millions of pensioners are again facing inflation-busting bills for vital household services,” said David Sinclair, head of policy for Help the Aged. “One in five older people survive below the poverty line - when all the spiraling household bills are paid they are left with less and less each year to afford basics like food and clothes.”

However, wealthier middle-classes aren’t immune. Areas where they spend money, such as school fees, childcare and private healthcare are all rising well above inflation too.

And according to the Daycare Trust UK, the cost of a typical nursery place for a child under two in England has soared by 5.1% - almost double the rate inflation. Parents in England are on average forking out £4,576 a year on childcare costs for children aged under two.

How to beat inflation

The first step to dealing with rising prices is to find out which areas of your expenditure are most vulnerable. Use the personal inflation calculator on the Office for National Statistics website to work out your own inflation rate.

By entering how much you spend in different areas, it shows how your income is allocated and therefore what price rises will affect you.

Most of us could cut unnecessary costs by giving our household expenses a serious MOT. When prices are rising it’s more important than ever to ensure you’re not paying more than you need to for everything from your mortgage and utilities, to insurance and your weekly shop.

Find out how to cut the cost of food

This doesn’t have to mean cutting back or going without, just identifying areas where you can make savings that help to mitigate the effects of inflation on your finances.

Mortgage repayments are most people’s biggest expense, even when interest rates are low. Being on a dud mortgage deal or languishing on your lender's standard variable rate can cause an unnecessary drain on your finances, so take time to research the market and remortgage when your current deal comes to an end.

Shopping around is equally important when your insurance comes up for renewal. It’s the easy option to renew with your existing insurer, but the best insurance deals are usually offered to new customers, so it pays to see what else is on offer because the insurance market is very competitive.

Pretty much every household in the country will feel the higher cost of energy bills - despite the big five all cutting prices in 2009, these failed to offset the huge rises seen in 2008. 

Going forward, the energy regulator Ofgem warns energy bills will spike by as much as 60% over the next decade.

However while the savings for regular ‘switchers’ may be small, if you haven’t switched before you could save hundreds of pounds every year. Opting to pay by direct debit, and picking an onine tariff, could also save you plenty.

With other household services, such as phone, broadband and satellite TV, it’s just a case of shopping around to get the best deal and not paying for services you don’t need.

When it comes to shopping, Klonowski says it can be quite difficult to cut costs unless you are prepared to change your spending habits. But if you are, simple changes like switching supermarkets and sticking with supermarket branded products can make big savings. If you don’t have time to shop around yourself, Mysupermarket.co.uk compares prices across Tesco, Asda, Waitrose and Sainsbury’s to find the cheapest deals.

When buying other products, such as household appliances, gadgets, or books, CDs or DVDs, use a shopbot to shop around for you. There are a number of sites, including Kelkoo, Pricerunner and Shopping.com, which will scour the market to find you the cheapest price. It’s also possible to boost savings by getting paid to shop online by using cashback sites.

To cut fuel costs, visit petrolprices.com - enter your postcode and how far you’re willing to travel, and it will list the days cheapest petrol stations for all types of fuel.

For some expenses you may be able to make savings by teaming up with other people to share your resources.


The most immediate effect of inflation is certainly on your day-to -day spending. However, unless you take steps to inflation-proof your savings, you could find the value of your money is gradually eroded over time too.

“Many people fear the stockmarket because of the risk of losing their money, but the same risk is true of holding money in cash due to inflation,” explains Klonowksi.

The news that inflation has risen so sharply will come as a blow to savers - as a lack of competitive savings rates mean it is tough to find a new account that can keep up with inflation.
A basic-rate taxpayer currently needs to find a savings account that pays at least 4.38% in interest to stop their savings pot eroding away. A higher-rate taxpayer has to earn at least 5.83% - however, there are currently no fixed-rate bonds paying interest above 5.83%, according to data provider Moneyfacts.
“Each month, inflation is cutting deeper into people’s spending power and lower savings interest rates are creating an even bitterer pill to swallow," Darren Cook, spokesman for Moneyfacts.

"Those who are relying on their savings pot to subsidise other income are seeing their savings being eroded on average by 2.92% per year for a basic-rate taxpayer and 3.06% for a higher-rate taxpayer."

The average instant access account currently pays just 0.86% - which equates to 0.69% for a basic-rate taxpayer and only 0.52% for a higher-rate taxpayer.

David Black, banking specialist at Defaqto, say: “The stark reality is that there are now no taxable instant access or notice accounts that will give a real rate of return to even a basic-rate taxpayer let alone a higher-rate taxpayer."

Gavin Haynes, managing director of Whitechurch Securities says bonds, fixed-interest and cash based investments will all suffer as a result of inflation. “These are not a safe place to be when prices are rising. It’s important to build a well-balanced portfolio, and that includes equities.”

Haynes likes equity income funds, because they aim to produce dividends to boost annual growth greater than inflation.

If you still don’t like the idea of equities however, Haynes suggests the risk averse could go for index-linked gilts – government bonds – or National Savings & Investment products, which are also index-linked.

Of course it always makes sense to keep some money in cash savings accounts. Just how much will depend on your circumstances and attitude to risk – but, however much you have in the bank it pays to remember that it’s unlikely to grow as fast as other investments so you really do need to make it work as hard as you can. That means earning the best rate of interest you can and making the most of your ISA allowance to protect your cash from the taxman.

Inflation-proof your pension

Finally don’t just need to think about inflation when choosing your investments, you also need to incorporate it into your financial planning, warns Klonowski. This is because you’ll have to make assumptions on the cost of living in the future.

He advises investors to err on the side of caution by making decisions based on a rate higher than the official rate of inflation. “Retirement income for example, needs to rise year on year, so it makes sense to allow for more inflation than not enough.”

Any index-linked contributions we make also have the potential to depreciate in value. “State pension contributions are index-linked to the RPI, but if the true cost of living is rising more than this, you really need to increase your contributions by making provisions elsewhere.”

Your pension fund is likely to be invested heavily in equities up until 10 years before you retire, which, as a long-term strategy, helps ride out any volatility.

But unless you increase your pension contributions every year then inflation can erode the value.

According to IFA Hargreaves Lansdown a £300 monthly contribution will reduce to just £92 over a 30-year period, assuming 4% inflation a year.

If you have already retired, then one way to dodge rising inflation is to buy an escalating annuity.

Around 87% of people currently opt for level payment annuities. But Tom McPhail, head of pensions research at Hargreaves Lansdown, says this could evaporate their spending power as inflation rises.

He estimates that by the time a man aged 65 reaches normal life expectancy his £1,000 annual income will be worth just £440 if inflation is at 4%.

If you are concerned about beating inflation then you could consider an inflation-linked annuity that escalates in value over time.

Be prepared for your income to start low – currently £100,000 will buy a 65-year-old man a level income of £7,764 or an inflation linked annuity starting at just 4,778.

However, by the age of 78 the annual income from the inflation-linked annuity will overtake the income from the level annuity, and by age 88 the total payments received from the inflation-linked annuity overtake the total received from the level annuity.

A 65-year-old man also has a 25% chance of living until he is 95, at which point the payments from the inflation-linked annuity would be twice as big as the payments from the level annuity.

McPhail says: “As ever, shopping around for an annuity makes sense, not only to lock into a better rate, but also to make sure you can get a quote for an escalating as well as a level annuity.”

Before you buy an annuity, make sure you take the time to shop around and exercise your right to buy from the open market. According to the Financial Services Authority, there is a 20% difference in value between the most competitive and the least competitive annuity.

If you have a large pension fund or final salary benefits then you could consider opting for a drawdown plan which will keep you exposed to the equities market. Although this is a riskier product than an annuity, it will allow you to draw an income while increasing your chances for growth.

Drawdown plans also offer you the choice to take your 25% tax-free cash and leave the rest invested for further growth.

Hargreaves Lansdowns recommends a conservative drawdown investment strategy such as opting for a cautious managed fund with up to 60% invested in equities and 40% in bonds and cash.

McPhail says: “You must also manage your income withdrawals carefully to avoid stripping out your fund.”