The problem with cash – should you be investing more?

Britain has become a nation of savers in lockdown. But what kind of financial cushion do cash savings offer if inflation takes hold?

Published on 16 Jul 20215 minute read

Written by Cherry Reynard

Unable to travel, socialise or do many of the other things that usually deplete their bank accounts, Britain has become a nation of savers. However, this welcome financial cushion may not be as protective as hoped if inflation takes hold.

Around £75 billion was held in ISA accounts in 2019 to 2020, an increase of £7.1 billion over 2018/2019. However, most of this rise – £4.8 billion – went into cash ISAs, while Stocks and Shares ISAs can only command a distant second place. (1.)

Cash has its role. If people have a short-term savings goal, such as a house deposit or a new car, cash is almost certainly the right place for their savings. Equally, it is always sensible to have a few months’ worth of expenses in a readily accessible cash account as a buffer against life’s various hiccups – redundancy, sickness, a leaky roof. But too much in cash for too long can be corrosive for long-term wealth, particularly today.

The impact of inflation

Rising prices will erode the real value of a saving pot. While cash may feel inherently safe – £10,000 goes in and, usually, it stays at £10,000 – if it only buys half as much, that is a real problem. This isn’t as unlikely as it sounds: a savings pot of £10,000 would be worth just £6,100 in real terms after 25 years with inflation at 2%, the current Bank of England target. If inflation rises to 3%, that drops to £4,780. At 4%, that savings pot is worth just £3,750. (2.)

This wouldn’t be a problem if savers were getting sufficient interest on their savings accounts to compensate. But the majority of savings accounts now pay less than 1%. The top-paying easy-access savings account pays just 0.5% (3.). In extreme cases, banks charge their customers to save with them. Low interest rates have, unfortunately, changed the landscape. Cash savers are often losing money in real terms and the longer they remain in cash, the more the problem compounds.

Inflation today

Inflation has been relatively benign in recent years, hovering around the Bank of England’s target rate. However, there are reasons to believe that a higher inflation environment may be imminent. There are short-term considerations: as the world emerges from the strictures of lockdown, there is pent-up spending. After a year confined to their home, people are keen to travel, socialise, shop. At the same time, production difficulties have created supply problems for certain commodities and key components such as semiconductors. This is creating shortages and pushing up consumer prices.

There are also longer-term reasons for structurally higher inflation. Governments are spending vast sums to ‘build back better’, pouring trillions into decarbonisation plans and infrastructure building. This is also creating significant demand in key areas and driving prices higher.

Equally, some of the deflationary forces that have curbed inflation over the past two decades are reversing. Deglobalisation, for example, brought cheap goods from China and lowered prices for everyone. But the fragilities exposed by the pandemic have shown the difficulties inherent in long supply chains that cross multiple borders. Global governments are now working to ‘reshore’ critical industries. This may raise the price of goods and services.

In normal circumstances, central bankers would simply put up interest rates in response to any inflationary pressure. However, the recovery is fragile and central banks, led by the Federal Reserve, have made it clear that they will look through short-term inflationary pressures until economic growth is firmly established. It is also increasingly difficult for central banks to raise rates: debt levels are higher, particularly for governments. High rates also risk real disruption to equity and bond markets, which have grown dependent on central bank liquidity. This means inflation will be allowed to ‘run hot’ for longer.

Potential solutions

Cash is not the only problem area. Other ‘safer’ assets can also struggle during periods of high inflation. Inflation is generally bad news for bonds, for example, because their income is fixed and therefore doesn’t keep up with higher prices.

Stock market investments can provide better protection against inflation, providing it doesn’t rise too quickly. 1970s-style inflation tends to be difficult for most asset classes. Companies should be able to put up prices in response to inflationary pressures, which in turn should be passed on to investors in the form of higher dividends or profit growth. Historically, savings held in a diversified portfolio of shares have kept pace with rising prices over the long term.

For savers who have managed to build up some spare cash over lock down, it is worth considering the risks of holding it in cash at a time of potentially rising inflation. The stock market can be a volatile place, but it has some natural advantages in today’s climate. A carefully blended and diversified portfolio can help protect the real value of a savings pot. Remember, investments carry risk and you can get back less than invested.

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