How can I make my savings beat inflation?

What does it mean to say saving accounts 'beat inflation'?

As the cost of living rises, making savings pay can feel like fighting an uphill battle.

But you can beat inflation: here's how.

Why inflation matters

Inflation is a measure of the rising the cost of living.

There are two major inflation indexes, the consumer price index (CPI) and retail prices index (RPI).

Both look at the cost of a 'typical' shopping basket (RPI includes extras like the cost of paying a mortgage) and compare its cost with the what it would have been 12 months ago.

If inflation is 4% then the typical basket is 4% more expensive than it was in the same month a year ago.

As we update this article, CPI was measured at 2.5% and RPI at 2.9% for August 2012.

The impact on savings

Inflation hurts day to day when it rises faster than wages. The same amount of money buys less.

For savers it hurts in the same way - a pot of cash will be worth less than when you put it aside - except that savers can 'beat' inflation with an interest rate that allows the amount to keep up with real prices.

With a 2.5% inflation rate, for example, a basic rate taxpayer needs an account paying at least 3.12% because, taking 20% income tax into account, that's a 2.5% return.

Inflation rates now

Earlier this year savers has reason to be concerned.

In March RPI shot up to 3.5% and there were very few, if any, accounts offering savers a real return.

Since then, though, we've been relieved to RPI fall to 3% in April and hover around where it is now, 2.9%, over the past few months.

CPI has also fallen in the same period and is now well on track to meet the Treasury's target of 2%.

According to Moneyfacts, that means that 198 accounts can beat inflation this month.

How to beat inflation

Inflation beating savings are likely to be individual savings accounts (ISAs), where interest is paid tax free, or fixed rate accounts, where the savings are not easily accessible.

ISA's are particularly useful in this sense because the account interest rate needs to be just above the inflation rate to beat inflation, you don't need to take tax into account.

Usually, however, tax will reduce an account's return. So, as we saw above, as we update this article, account holders will need a 3.12% rate in order to beat rising rates after basic rate tax.

Long term fixed rates can often do this job, though inflation linked accounts may be worth considering too.

Let's take a closer look.

First port of call: ISAs

Bear in mind there are restrictions on the amount that can be invested in cash ISAs so this limits the eventual rate of return.

The current cash ISA allowance for the 2012/2013 year is £5,640, ending 5th April next year.

As always, those prepared to store their money away longer term can get the highest rates but will need to take a gamble on possible future ISA rates.

Bear in mind that, currently at least, even a few fairly accessible ISAs can just about beat inflation, though.

Andy Hutchinson, Nationwide's head of savings agrees that ISAs should be the first port of call for people's savings and investments at any time of the year, not just around the time of the end of one tax year and the start of the next.

"We... encourage consumers to consider using their ISA allowance throughout the year, getting into a regular savings habit along the way."

Fixed rates

Of course, those with a large amount of savings may want to invest the rest in another pot.

That means taking a look at fixed rate accounts.

These accounts can offer quite high interest rates. However, bear in mind that this option often requires putting away at least £1,000 and not being able to touch the money for a minimum of two years.

The trick with any of these accounts where you are agreeing to a fixed savings term is double and triple checking the conditions.

You don't want to be stung by penalties for taking out your money too early or making too many withdrawals.

Inflation linked rates

The downside to a fixed rate, however, is that it's just that - fixed - if inflation were to increase substantially the account could end up losing money again.

For that reason some people prefer accounts that offer an interest rate that increases as inflation does.

This usually works in the form of a promise to pay either RPI + interest or a fixed rate, whichever is higher, at the end of an account's life, guaranteeing a return even in the case of deflation.

The problems with these accounts are generally the same as with fixed rates - they require a large initial investment and put strict restrictions on withdrawals - with one additional problem: they're thin on the ground.

At the time of writing, there's just one account open to new applicants.

A note on pensions

It's worth noting at this point that inflation is usually associated with one form of saving in particular: pensions.

This make sense, of course, because you really want to be able to live on the cash you put away.

So many pensions schemes promise to beat inflation and, in return, ask account holders to receive most of the pensions pot in the form of an annuity, like a salary, once holders reach a set age.

Just like a salary, that annuity will be taxed so it's unsurprising, as many expect tax to rise and people to work longer, that many are choosing to put less in their pensions and more in ISAs and other more flexible savings accounts.

We don't cover pensions so take a look at our useful links above for more information on this elsewhere.

Debt vs savings

Finally, it's fair to say that there's a big group of people who really shouldn't be stressing about whether their savings are beating inflation: those with debts.

Investing in savings is great but it is possible that what it's offering is actually a false sense of security.

With currently low interest rates on money stashed away, paying off debt before saving is often the better choice.

We can see this just by numbers. A 3% saving rate will never beat a 15% rate paid for a credit card debt.

Having said that, those that can't, for some reason, find an inflation busting savings account shouldn't be put off saving altogether.

It's always useful to have a safety pot tucked away should you need it in the future especially if the alternative might be borrowing money, a much more expensive option in the long run.