The latest figures reported by the Office for National Statistics show that inflation reached a five year high of 3% in the 12 months to the end of September. This rate is 1% above the Bank of England’s target and is likely to continue to rise, as the Bank predicts that inflation will likely reach 3.2% when October’s figures are released later this month. This rapid rise in the level of inflation has also contributed to the Bank of England raising their base interest rate for the first time in 10 years, from 0.25% to 0.5%.
Increasing inflation and interest rate hikes can be a dangerous combination, and as the cost of living for many will rise, so we will also start to ask more of our capital than we have done for some time. The increased demand for more income and/or capital growth may make investors evaluate their financial position and review their savings and investment portfolio. So here we take a look at some of the main factors to consider when considering a change of strategy.
Savings and Investment Strategy
Whether you have just started saving, or you already have an amount of capital built up over the years, it is understood that spreading your money across a number of different areas and products in order to diversify your risk, is a better strategy than putting all your eggs in one basket. A mixture of instant access, fixed rate bonds and investment plans may therefore provide a useful framework for a savings and investment strategy.
For many savers and investors, putting a percentage of their capital into an instant access account may be an essential part of a diversified portfolio. These accounts normally provide a variable rate of interest (which may or may not include an introductory bonus) and usually offer unlimited withdrawals, which can be made without the need to give any notice period. One of the advantages of an instant access account is that your capital is not at risk, and this is one of the main reasons these accounts are used, with most accounts also falling within the FSCS.
Although this combination of flexibility and capital protection are attractive features, it should be noted that the best instant access account interest rates on the market, such as the 1.30% AER variable from RCI Bank’s Freedom Savings Account, are still significantly below the rate of inflation. Indeed, at 3.0% this account doesn’t even pay half the prevailing rate.
Fixed rate bonds
A fixed rate bond is an account where your capital is locked away for a set period of time, during which you are not able to access your cash. The term is known and selected at the outset, and is normally in the range of one to five years. For many years, fixed rate bonds were the corner stone of many saver’s cash portfolio.
In return for tying up your money, fixed rate bonds usually offer the saver higher interest rates than are generally on offer from instant access accounts, for example, Vanquis Bank’s 5 Year Fixed Rate Bond is currently paying 2.40% AER fixed. Since the rate is fixed, it is a guaranteed not to change for the term of the bond, whilst some bonds also allow you to choose the frequency of your interest payment, for example monthly or annually.
However, it is also important to note that even the best fixed rate bonds on the market do not provide interest rates higher than 2.5%. Therefore, with inflation currently running at 3.0%, even a long term commitment of five years would fail to allow the value of your money to keep up with the rise in the cost of living.
Cash falling short
Instant access and Fixed Rate Bonds are both cash accounts, which means that your capital is protected and returned in full when you either transfer your instant access account, or your fixed rate bond comes to the end of its term. The only risk to you not receiving your capital back is that the bank becomes insolvent, although most of these accounts are covered by the UK FSCS or a European equivalent.
However, we have also revealed that based on the current rate of 3% inflation, none of these accounts beat inflation, and so there is the additional risk with cash in that your money is losing value in real terms. Cash therefore is not without its own risks.
As you can see, long gone are the days where cash products alone can generate enough interest and income for savers to effectively grow their capital whilst hedging against inflation. In an attempt to replicate some of the returns of yester-year, more and more savers are having to consider taking on more risk. One way to access potentially higher returns is by investing in Investment plans.
This type of plan offers a defined return (either an income, fixed or variable, or capital growth), for a defined level of risk (normally aligned to the performance of an underlying stock market index, e.g. the FTSE 100 Index.
Investment plan features
One of the main reasons for considering an investment is the potential for the attractive headline rates on offer. There are a wide range of investment plans to choose from in today’s market and all of them aim to provide the investor with the opportunity to access returns higher than the current rate of inflation. Two popular examples of income investment plans are the Investec FTSE 100 Defensive Income Plan offering investors with 7.25% annual income, and Investec’s FTSE 100 Enhanced Income Plan paying a fixed income of 4.35% per year. These plans normally have a term of between 5 and 10 years which is known at the outset, prior to investing.
A feature which is unique to investment plans is that they offer conditional capital protection. This means that your capital is returned at the end of the term unless the underlying investment, usually the FTSE 100 index, falls by more than fixed percentage below its value at the start of the plan. This percentage is normally in the region of 30% to 50% and so investors may still receive a full return of their capital even if the market falls up to 50%. However, if the Index has fallen below the fixed percentage, you will lose the amount the Index has fallen, so you could lose some or all of your initial investment.
Savings and Investment Portfolio Example
In this example we take a product from each of the three areas covered above (instant access, fixed rate bond and investment plans) to show you how a combination of cash and investment plans can keep your capital producing income which is in line with the current rate of 3.0% inflation. Targeting a five-year timeframe, based on a savings and investment portfolio of £100,000, the capital is split as follows:
- £15,000 into RCI Bank’s Freedom Savings Account, paying 1.30% AER variable
- £45,000 into Vanquis Bank’s Five Year Fixed Rate Bond, paying 2.40% AER fixed for five years
- £40,000 into Investec’s FTSE 100 Enhanced Income Plan, paying 4.35% p.a. fixed for five years
RCI Bank and Vanquis Bank both have a monthly income option, whilst Investec’s plan pays monthly as well. RCI’s Freedom Savings Account has no fixed term whilst the other two both have a fixed term of five years.
Based on the above investments, the cash part of the portfolio would achieve £1,275 per year (£160.25 per month). The investment part of the portfolio would achieve £1,740 per year (£145 per month) and would be fixed for five years.
Combined, this equates to £3,015 per year (3.015% yield) or £251.25 per month, most of which would be fixed for five years except the £195 from the instant access account which could go up or down over the next five years, although you should note that any changes to the RCI Bank rate are passed on to existing customers as well as new customers. By comparison, if the investor placed all of the £100,000 into the RCI instant access account, they would only receive £1,300 per year in interest.
Treatment of capital
£60,000 would be in cash based savings accounts, with Vanquis Bank deposits eligible for the UK’s FSCS protection up to the £85,000 limit, whilst deposits held with RCI Bank are eligible for the French deposit protection scheme (the FGDR), which protects the first €100,000 per customer.
The Investec plan puts your capital at risk, with a return of your initial £40,000 dependent on the performance of the FTSE 100 Index. Your capital is returned at the end of the five years unless the FTSE has fallen by more than 40% from its value at the start of the plan. If it has, your initial capital will be reduced by 1% for each 1% fall – therefore you could lose some or all of your original £40,000 investment.
The above savings and investment example combines cash and investment products to give an annual yield of just over 3%, the majority of which (85%) is fixed for five years, thereby offering a high degree of predictable income of a fixed timeframe. 60% of the portfolio is in cash and so is capital protected, whilst 40% is invested and so puts your capital at risk.
Whatever you decide to do when reviewing your current savings and investments or considering options for a new investment, taking a view on inflation, what might happen to it in the future, and most importantly the impact this will have on your capital, are all sensible places to start.
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are at all unsure of the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice.
The investment plans mentioned are structured investment plans that put your capital at risk and are not covered by the Financial Services Compensation Scheme (FSCS) for default alone. There is a risk of losing some or all of your initial investment. There is a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index is not a guide to its future performance. These investments do not include the same security of capital which is afforded to deposit accounts.
AER stands for the Annual Equivalent Rate and illustrates what the interest rate would be if interest was paid and compounded once each year.