With inflation outstripping interest rates it is hard, if almost impossible, for most UK savers to get a return on their savings accounts above inflation.
Furthermore, with the extension of the Funding for Lending Scheme (FLS), inflation predicted to rise and more Quantitative Easing (QE) on the horizon, things are likely get worse for savers before they get better.
What rate of interest do you need to beat inflation?
Inflation is the enemy of all savers, but the damage it does isn’t always obvious, after all, your savings look as though they are growing each year, whilst in fact, for every year the interest rate is less than inflation, you are actually losing money.
The Consumer Prices Index (CPI) stood at 2.80% in March; this means a 20% tax payer needs a gross interest rate of 3.50% to match inflation, whilst a 40% tax payer needs 4.66%; neither of which is available in the current savings market.
Even people who pay no tax and savers who use their Cash ISA (Individual Savings Account) allowance, only have a handful of savings accounts to choose from.
The simple fact is, for most of us, inflation will outstrip the best rate of interest we can get.
Is ‘peer to peer’ lending the answer?
The basic concept of ‘peer to peer’ lending is actually very simple, borrowers are introduced to savers cutting out the banks and building societies, but like most things, in practice it is more complex.
One saver, lending to one borrower is risky; if the borrower fails to make repayments, the saver will be out of pocket. To reduce the risk, ‘peer to peer’ lending sites, such as Zopa, take savers money and lend it out in small amounts to many borrowers. By doing this, Zopa claims to be able to offer interest rates of 4.6% per year over three years and 5.1% over five years; both rates are net of any fees payable to Zopa, with a default rate of just 0.8%.
However, whilst the interest rates might sound attractive, ‘peer to peer’ is not the same as a traditional bank or building society account.
To begin with, the interest rate is not guaranteed, it doesn’t work like a fixed rate bond does. Secondly, saver’s capital is not covered by the Financial Services Compensation Scheme (FSCS), exposing savers if Zopa fails.
To reduce the risk of borrowers defaulting, Zopa has followed the lead of Ratesetter, another ‘peer to peer’ lender, by launching a ‘safeguard fund‘, which is says will make up money owed by a borrower should they be unable to keep up with their repayments.
The introduction of the ‘safeguard fund’ should help to reduce the risk when borrowers default, however it is far from the cast iron guarantee provided by the FSCS.
As the interest rates paid by banks and building societies remain pathetically low and inflation continues to erode savings, ‘peer to peer’ lending is likely to grow in popularity; Zopa so far has lent more than £300 million since they launched in 2005.
Those people, who use Zopa, or their competitors, are simply exchanging the risk that their savings won’t keep pace with inflation, with the risk that some or all of their capital may be lost; not an easy choice for everyone to make.
What other alternatives are there?
If you are fed up with your savings losing the battle with inflation, what alternatives do you have?
The first thing to make clear, is that every alternative to a traditional savings account will open you up to the risk of your capital falling in value, of course for many of us inflation is having much the same effect now, at least in ‘real terms’.
The traditional alternative to saving has of course been investing, in assets such as stocks and shares, corporate bonds or gilts, whether directly or more usually through a fund, run by a fund manager such as M&G, Invesco Perpetual, Jupiter and so on. The value of these investments can of course fall as well as rise, although the aim of is to reward the investor for the additional risk they are taking, by giving better returns over the medium to long term, than they can get from a savings account.
Property, in the form of a buy to let investment, has also been popular over recent years, with buyers taking advantage of the dip in prices, low interest rates and a ready supply of tenants. Of course property isn’t the panacea it is made out to be by some people; tenants can be troublesome, repair bills can mount up and the value of property can fall, as the past few years have proven.
Finally, we are seeing a wave of single company bonds, such as those offered by Agri Bank or more recently the Jockey Club. These are effectively loans to organisations or companies, with the main risk being that the loan is not repaid at the end of the term or is defaulted on before it is due for repayment.
Risk v Reward
All investment decisions are a trade-off between risk and reward. In our opinion people focus disproportionately on capital risk, in other words the risk they will lose money in absolute terms if an investment performs poorly.
We believe investors and savers need to focus equally on the risk that their capital fails to grow at least as quickly as it is being eroded by inflation.
Of course tackling inflation means taking more risk with the capital, but at the moment, for most savers, inflation is guaranteeing a real terms annual loss, the big question though, is how much risk are savers prepared to take to address this problem?