A fall in the official inflation rate is good news for many households and, of course, for the Government and Bank of England, which are trying to keep the economy on track.
The CPI drop from 2.5% in August was mirrored in the Retail Prices Index (RPI), which includes mortgage payments. It showed a similar fall, to 2.6% last month from 2.9% in August.
The drop could, however, be bad news for people on benefits (including state pensions), because any increases they receive are generally pegged to the September inflation figure, no matter what happens to price trends during the rest of the year. (We’ll need to wait for the Chancellor’s Autumn Statement in early December 2012 to hear whether the usual formula will apply, but there’s no reason to suppose it won’t.)
The way the calculation works is particularly bad news for older people, who tend to suffer a higher rate of inflation than other demographic groups. This is because they spend a higher proportion of their income on things that tend to rise in price more steeply, such as food and fuel.
At the same time, they spend a lower proportion of their income on items such as electronic goods, which tend to fall in price over time and pull the average down in the basket of items used to measure the overall rate.
Increases in the cost of living
Research carried out for Saga shows that since September 2007, when the mortgage bank Northern Rock collapsed, the cost of living has risen for the population as a whole by a not inconsiderable 16.8%. Yet those aged between 50 and 64 have suffered an inflation increase of 19.6%, while the over-65s have been hit with an eye-watering hike in the cost of living of as much as 22.8%.
While those still working may be able to ask for a pay rise or change jobs to obtain a higher salary, those who depend on the state for their income must be satisfied with what is handed out to them.
Worse, many of those who have put money aside and purchased their own pension can only watch helplessly as the spending power of their fixed income dwindles as inflation races ahead.
Read Paul Lewis' guide to the new state pension.
The difference between CPI and RPI linking
More than 90% of those who buy an annuity to fund their retirement purchase a level income, which means their real spending power is reduced over time.
Although those who purchase “RPI linking” for their pension are a little better off, the yearly uplift does not keep pace with the higher rate experienced by older people.
Finally, most public sector pensions, and even the state pension, are now linked to the – generally lower – CPI figure rather than RPI.
A switch to CPI from RPI has the effect of taking a slice off spending power immediately. Over time, however, the cumulative effect of the yearly reduction is dramatic. Someone who was receiving a £10,000 pension in 2010 would have seen this rise to £10,846 in April 2012 using CPI figure and will see it rise again to £11,084 next year.
However, the figure this person would have received last April would have been £11,046 had the RPI been used to calculate the increase, and a very much higher £11,333 by next April.
How long should you keep old paperwork for?
How to protect your savings and annuity from inflation
So, what is to be done by those who face the prospect of seeing their income withering on the vine?
Inflation link your annuity
If you are coming up to retirement, or haven’t yet taken your annuity, consider putting at least some of your pension pot towards some sort of escalating income. You can mix and match between level income, inflation-linked income or an income that rises by a predetermined amount, such as 3% or 5% a year.
Shop around for your annuity
Don’t just sign up for whatever is offered to you by the insurance company you saved with. If you have a health condition, or you have a lifestyle issue such as being overweight or a smoker, you may be able to get a better rate. Make sure you shop around the market, including companies like Saga, to find the best rate.
Switch your savings
If you don’t have much of a pension and are using savings to supplement your income you have your work cut out to find a good deal – but don’t give up.
The general trend of inflation downwards towards the Bank of England’s 2% target has meant that there are now more accounts on the market paying a positive return once inflation has been taken into account.
To beat CPI inflation and tax, basic-rate taxpayers need to find an account paying at least 2.76%. There are just four easy access accounts that fit the bill, but there are 144 fixed-rate savings bonds (including Saga’s) and 19 notice accounts available. Alternatively, you need to choose one of 16 cash Isas or 61 fixed-rate Isas that beat inflation.
Higher-rate taxpayers need a rate of 3.68% to stay ahead of inflation and tax, and they have a choice of 12 fixed-rate bonds, while those on 50% tax can beat tax and inflation with just one account.
Golden rules for investing safely
Unfortunately, it has not been possible to buy National Savings index-linked certificates since September 2011, when they were withdrawn from sale. However, if you have an existing investment you can roll it over into a new one. You should note that the terms of NS&I certificates are changing, including the rules on withdrawals and the way interest is calculated. If you are thinking of letting your savings roll over, check you aren’t going to be caught out by the new small print.
Only take risks within your comfort zone
Income seekers may be tempted to take more risk with their money than they are comfortable with. You should only ever invest in something if you understand exactly how it works. If you are tempted by an investment never be reluctant to ask for a full explanation, and if you don’t like the look of an investment say so and walk away. Slick salesmen and scammers rely on you feeling too embarrassed to speak up – so don’t let them get away with it.
Spread your money around
Never invest all your money in any one account, scheme or plan where there is any risk involved. That way, if anything goes wrong, you will not be left destitute.
Finally, never invest in anything that is going to keep you awake at night. Trying to make a little bit extra to redo the garden or take a holiday is not worth nightmares about losing your cash.
Find out more about our new Saga Saving accounts provided by Goldman Sachs International Bank.