In uncertain times, stashing away banknotes can help us feel more secure. This was certainly the case with my grandparents, who kept emergency savings under their pillow. Unfortunately, they forgot and popped all the bed linen in the washing machine. Luckily, the world’s unlikeliest money launderers didn’t lose their savings. As the serial numbers on the notes had survived the spin cycle, the local building society was willing to accept them.1 Even when safely deposited in a savings account, my grandparents’ money remained vulnerable to another threat: inflation.
Inflation is the process by which prices increase over time, and it’s also how money loses its value. The effect is barely perceptible on small amounts of money in periods of low inflation, but it can have a dramatic impact over the long term. This chart shows what’s happened to inflation over the last 10 years. Although the rate has dropped this week to 1.8%, it was over 3% at the beginning of last year.
Of course, your savings are probably earning interest from the bank – but does this rate actually beat inflation? Your money could be shrinking faster than it can grow. Here’s an illustration. Imagine you’re 60 years old and have saved £300,000 in cash for your retirement or withdrawn that amount from your pension pot. Assuming inflation is 3% and you’re earning an interest rate of 2%, your money is shrinking by 1% each year. By the time you’re 85, that £300,000 has the purchasing power of £229,836. To make matters worse, you’re liable for tax on the interest. A basic-rate taxpayer would owe around £1,000 each year based on this scenario.2
What you need, therefore, is an interest rate that’s higher than inflation. This isn’t straightforward, though. Many savings accounts pay less than 0.5%, making it almost impossible to achieve growth – especially if you’re liable for tax on the interest.
Over the next few posts, I’m going to present some ideas on how you can grow your money. We’ll look at ISAs, savings certificates, premium bonds, and more. I’ll also introduce you to the basics of investing and how it differs crucially from cash. For now, remember that your money is safe in a savings account, but its value is at risk.