Help futureproof your money by getting on top of inflation

Inflation can dent the purchasing power of your money in very real ways. Understanding how it works can help you take control of your finances. Here’s what you need to know.

If it seems like everything costs more these days, you’re not imagining it. From petrol and food to basic household items like toilet rolls, prices are generally getting higher for everything. That’s because of inflation.

In a nutshell, inflation is the rise in the cost of goods and services. When it increases, you can buy less with your money and when it decreases, you can buy more. However, it can have some knock-on effects on the rest of your personal finances, too.

Inflation doesn’t just affect how you spend, but how you save. That’s because rising prices reduce the purchasing power of your money. If you want to save and invest effectively, it’s good to have an idea of how inflation works and how it can affect your financial plans.

The money illusion

One issue with inflation is the ‘money illusion’, which you may have experienced yourself. This is when you don’t consider the effects of inflation on your wealth, and wrongly believe your money is worth the same as last year.

For example, you might think that because you got a pay rise, you’re better off. But if inflation is running higher than that pay rise, you’ve actually had a pay cut in real terms.

Why does inflation matter?

Inflation is used by policymakers and companies to inform a whole range of decisions, including pensions, rail fares, mobile phone tariffs and taxes. Every month, the Office for National Statistics (ONS) checks around 180,000 prices of around 700 items in a shopping basket of goods and services, like food, clothing and energy. The average price is compared with the previous year to work out the Consumer Price Index (CPI) measure of inflation.

If the prices have gone up, it means inflation is on the rise. The problem with rising inflation is that you can’t buy as much with the money that you have and if wages don’t go up, then living standards fall.

Although it makes everything more expensive over time, a bit of inflation is usually good news because it means the economy is growing at a healthy pace. However, if inflation rises too quickly it can put off consumers spending more money as everything just costs that bit too much. When this happens the central bank will step in and raise interest rates to keep inflation in check and prevent the economy from overheating.

If inflation spirals out of control it can have dramatic consequences for the economy. For example, Venezuela was gripped by hyperinflation in 2018 — when the price of goods and services rose by more than 50% in a month. That year, inflation peaked at 1.8 million percent. At one point, prices for some goods were doubling almost daily, leaving many Venezuelans unable to afford basic necessities.

Inflation can spiral out of control like this for many reasons. They include a surge in demand for products and services, lack of supply of goods causing prices to rise, as well as a lack of confidence in the economy (and government) by investors, businesses and consumers.

Why inflation matters to your future

Understanding the basics about how inflation works is crucial to saving and investing. Let’s look at a few ways it can affect your financial plans:

Your pensions

If you’re approaching retirement you may need to think about how to protect your pension from inflation. If you’re lucky enough to have a final salary pension, your retirement income will often go up each year with inflation. The state pension has a ‘triple lock’, which rises in line with inflation, average wages or 2.5% each year. However, the 'triple lock' was temporarily suspended from April 2022 for one year, to make the system more 'fair'. Those with most of their retirement savings in cash in a personal pension could see their purchasing power reduced.

One solution may be to take out an inflation-linked annuity so that your spending power keeps pace with the cost of living. A pension annuity works in a similar way to an insurance product, which you can buy using some or all of your pension savings when you retire. Like a regular annuity, inflation-linked annuities pay out a guaranteed income for life but also have the advantage of rising in line with consumer prices each year. However, the downside is that they tend to cost a lot more.

Your investments

Inflation is a risk for investors as it can chip away at returns, and if your investments are giving you a lower rate than inflation, you could lose money in real terms. The impact of inflation will depend on the type of investment. Many investors buy ‘fixed income’ securities like bonds — as they offer a stable income stream. However, as the rate of interest remains the same until maturity, inflation can cut into bond earnings.

On the other hand, the stock market has historically often provided returns that have beaten inflation over the long term. One of the reasons is that many companies can increase their prices in an inflationary environment (which means higher returns for you, however, no investments are guaranteed and you could get back less than you initially invested.)

Just don’t ignore it

Yes, it’s beyond our control, but there are ways to help keep your savings and investments healthy. Focusing on the real value of money after taking inflation into account will give you a better understanding of what’s happening to your money. So when you’re planning for the future, don’t forget to factor in a reasonable rate (Opens in new window) of inflation, and read our top tips to fight inflation.

Sources:

• Reuters.com Article dated 11 May 2020 "Venezuela's timid gains in taming inflation fade as food prices soar"

Disclaimer: This article is for information only and does not constitute financial advice