Inflation-linked savings accounts sound great – but watch out for the pitfalls

Banks are falling over themselves to offer inflation-linked bonds to savers. But are they as good as they are made out to be? Ruth Jackson investigates.

For months now the main worry for savers has been that the interest they get on their savings is just too low for them to have a hope of keeping pace with inflation.

With the retail price index (RPI) rising at an annualised rate of 5.3%, basic rate taxpayers would need a rate of 6.6% in order to see their savings grow in terms of spending power after tax. Unfortunately, there isn't a single account on the high street offering that. And things are even worse for higher rate payers: if you pay 40% tax you need 8.8%; if you pay 50% you need 10.6% - which you haven't a hope of getting.

However, the banks have suddenly noticed the gap in the market and have dived in en masse to plug it: they're all tripping over themselves to offer inflation-linked bonds to the retail market. On the face of it, that sounds like good news. But we aren't so sure. Normally when banks jump on the same bandwagon it is because there is money in it for them, not for us. So is that the case this time too?

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An inflation-linked bond is really just a type of savings account that pegs your savings rate to inflation plus a bit on top, so that you can be sure your money will always grow slightly faster than inflation. You might be offered a return of the annual rate of inflation as measured by the RPI plus 1.5% a year, as long as you lock your money away for five years for example. However, straightforward as this sounds, odds are it will come with a whole lot of small print.

The first thing to note is that a lot of these accounts are technically structured products. This means that the account is backed by a third party typically an investment bank which can affect the safety of your deposit. For example, the inflation-linked bonds on offer at Yorkshire, Barnsley, Chelsea, Saffron and Principality building societies are actually products from Credit Suisse.

So before you invest, make sure you check whether your money will be fully protected under the Financial Services Compensation Scheme (FSCS). Mostly it will be. They are usually termed as structured deposits rather than structured investments, so deposits up to £85,000 are fully covered under FSCS. However, this is not a given, so do check and if it isn't covered think about giving it a miss.

Secondly, look at the way the interest is paid so you don't have any nasty surprises. Most accounts pay their interest annually, so while the RPI may be running at 5.3% today, the RPI figure that will be used to calculate your interest will be next April's. If inflation has fallen by then (as Mervyn King claims it will) so will the interest rate you get.

Then there is the nasty 'set-aside' trick: many accounts, for example Birmingham Midshires' bond, say they pay interest annually, and they do - but they put the interest you earn every year in a separate account, and pay you no interest on that. So you won't benefit from the magic of compound interest.

That could cost you. Say you put £5,000 in an account for five years and inflation ran at 5% each year. With no compounding you would end up with a total return of £1,250 (five times £250). With compounding so you get interest on the interest - the total return would be £1,381.40.

That represents a nice little earner for the banks, as will the exit penalties most of the bonds charge. The best rates tend to be dependent on you locking your money away for three to five years. If you need your money back early, you'll be stung for an early exit fee. These can in some cases be so high that they leave you with less money than you started with.

With that in mind it is worth noting that the current situation (high inflation, low interest rates) is highly unusual. It is entirely possible (although not MoneyWeek's base scenario) that RPI growth will fall back fast over the next few years and just as possible that interest rates will rise fast. That could mean that ordinary savings accounts end up paying out more than inflation-linked bonds at some point in the next few years. If you are locked in to the latter, you'll suffer accordingly.

If that is still a risk you are prepared to take, you might want to check the tax status of your chosen bond. Some of the inflation-linked bonds on offer, including the ones from Yorkshire, Barnsley, Chelsea, Principality and Saffron, can be invested in through a cash individual savings account (Isa). That will give a nice little boost to your returns if you haven't used up your Isa allowance already.

Ruth Jackson-Kirby

Ruth Jackson-Kirby is a freelance personal finance journalist with 17 years’ experience, writing about everything from savings accounts and credit cards to pensions, property and pet insurance.

Ruth started her career at MoneyWeek after graduating with an MA from the University of St Andrews, and she continues to contribute regular articles to our personal finance section. After leaving MoneyWeek she went on to become deputy editor of Moneywise before becoming a freelance journalist.

Ruth writes regularly for national publications including The Sunday Times, The Times, The Mail on Sunday and Good Housekeeping, among many other titles both online and offline.