Protect yourself from the inflation spike

The beast is back; inflation once pronounced dead has started to make a comeback and the implications for savers, borrowers and pensioners could be devastating.

Experts may have been waiting for inflation to rise, but when it was announced that the Consumer Prices Index (CPI) soared to 2.9 per cent in December, the size of the increase came as a shock to many. The measure of inflation was a far cry from the Bank of England's target at just 2 per cent and the spike from 1.9 per cent in November made it the biggest monthly jump on record.

Next month, when the impact of VAT returning to 17.5 per cent is factored in, many analysts are expecting inflation to rise above 3 per cent, making it far more likely that interest rates will start rising before we see the year out. Some analysts, seeing rising commodity and Chinese export prices, have even suggested that annual inflation could top 10 per cent.

"Expect inflation to rise further in the months ahead," says James Hughes, the chief economist at Black Swan Capital wealth managers. "We're about to enter a nasty stage of the recovery when inflation could easily move into double-digit figures. The already inflationary effects of weak sterling will soon be amplified by rising commodity and energy prices triggered by growing demand in the Asian economies."

On one level, the increase was always expected because there were a number of factors contributing to the lower annual inflation rate in December 2008, including the reduction of VAT to 15 per cent and a significant drop in the price of oil. One year on, those lower figures were always going to make a sharp contrast with the current inflation rate; banks are lending more money; the pound is weak and commodity/energy prices are rising.

However, there is no doubt that there has been swifter than expected growth and it does raise the question of how savers and borrowers can protect themselves from the potentially devastating effects of inflation.

Your mortgage

Inflation is basically a measure of the rate by which the cost of living is increasing. The main measures used are CPI and the retail price index (RPI), which also includes housing costs, such as mortgage payments. This also climbed in December, jumping from 0.3 per cent in November to 2.4 per cent. Although there have been suggestions that the spike is merely temporary, if interest rates are increased to combat inflation it will have an immediate impact on mortgage rates.

"The recent inflation spike has put 'rumours' of a base rate rise firmly on the agenda, and expectations of a future rate rise, which we believe will happen this year, may soon be reflected in mortgage pricing," says Andrew Montlake, a director of mortgage broker Coreco Group.

One option he says borrowers should consider is taking out a fixed-rate mortgage. If the base rate were to rise quickly, some homeowners could struggle with their tracker rates or standard variable rates. "It is easy to become blasé about cheap tracker products and get sucked into the cheapest-is-best vacuum. The reality is that rates are going to rise and margins on tracker products are still high," says Mr Montlake.

There are currently many more people on variable rate mortgages, willing to risk leaving it till later to fix because of the low-rate environment. In fact, variable rate mortgages accounted for more than four out of five home loans arranged by broker John Charcol in December 2009. This is no surprise, with the best trackers offering rates that are about 1.5 per cent cheaper than the top fixed rates but some experts warn that this could now be a dangerous strategy.

If rates do rise to contain inflation, many borrowers will find themselves having to cope with significantly higher monthly payments. For more budget-conscious borrowers and first-time buyers, it may be better to opt for the safety and peace of mind offered by a fixed rate.

However, not all property experts agree and some are cautioning against fixing too early. "I don't see a need for immediate panic from borrowers worried about whether they should fix now," says David Hollingworth from mortgage broker London & Country. "Higher inflation was expected but I don't think interest rates will climb in the short term, perhaps remaining the same well into this year."

As for the property market as a whole, the return of inflation and higher interest rates could kill off the present recovery in prices. Inflation and rate rises will eat significantly into family finances, making an upturn in repossessions likely. This in turn will increase supply of property which could dampen prices.

Protecting your pension

The impact on pensions will depend on whether it turns into a prolonged period of inflation. "Irrespective of whether this is a spike or not, with a pension, inflation is always going to cause damage over the long term so you need to make sure you are prepared for that," says Laith Khalaf, a pensions analyst for independent financial adviser Hargreaves Lansdown.

The effects of inflation can be devastating to a pension in the long run. For example, a £10,000 level income would be worth just £5,537 after 20 years of 3 per cent inflation. Also, for those in or approaching retirement, the headline inflation rate is only ever part of the story and the actual inflation rate for those in retirement is usually much higher than the official figures.

According to the Alliance Trust's monthly study of inflation rates facing different age groups, the 50-64 age group faces the highest rate of inflation at 4.1 per cent. Although the over 75s face the lowest rate of inflation, at 3.3 per cent, because gas and electricity prices have dropped, this age group is still vulnerable.

"The goods and services that older people usually buy often increase in cost much faster than the typical basket of goods for younger people. This makes inflation protection an even more pressing concern in retirement," says Martin Bamford from IFA Informed Choice.

For pensioners on a fixed income, price inflation is particularly bad news. Those with a more flexible pension arrangement should take the time to review the performance of their portfolios, in terms of actual returns. However, if an annuity has already been selected and it is fixed, there may be little that can be done to protect against inflation.

Anyone approaching retirement has a few more options such as an index-linked annuity which escalates either at a fixed rate or in line with price inflation. The drawback is that they are more expensive than level annuities and will mean starting at a lower level of income but, while the spending power of the level annuity will fall, that of the inflation-linked annuity should remain the same.

Another alternative is an unsecured pension which keeps the pension fund invested, while drawing an income. This could mean that investors benefits from capital growth in line with inflation and can maintain their purchasing power. This will involve taking on risk, and there is a chance that the capital or income will fall.

Savings accounts

For savers, the rise in inflation is a real concern. Inflationary erosion can have a devastating impact on money left in a savings account, particularly as few savings products now on the market pay a healthy level of interest.

But what can be done to limit the impact? Make the most of tax-free savings and ensure that money is held in a top-paying account. "Use your tax-free ISA allowance this year and next, when the amount you can squirrel away in cash increases to £5,100 from April," says Kevin Mountford, head of banking at Moneysupermarket.

National Savings & Investments savings certificates are guaranteed to beat inflation, and offer a tax-free return. Most easy-access savings accounts will allow savers to move their money around without too many restrictions. The problem is that too few of these accounts pay healthy returns.

Moneysupermarket.com says that basic rate taxpayers need to find a savings account paying at least 3.63 per cent to combat inflation; for higher rate taxpayers, that figure increases to 4.84 per cent. There are currently no easy-access savings accounts for balances of £1,000 paying enough interest to counteract the effects of inflation and tax. The top rate from Coventry building society pays 3.3 per cent. However, it's not all doom and gloom. "The record increase should mean a rise in base rates this year, which will be better news for savers," says Mr Mountford.

Inflation-proof investments

Rising inflation poses a serious risk to any investor without a diverse portfolio. Cash and gilts are the most vulnerable asset classes when it comes to erosion from inflation: cash because the returns are generally quite low and gilts because they pay a fixed interest. In contrast, rental income and company earnings tend to rise in line with inflation. Equity income funds, which invest in companies, can pay and grow dividends above the rate of inflation. Advisers often recommend gold because of its ability to retain value over time. This can be bought easily through an exchange traded fund but there will be management charges of about 0.4 per cent a year.

"An investor holding a spread of different asset classes should be reasonably well protected from the return of inflation, although they might consider tweaking some holdings for additional protection," says Mr Bamford.