Last month, National Savings & Investments (NS&I) announced that its above-market average interest rates will be cut significantly in November. The popular Direct Saver and Income Bond accounts, which offer 1% and 1.15% per annum respectively, will now only pay 0.15% and 0.01% per annum. Premium Bonds will see the prize fund reduce from 1.4% to 1% in December.
The suite of cash accounts available from NS&I has been popular with savers in recent years, not only because balances are fully backed by the Government (not just up to the £85,000 FSCS limit), but also because of the competitive interest rates it has had on offer.
The new rates fall in line with that of banks and building societies.
Why has NS&I cut its interest rates?
In July 2020, the Treasury instructed NS&I to increase net inflows into their range of accounts from £6 billion to £35 billion for the year “to reflect the Government’s funding requirements due to the Covid-19 pandemic”. Within a few months, NS&I had achieved this target.
Offering above market average interest rates on NS&I accounts is a relatively expensive way for the Government to raise capital. After all, it is the Government that is paying the interest on the accounts. NS&I has therefore reduced their interest rates to “strike a balance between the interests of savers, taxpayers and the broader financial services sector”.
What does the NS&I interest rate cut mean for savers?
Whilst cash has traditionally been considered risk-free, a consequence of particularly low-interest rates is inflation risk. To give an example, if you receive 0.25% per annum interest on your cash savings and the rate of inflation over the same period is 2.25%, this means that your £1 today is effectively only worth 98 pence in 12 months. Prices have risen but your cash hasn’t – it has actually gone down by 2% in real (post inflation) terms. The impact of this over longer time periods is considerable and should not be underestimated. Assuming the same -2% differential continues for five years, the purchasing power of your cash will have dropped 10%, effectively making your £1 only worth 90 pence. This erosive trend will continue until such a time where cash interest rates overtake inflation.
The average rate of inflation over the last 30 years is 3% per annum. The average interest rate since the Bank of England (BoE) took responsibility for rate setting (1997) is 2.4%. This is evidence that cash returns lagging behind inflation is not just a new, temporary issue. With the prevailing BoE base rate sitting at 0.1%, cash account rates could remain well below 2.4% per annum, and inflation, for quite some time.
So what can you do?
Achieving a better return than cash interest rates does not have to involve ploughing all your capital into the stock market. Far from it. At Carbon, we prefer you to take a more diversified approach and consider a mix of assets that targets an inflation+ return. This could involve a blend of growth assets (shares) and more defensive assets (bonds). If all you are looking to do is keep up with inflation over the long term, or even just beat it slightly, a portfolio with a high proportion in bonds is likely to be sufficient. There is still an element of risk associated with bonds, which are essentially loans to governments and large companies, but their value will typically fluctuate to a far lesser extent than stocks and shares.
An important distinction between cash and bonds is that the interest paid on bonds is higher than cash accounts. If the governments and companies which the bonds are linked with struggle to repay the underlying loan, there is a risk to the investor’s capital. The idea with bond investing, however, is to only lend to credible, financially robust institutions, as this helps mitigate the level of risk involved. It also needs to be compared with the inflation risk that your cash is exposed to.
Food for thought
So, if you find yourself with surplus cash that you do not expect to need for several years (we think at least five), it’s worth considering a well-diversified investment portfolio. At Carbon, we believe that taking the least amount of risk necessary to achieve your goals is the best way to plan over the long term and we would be very happy to discuss your options with you.
You can view the various NS&I account interest rate reductions on this NS&I's news page.
Iain Harper is a Financial Planner at Carbon. Contact Iain via email at email@example.com.
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