A tricky time for borrowers

Savings accounts

Headline rates will be lower when inflation is low. In real terms, however, savers are likely to be better off. In the late Seventies National Savings paid 15 per cent but, since inflation was higher than this (18 per cent in 1980), savers were actually getting a negative return. Nowadays, with inflation at 2.3 per cent, savers in accounts paying 5 per cent are getting 2.7 per cent in real terms.

Equities


Returns on equities are likely to fall in the long-term even if, in the short term, the prices jump when the Bank of England base rate is cut. The authors of the Financial Services Authority's paper on low inflation say: 'Over the longer term, it will be associated with lower nominal investment returns. Lenders and investors do not have to be compensated so much for the erosion in the real terms of the principal [as they would in a period of high inflation].'

The fact that the FSA's growth estimates, which pensions firms must use in their sales material, are now 5, 7 and 9 per cent for the coming years indicates the regulator's view on likely investment returns. At the beginning of the Nineties, when inflation was often three or four times the current level, the equivalent figures were 8.5, 10.75 and 13 per cent.

Actuary Ronnie Sloan accepts the likelihood of lower returns on equities.But he says: 'In real terms, it would still seem reasonable to expect returns of between 4 and 5 per cent. When inflation was 7 per cent, people were often getting 13 per cent. But if inflation is 2.5 per cent, you're only going to get 7 per cent.'

Guaranteed annuities


Annuities guaranteeing to pay above the prevailing rates can become extremely valuable, as the crisis-ridden Equitable Life knows to its cost. The insurer agreed to pay above 12 per cent. This did not appear high at the time of the guarantee but is now getting on for double the going rate. Other insurers entered into these contracts but seem better able to pay their debts than Equitable.

Pensions


High inflation has always been the enemy of pensioners and anyone else living on a fixed income. The Pensions Law Handbook 2001, published by the law practice Eversheds, says: 'The basic state pension is falling in relative terms year by year, since it is indexed to prices rather than earnings, and will eventually be worth less than 5 per cent of national average earnings.

'This problem is exacerbated by the fact that people in personal pensions and in occupational money purchase schemes have to buy an annuity. Most have opted for a level annuity, which means they are getting the same monthly payment after 30 years as they did in month one.

'But there has been widespread recognition of this problem and various factors are conspiring to help. A period of low inflation will mean that the value of pensions will erode more slowly. But if they can afford it, pensioners can delay buying an annuity until their seventy-fifth birthday. Meanwhile, they can put their pension fund into an income drawdown plan, drawing some income while leaving most of the fund to continue growing.'

However, most professionals suggest this is potentially risky, and that drawdown plans should be taken out only by people with a fund of £250,000 or more who can withstand some risk. Research by Money Management magazine shows that some of these plans, which are still fairly new, have underperformed their annuity equivalents by nearly 25 per cent.

A huge concern for new pensioners is the way that annuity rates have tumbled as a reaction to falling inflation and lower interest rates. A £100,000 fund would have bought annual annuity income of £11,000 in 1990 for a 65-year old married man; a decade later, the annual income would have been just £6,000. Although there is a slight recovery in annuity rates now, the general trend in interest rates throughout the European Union is down.

Money Management magazine warns : 'Ironically, this could, in turn, mean that by delaying annuity purchase, income drawdown may actually reduce pension entitlements and develop into another sorry scandal.'

Bonds


Getting into a good fixed interest deal is ideal if you can do it just before interest rates fall. Many people benefited from this in the past but often more by luck than judgment since rates are hard to predict.

If your calculation is wrong, and you buy a gilt (a Government stock such as a Trea sury bond), you will see its capital value fall if interest rates rise. Its final redemption value will not change, but its value on the market if you decide to sell before redemption will decline. This is because other assets will be able to offer comparable or better returns. Many insurance company products are bonds.

Rates on guaranteed income bonds (GIBs) have gradually fallen to the extent they are no longer an attractive proposition, according to financial adviser Baronworth. In April, however, rates improved and some of them are now competitive.

With-profits bonds allow investors to take 5 per cent of their original investment each year and defer the tax for up to 20 years. But if investment returns are low, the investors may be eating into the capital when they take out their annual 5 per cent. The Financial Services Authority is extremely concerned about these products and warns that the past performance rates, which companies use to sell their products, are very high compared to current projection rates and may well not be sustainable in future.

Salaries


Pay rises are closely linked to inflation. Wage settlements have averaged 3.3 per cent a year so far during 2001, according to Incomes Data Services, but they could drop to 3 per cent or even below that if the inflation rate dips below 2 per cent, as seems possible.

Mortgages and debt


Don't be fooled into thinking that low inflation is good for borrowers. Certainly, you are borrowing at low rates but you do not see your debts become smaller each year compared to your earnings as you do during high inflation. High inflation will, in effect, pay off most of your debt, leaving you just to worry about meeting the interest payments.

In times of very low inflation, where asset prices fall, homeowners will be left with loans that are higher than the value of the asset they used the loan to buy. The consensus from economists is to repay your debt as quickly as possible. Howard Davies, chairman of the FSA, expressed his concern last December about the continuing rise in loans at high income multiples: above three times income for a single person or 2.5 times income for joint borrowers.

House prices


House prices could be underpinned by low inflation if more young people want to buy. In theory, they would be attracted to bricks and mortar since the burden of debt is pushed away from the monthly interest payments, which are low, to the time of mortgage redemption, which could be 25 years away for those choosing an interest-only loan.

Of course, problematic low inflation which turns into problematic deflation can lead to negative equity, but this possibility is not being suggested as likely now.