Further pain ahead for cash savers?

The Bank of England expects its interest rate to edge to just 1.25% by 2022, while the Office for Budget Responsibility believes inflation will fall back towards the Bank’s 2% target over the same period. This means that savers with a cash ISA will continue to lose out to the effects of inflation.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Cash saving

Although the Bank of England (BoE) recently chose to raise its interest rate to 0.5% from 0.25%, rates have been at (or below) 0.5% now since March 2009. For borrowers, this period of cheap money has been a blessing, but for savers who have kept their wealth in cash, it has been a costly experience.

Inflation is the rate at which the prices of goods and services increase over time. Between 1998 and 2008, the rate of inflation was below the interest rate that was paid on your cash in your bank account. If you receive a positive real interest rate, the purchasing power of your money is increasing over time.

However, real interest rates became negative in 2009, when the UK economy fell into recession as a result of the financial crisis. Banks were bailed out, and interest rates were slashed to 0.5% in an attempt to get lenders lending again, and businesses and consumers spending.

At the same time, inflation soared due to the pound weakening against other currencies. Since then, the rate of inflation has remained firmly above interest rates. For savers, this means that any cash saved in a bank account has now yielded a negative real interest rate for the previous 96 months.

As a measure of inflation, we prefer to use the Retail Price Index (RPI) rather than the Consumer Price Index (CPI), as it includes housing costs and so provides a more realistic rate for the majority of UK households.

Expect real interest rates to remain negative for the foreseeable future

The trend of negative real interest rates doesn’t look like it will be changing any time soon. In November 2017, RPI inflation ticked up to 4%, dragging the real interest rate down to its lowest level since January 2012.

Is inflation higher than normal, or are interest rates extraordinary low? In fact, the current level of inflation is not unusually high. RPI inflation has averaged 5.3% since 1948. What is unusual is the current interest rate, which has historically averaged 6.4%. Therefore it seems the only way cash savers will see the return of positive real interest rates is if rates start to rise considerably.

But when could rates rise to anywhere close to their long run average? The furthest dated forecast from the BoE is for 2022, where the Bank predicts the base rate will climb to just 1.25%. This signals further pain ahead for savers, as inflation continues to eat into savings.

What if I invest?

The chart below compares returns on £20,000 saved in a bank account receiving the bank’s interest rate (dark blue) versus investing in a simple 50/50 UK equity and bond portfolio (light blue). We’ve constructed this using the FTSE All Share Index and a UK Government Bond Index.

Investing at the start of 1999, unfortunately just before the 2000 Dotcom crash, would have led to negative returns up until the end 2002 with a maximum loss of around 11%. By contrast, cash in the bank would have grown steadily, as interest rates were comfortably above the level of inflation. Financial markets then recovered during the noughties until these gains were reversed in the 2008 financial crisis.

However, since the financial crisis there has only been only one winner. While the value of our theoretical portfolio has risen substantially, the real value of cash has been eroded continuously due to negative real interest rates.

Overall, between 1999 and 2017, the 50/50 portfolio would have provided a real return of 73% while the value of cash in the bank would have would have fallen by 0.4%.

Regular investing can cushion short-term market declines

There are some lessons to be taken from this. Everyone should have cash saved for emergencies or a rainy day no matter what. However, once that emergency fund is put aside, then investing for the long term should be a consideration for anyone. While investing comes with increased risk, and there’s no guarantee you will get back what you put in, investments have historically outperformed over longer time periods.

If you want to start investing, but aren’t able or willing to put in a large amount to start, you can add small amounts on a regular basis and benefit from what is called pound cost averaging. See more on pound cost averaging.

Investing on a regular basis yields huge benefits, by smoothing the ups and downs of the market and avoids you from having to second guess the best time to buy in. Investing throughout both the 2000 Dotcom crash and 2008 Financial Crisis would have allowed you to buy more shares at a lower cost, leading to higher returns over time.

Investing just £100 a month since the start of 1999 you would have contributed a total of £22,600. In our theoretical 50/50 portfolio, this would have grown to £32,557. If you had instead stuck this cash in a bank account, it would have declined in real terms to £15,700.

The decision to keep your wealth in cash over the last decade has therefore proved to be a bad one. While past performance is not a guarantee, history shows that over the long term, regular investing in a diversified portfolio has beaten inflation, protecting the real value of your wealth.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.