Index-linking could be one way to help protect savings against inflation erosion

THE low interest rate environment has savaged the returns available to savers while inflation continues to eat into any interest earned.

But while there are now virtually no conventional savings accounts that keep pace with inflation, there are some products that are specifically designed to do just that.

The savings certificates offered by National Savings and Investments (NS&I) aim to overcome these problems by index-linking the interest rate paid to savers and then adding a guaranteed percentage on top.

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Whatever happens, therefore, the return received will stay ahead of inflation and savers can take confidence from the knowledge that there is a minimum growth guarantee in place. So where's the catch?

Like any financial product on the market, savings certificates are not for everybody. Sold in issues, with a maximum investment of 15,000 per person per issue, they are medium-term, tax-free products designed to lock money away for either three or five years.

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This is where the first disadvantage lies – anyone that needs instant access to their capital or who needs to earn a regular income from their cash should look elsewhere.

Currently, the return offered on both the three and five-year issues is inflation plus 1 per cent and the interest is calculated and applied annually.

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The fixed rate of interest is not added as a flat 1 per cent each year, but instead is staggered to ensure those who keep their money invested for the full term will see the best returns.

Although investors are free to withdraw their money at anytime, no interest will be paid if the withdrawal is made in the first year. After the first anniversary, index-linking and interest will be paid on each full month of investment.

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So just who are savings certificates good for, and how does the index-linking work?

Consumers with some surplus capital that they want to lodge in a secure environment promising a guaranteed minimum return should certainly consider them.

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Equally investors who want to balance riskier investments elsewhere with safe cash holdings should consider savings certificates as part of their overall portfolio.

Those who believe inflation is going to rise may also want to investigate savings certificates as a means of protecting their capital from being eroded in other non-index-linked products.

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The inflationary measure used in the index-linking calculation is the retail prices index (RPI). The actual calculation used is the purchase price times the RPI end level for the year divided by RPI start level for the year.

In effect this calculation establishes the annual rate of inflation and applies it to the capital invested before adding the guaranteed portion of the interest.

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As an example of how this works over the course of an investment, 10,000 paid into the three-year Index-linked savings certificate available in June 2007 would generate a total return of 11,412.46 in June 2010.

The issue at this time paid index-linking plus a fixed interest rate of 1.35 per cent, as opposed to the 1 per cent offered in the current issue, and the full calculation is illustrated alongside this article. Where inflation falls below zero, no index-linking is added, protecting the original capital investment made against sustained and significant deflation.

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Looking back to 1950, there is only one year in which annual inflation has been less than 0 per cent. That was last year, when a figure of -0.5 per cent was recorded.

In those 60 years, the highest level of annual inflation was the 24.2 per cent seen in 1975. Since the turn of the millennium, annual inflation has fluctuated between a low of -0.5 per cent in 2009 and a high of 4.3 per cent in 2007.

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Gill Stephens, senior media and PR Manager at NS&I, said: "Because the interest earned on index-linked savings certificates produces inflation-beating savings and is tax-free they are especially popular amongst higher and additional rate taxpayers.

However, they continue to be popular amongst each group of taxpayers who want the peace of mind that the value of their savings will stay ahead of any increase in RPI over the investment term."

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But Peter Haveron, financial services manager in Glasgow at French Duncan chartered accountants, does not believe that savings certificates are right for everybody. "For those who cannot afford to tie their money up and who need liquid assets then this is not the right option. Nor is it a good option for people that need to generate an income from their capital," he said.

However for the right person they do offer good value, he added. "For those with surplus funds who can tie them up in the medium term then it is certainly worth considering.

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"It is also a good option for those that want a degree of certainty in their savings."