Simple Pound

Purchasing power risk is one of the most fundamental constraints you should always bear in mind when deciding how and where to invest your money. As much as compounded interest works in favour of any investor, inflation will always work against you and erode the real value of your money over time - if you don’t do your best to protect it.

The following table is taken from the book I’m currently reading (“The Art of Asset Allocation” by David M. Darst) and shows vividly how important capital protection is and what growth rates it requires over the years.

It is quite frightening to see that inflation at the 15% level would erode 96% of your money’s purchasing power if you kept it “safe” under your mattress. Obviously, most developed countries don’t face double-digit inflation rates anymore, but it is nevertheless an economic force that cannot be ignored. The list below (alphabetical by country name) should give you a reasonable idea of how much various countries are currently affected.

All figures express the year-on-year percentage change in inflation for March 2008, unless otherwise stated.

• Australia: 3.00% (December 2007)
• Bulgaria: 13.20%
• Canada: 1.40%
• China: 8.30%
• Colombia: 5.93%
• France: 3.50%
• Germany: 3.30%
• Iceland: 6.80%
• India: 5.20%
• Japan: 1.00% (February 2008)
  
• New Zealand: 3.44%
• Mexico: 4.25%
• Russia: 5.60%
• Spain: 4.60%
• South Africa: 9.8%
• Switzerland: 2.50%
• Turkey: 9.10%
• United Kingdom: 2.50%
• United States: 3.98%

It is immediately obvious that the inflation threat is more real in some countries than others - compare Japan and South Africa. To give you a better idea what sort of growth rates you need to achieve in order to simply maintain the purchasing power of your money, I have adapted the table above to show growth rates.

These are calculated by simply dividing 1 by the fraction representing the real value of your money after x years. For instance, if we assume that your money’s real value after 20 years at an inflation rate of 3% is equal to 0.54, then you need to nearly double your money to maintain purchasing power: 1 / 0.54 = 1.85.

So what can you do to achieve these growth rates?

• make sure the return on your savings account is positive in real terms (after inflation & tax)
• take advantage of tax-free savings and investments (ISAs, pensions etc.)
• if you want to play safe, inflation-linked gilts will always give you a fixed real return as they are linked to the current RPI (which includes mortgage costs and is hence usually a lot higher than the CPI)
• diversify your investments to reduce the impact of one asset class underperforming or showing negative growth rates
• avoid mutual funds with high entry and/or exit fees (where possible) as you will need even higher growth rates to just restore your purchasing power

A year ago on Simple Pound: Investment Choices - Bonds (I)

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According to the BBC, 69% of no-notice savings accounts pay interest that isn’t even sufficient to cancel out current inflation rates. In March the Retail Price Index (RPI) was up 4.8% from March 2006 - which means, if your bank is paying anything less than those 4.8% your money gets effectively de-valued while sitting in your savings account.

That is certainly the case with my Lloyds Online Savings Account, which currently pays a monthly interest of 4.65% AER. This rate already includes a 0.6% bonus paid for one year from opening the account, so if I was going to stay with them in the long run, my gross interest would drop to 4.07% in July.

Well, 4.65% at the moment isn’t that bad you might think - but here’s another catch: tax. All the interest you’re earning is taxed at currently 20% - so the net interest that eventually ends up in your account is only 3.72% including the bonus. Oh and did I mention that these rates don’t apply for anything in the account from £0 - £250. No… for the first £250 I get a net interest of 0.08% - that’s an eighth of a percent!

So, what should this rant tell you? If you belong to one of those people who have an account that doesn’t even match inflation anymore, then switch. And do so right now because you’re losing free money!

I have been looking around for good rates for quite some time now (in anticipation of my sign-on bonus needing a home), but it wasn’t until a friend recommended his savings account that I came across Icesave.

Icesave is a subsidiary of the Icelandic bank Landsbanki Islands, which was established in 1866 and is (apparently) Iceland’s first and longest running financial institution. They have only recently appeared on the UK market, but have already established operations in 13 other countries. Why am I telling you this? Well, when it comes to the bottom line banks are institutions just like any other company and thus there’s always a risk of them going bust. This risk is greater, the smaller the institution - so I think it’s reassuring to know that there’s a larger apparatus in the back.

Anyway… facts now: Icesave offers you an online savings account with 5.7% AER (5.56% if paid monthly), which comes down to 4.56% net interest after 20% tax. Funnily enough that’s scarily close to what I currently get in gross interest with Lloyds - but only if you include a bonus! This is by far the best rate I’ve found on the web - and it comes with almost no strings attached. That means no penalties for withdrawing money, no notice periods, but there is a minimum investment of £250 (and a maximum sum of £1,000,000 in case that matters to you).

Reading through various forums online, people are usually concerned about the response time of online banks, because - after opening an account - you are send your User ID by post - which in one case apparently took 8 weeks (?). After that all communications with the bank will be handled through the Internet or a (0845) customer service hotline.

I tested Icesave’s responsiveness by sending an email to customer services asking about details regarding the calculation of interest (when, how often etc) yesterday afternoon. I got an automated response saying that due to high demand for their account a reply could take up to 5 business days. Grmph, I thought (or something very similar). But then I got a very lengthy and detailed reply this morning… It’s not an instantaneous response, but not bad either.

I am basically now running out of tricks to test them (I couldn’t think of many other questions after reading their FAQ’s online). Since I don’t have the money to open the account at the moment anyway, I’ll just keep watching them closely for now. But unless I come across some really concerning information in the meantime, I’m pretty sure I’ll be opening an account with them in June/July…

Please leave a comment if you’ve had any experience / know anything about Icesave and their online savings account (any other comments welcome too… ). People having to make decisions tend to look for information supporting their initial “gut feeling”, so throw all the bad news at me that you can find…

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Having read yesterday’s post, you should now know what bonds are and that their price can differ from their par (face) value depending on various (mysterious) external circumstances. You have also read that after you’ve bought a bond its price only really concerns you if you’re planning to get rid of it before the maturity date. That’s a major difference to shares, whose price determines the value of your investment. With a bond on the other hand you can be certain that you will always get the bond’s par value back (assuming the issuer doesn’t default) plus any interest that might be payable ‘along the way’. This is the major reason why bonds should only constitute a small percentage of your portfolio while you’re young (i.e. you should make the most of your money rather than sit on a close-to risk-free bond)…

So what is it that influences the price you can sell your bond for?

• Interest rates: Rising interest rates mean you could potentially get a higher return even if your money is only sitting in a savings account. Therefore, bonds that issue after a rise in interest rates will offer a higher annual return (yield) in order to keep up with your savings account (and thus your bank!). This also means, the price for existing bonds might drop because their yield has now become less competitive and thus investors are willing to pay less. The only way to ‘convince’ investors to buy a bond with a low coupon rate, is by offering it at a discount. The same logic applies when interest rates drop - already issued bonds become more attractive and demand can only be limited via an increase in price.

• Inflation: When inflation increases, bond prices will decrease because the coupon rate might not be high enough to keep up with inflation. Especially with bonds that have a long maturity you will often find higher coupon rates to keep the bond attractive even if inflation might change substantially over the long run.
• Financial health of issuer: If the market believes that there is almost no risk of the issuer defaulting, the bond’s price will increase to reflect a high-quality security. On the other hand, if the investor is in some financial difficulties, not many people will be willing to accept the associated risk and the price will drop.

If you are keen to find out more about bonds (there is so much more material out there, trust me), I suggest you start here. There are many varieties of bonds available plus the option of investing in bond funds - i.e. a collection of bonds administered by someone who (hopefully) knows what they’re doing. The concepts are fairly similar to mutual funds so I will only cover them briefly next time.

Read part 7 of “Investment Choices” on bond funds >>

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A few days ago, I read a blog entry @ The Simple Dollar reviewing an article on retirement benchmarks that appeared in the April issue of Money Magazine. According to this article, at the age of 35 you need at least 1.6 times your annual salary tucked away in savings in order to retire at the age of 60 and have the financial resources to pay yourself 80% of your last annual salary for the coming 35 years.

Obviously compound interest will work in your favour the sooner you start. That is why I decided to have a closer look into the pension contributions my (soon-to-be) employer is making on my behalf to establish whether or not I would need to worry about reaching this target. With a little bit of help from Excel I established that I don’t - assuming the pension fund has an average return of at least 6.6% over the next 14 years.

This interest rate / growth rate seems definitely feasible and not only compound interest is working in my favour, but also the fact that my employer will increase the pension contributions over time with my years of service and age. For instance, while they contribute 5% of my annual salary when I start, I will be up to 11% when I’m 32 - assuming I have been employed for the 10 years in between.

Feel free to use my template to establish whether you’ll beat the benchmark or not (all numbers in the template are in relative terms rather than absolute monetary values).

Random statistics: RPI inflation rose to 4.6% in February (from 4.2% in January) which effectively means that I’m not even beating inflation with my current savings account. As soon as I start getting a regular salary, I will have to find a savings account that will actually earn something over time.

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