How NS&I index-linked savings certificates really work

by Jane Baker on 11 June 2010  |  27 comments
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How do index-linked savings certificates really work? NS&I provides the definitive answer.

Our recent article This account pays 6.3% on your savings - tax-free! has caused a bit of a stir with lovemoney.com readers. So, to clear matters up once and for all, we asked National Savings & Investments (NS&I) to write a definitive Q&A which explains exactly how index-linked savings certificates work, and how the returns are calculated.

Let’s start off with the basics:

What is inflation?

The Retail Prices Index (RPI) is the most familiar measure of inflation in the UK. It measures the average change from month to month in the prices of goods and services purchased by most UK households.

The inflation rate is quoted as a percentage and is widely quoted in the media. The inflation rate for April (announced in May) was 5.3%.

This is the percentage change in the index compared with the same month one year previously and doesn’t take account of the monthly changes in between. In April 2010, the RPI figure was 222.8 and the RPI figure for April 2009 was 211.5. The change is worked out below:  

(222.8/211.5) x 100 = 105.3427

105.3427 - 100 = 5.3427%

The ONS (Office for National Statistics) measure to 1 decimal place, therefore inflation in April 2010 is 5.3%. This means compared to April last year prices have gone up by 5.3%. 

What are index-linked savings certificates?

NS&I index-linked savings certificates are designed to give savers a guaranteed tax-free* rate of return, which is higher than inflation measured by the RPI, if held for the full term. They are currently available in three and five-year terms and are sold in issues. Savers are able to save between £100 and £15,000 in each new issue.  

How do the Certificates work?

Index-linked savings certificates are lump sum investments, designed to be held for fixed terms. Returns on the certificates are added on each purchase anniversary.

Each year the certificates move in line with inflation and a fixed rate of interest (currently 1% AER**) is added as well. As the fixed interest rate increases year on year, a three or a five-year certificate must be held for the full term in order to gain the maximum rate.

The separate, variable part of the return, linked to inflation, is known as index-linking. NS&I work out index-linking by using the RPI figures applicable at the start and end of each year of an investment, not the monthly changes in between.   

Which month's RPI do NS&I use?

During each month the Office for National Statistics (ONS) collects prices for a range of goods and services to calculate the RPI, which it then publishes the following month. For example, the RPI figure for April 2010 was published part way through May. To calculate the index-linking we would then use this as the "RPI start level" for any certificates bought in June. We would also use this as the "RPI end level" for any certificates reaching an anniversary or cashed in during June.

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How do NS&I use inflation figures to work out the return?

NS&I use the RPI figure to calculate the index-linking value to be added to certificates. On each anniversary of the purchase date, until the end of the certificate term, NS&I work out the index-linking by dividing the RPI end level by the RPI start level and multiplying this figure by the purchase price/previous anniversary value of the certificate.  At the same time NS&I also add the fixed rate of interest. All of the certificate anniversary values are calculated in this way until maturity to provide the overall certificate value.

What happens if you need your money early?

Certificates are designed to be held for the full term, as the guaranteed rates of interest increase each year during the term. But savers can take their money out early if they wish. However, if certificates are cashed in during the first year of investing, they don't earn any index-linking or extra interest. If they are cashed in any time after the first year, any positive index-linking plus extra interest is earned for each complete month the certificate is held since the first or subsequent anniversary.

What if you invested a year ago, how much would you earn today?

 A £10,000 investment in a three-year certificate taken out in June 2009 would, on its first purchase anniversary in June 2010, earn £534.28 index-linking. This is calculated as follows:

Purchase price x RPI end level (which in April 2010 was 222.80), divided by RPI start level (which in April 2009 was 211.50).

Or 10,000 x (222.80 ÷ 211.50) = £10,534.28.

You would also earn the guaranteed fixed rate of interest of £85 or 0.85pc. The first anniversary value of £10,619.28 would then be used as the basis on which the second anniversary value is calculated in June 2011.

At the first anniversary your investment has grown by 6.19%, therefore if you invested in inflation beating savings in June 2009 you would have needed a return of 7.74% as a basic-rate taxpayer, 10.32% as a higher-rate taxpayer, or 12.38% as an additional rate taxpayer to obtain an equivalent return on your savings.

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What if inflation next April (announced in May) was 3%? What does this mean for your investment?

For any certificates bought in June 2010, it is the percentage change in the RPI of April 2010 and April 2011 that will determine the amount of index-linking you will earn.  This will be the equivalent to the inflation rate of April 2011 (announced in May 2011).

Therefore if ONS announced the RPI index figure in April 2011 was 229.5 then the amount of index-linking would be equivalent to 3%. So an investment of £1000 in a three-year certificate bought in June 2010 would have index-linking of £30, the calculation is shown below;

(229.5/222.8) x £1,000 = 1030

£1,030 - £1,000 = £30

Plus guaranteed interest of 0.85% in the first year: 

0.85/100 x £1000 = £8.50

The first anniversary value is therefore: £1000 + £30 + £8.50 = £1,038.50

To gain an equivalent return in a taxable product you would have needed a return of 4.81% as a basic-rate taxpayer, 6.42% as a higher-rate taxpayer, or 7.70% as an additional rate taxpayer.

For the second year of your investment, the RPI start level would be the April 2011 (announced in May 2011) RPI index figure. So from the example above this would be 229.5. This means the index-linking in year two would not be affected by the index-linking added to your investment in year one.

As a consequence any negative index-linking in year two, for example if the RPI index was to decrease from 229.5 to 225.0, would not impact the index-linking in year three.

NB. The RPI figures and the interest earned in the above answer are hypothetical and for illustrative purposes only.  

Anyone considering investing in index-linked savings certificates should not invest on the basis of this article, but should refer to the product details and terms and conditions available here; NS&I.

* Tax-free means that interest and index-linked returns are exempt from UK Income Tax and Capital Gains Tax.

** AER stands for Annual Equivalent Rate and enables the comparison of interest rates from different financial institutions and across different products on a like-for-like basis. It shows what the notional annual rate would be if interest was compounded each time it was credited or paid out. Where interest is credited once a year the rate quoted and the AER will be the same.