The worst returns for savers since 1978

by Cliff D'Arcy on 08 February 2010  |  9 comments
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Real interest rates (after accounting for inflation) are now the lowest for 32 years. We show savers how to beat this terrible trend.

When savers search for savings accounts, they tend to concentrate on two things:

• 1. the headline interest rate on offer -- the higher, the better; and
• 2. the ease of access to their money -- the quicker, the better.

However, smarter savers know of two other problems which have a negative effect on their savings returns...

Two problems for savers

The first problem is tax, because savings interest is taxed as unearned income.

At present, basic-rate savers lose a fifth (20%) of their interest to the taxman, with higher-rate taxpayers handing over 40% to the taxman. From 6 April this year, super-high earners (those making £150,000+ a year) stand to lose half (50%) of their savings interest to HM Revenue & Customs.

The simplest way to avoid this problem is to save inside a tax-free wrapper that keeps the taxman at bay. The most popular is a cash ISA, into which you can save £3,600 each tax year (or £5,100 if you are 50+), rising to £5,100 from 6 April 2010. Over 19 million British savers have one or more cash ISAs, and I'd urge you to join them without delay.

The second problem is inflation -- the tendency of the price of goods and services to rise over time. As inflation reduces the future buying power of your cash, high inflation rates create serious problems for savers. Alas, the bad news is that inflation is rising steeply.

Terrible news for British savers

Indeed, the government's preferred measure of inflation -- the Consumer Prices Index (CPI) -- has just recorded its biggest-ever one-month jump. For the record, CPI jumped from 1.9% in November to 2.9% in December, a rise of a full percentage point. Although the Office for National Statistics claimed that this was due to temporary pressures, the CPI remains well above the government target of 2% a year.

Of course, inflation is a backward-looking indicator, as it measures changes over the previous 12 months. Nevertheless, savers should be worried because 'real' interest rates, such as the Bank of England's base rate minus the inflation rate, are the lowest they've been for 32 years.

Since 5 March 2009, the base rate has been held at a 316-year low of 0.5% a year, in order to boost our ailing economy. This would be bad enough for savers, were it not for the fact that the RPIX measure of inflation (the Retail Prices Index eXcluding mortgage interest payments) surged to 3.8%.

In other words, the 'real' interest rate, after accounting for RPIX inflation, is strongly negative, at -3% a year. By my reckoning, this is the worst real return for savers since 1978, when I was still a little boy in short trousers.

How interest rates have fared against inflation

Four ways to boost your rate

Therefore, after taking inflation into account, almost all British savers will be losing money. So, what can we do about this? The simplest way to fight back against low real interest rates is to maximise the returns which your savings earn. Here are four ways to do just that:

Stop paying tax

Again, why pay tax on your interest when you don't need to? Here are The top 10 cash ISAs for 2010, all of which pay attractive rates of tax-free interest.

Try fixing your rate

By locking away your cash in a fixed-rate savings bond for, say, one to five years, you can earn interest rates of up to 5.25% a year before tax (for a five-year bond from State Bank of India). However, bear in mind that once you handcuff your money in a fixed-rate account, then you will not be able to remove it without penalty until your bond matures.

• Search for fixed-rate savings accounts

•1.    Try 'specialist' accounts

Banks and building societies have many accounts aimed at 'senior savers' -- those aged fifty or over. Although many of these specialist accounts are nothing but gimmicks and pay low rates of interest, there are some gems in this pile, with the best paying 3% or more a year before tax.

•2.    Save as you go

My favourite way to save -- while earning the highest rates of interest -- is in regular-saving accounts. In return for saving a set monthly amount for a year or more (usually £25 to £250), you can earn rates of up to 5% a year before tax on a growing pot of cash. I like my monthly deposits to go out on payday, when my bank balance is strongest.

Better times are coming...

Savers can take heart from forecasts that inflation will start to fall back later this year. Indeed, by the end of 2010, the CPI is expected to drop below the government's target of 2%. Nevertheless, savers should never drop their guard, as high inflation is sure to make a comeback at some point.

Finally, the Bank of England base rate can't and won't remain at its present rate of 0.5% forever. Indeed, economists expect it to start rising well before the end of 2010, which will be a welcome relief for hard-pressed savers!

Compare savings accounts at lovemoney.com

More: Don't miss these inflation-busting savings accounts | Avoid this massive savings mistake