American author and humorist Sam Ewing said that inflation is “when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair”.
Most of us will smile in recognition at this statement, but yet too many people do not take inflation seriously as a threat to their wealth. I should probably quote Ronald Reagan instead: “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”.
More recently, the UK protest group Save our Savers described inflation as “the kiss of death to savings”.
Wealth preservation is about protecting the value of your capital in ‘real terms’ – that is, after inflation and tax. There are various threats to your wealth that you need to plan for, but often interest rate risk and inflation risk come lower down the list than they should.
While cash was viewed as a no-risk investment option by many, recent years have proved this is not the case, with a prolonged period of very low interest rates as well as bank failures.
If, as most British expatriates do, you still have cash savings in Sterling, the bad news is that markets now imply that the first Bank of England interest rate rise will not be until February 2017. They have now priced in a cut to 0.25% by the end of this year. Save our Savers calculates that over £100 billion has already been lost since the BoE base rate was cut to 0.5%, and this figure is only going to grow.
Another round of quantitative easing also looks increasingly likely, and there is concern that this contributes to higher inflation. Central bank policies over recent years have been described as a “disaster” for savers in general, and more so for retirees, by the over 50s group Saga.
If inflation outpaces the low interest rates available on your savings accounts, wherever you live, your capital is not only not growing, but declining in value.
Prices have risen throughout history. Using Sterling as an example, the pound lost 99% of its value in less than a century. In the same way, the Euro is losing purchasing power every year. You may not worry about a 100 years’ time, but inflation can have a significant impact on your capital over your retirement years.
Inflation is insidious – you may not notice the effects each year until it is too late. Remember that official figures are based on a basket of goods and your personal rate is likely to be different.
Over the longer term inflation reduces the spending power of your capital.
For example, an inflation rate of 4% will reduce the spending power of 100,000 (be it Pounds or Euros) to 81,537 after just five years. After 10 years it falls to 66,483 and after 20 years it will have lost 56% of its value. If your personal inflation rate is 5%, 100,000 would be worth just 35,849 in 20 years’ time.
Even lower interest rates have an impact over time. 2.5% inflation reduces the spending power of 100,000 to 77,632 in 10 years and 60,269 in 20.
With more and more people living longer than 20 years in retirement, many for 30 years or more, you need to plan for this possibility. 30 years of inflation could decimate your savings if they do not keep pace with inflation. A 4% inflation rate would wipe out over 70% of the value of 100,000, taking it down to just 29,386. It would even lose over half its value with a lower rate of 2.5%, ending up being worth 46,788.
These calculations are only based on the real value after inflation. They do not take tax into equation, another thing you need to consider and plan for.
A recent research paper by First Direct provided a good illustration of how a million is not what it used to be, with inflation downgrading the lifestyle it can buy you. The value of £1 million today was worth £2.6m 20 years ago.
In 1992 £1 million could buy you all the following: an average house in Kensington or Chelsea, a Rolls-Royce, a seagoing luxury yacht, a holiday home in Tuscany and another in Cornwall, two high end luxury brand watches, a 3.5 carat diamond necklace and a 32 night Caribbean cruise. A comparative £1 million basket of goods today would consist of an average house in Hounslow, an Aston Martin, a river cruiser, a house in Cornwall, two basic model luxury brand watches, a 0.45 carat diamond pendant and a 14 night Northern European cruise. It is a similar story in the Eurozone.
To quote Save our Savers again, “Albert Einstein said that compound interest is the most powerful force in the universe. Given that inflation is its opposite, it is surely equally true to say that inflation is the most destructive force in the universe.”
Speak to an experienced adviser like Blevins Franks to discuss strategies for your capital to keep pace with inflation, based on your circumstances and objectives. At the same time discuss the opportunities available to protect your income and wealth from unnecessary taxation.
By Bill Blevins, Blevins Franks Financial Correspondent
22nd June 2012