The time to think about how to stop inflation making you poorer is long before it strikes. You want to move before too many other people fear inflation, and so bid up the price of taking action.

Of course, a core tenet of long-term investing is that inflation is one of your biggest threats, alongside costs, taxes, and being scared out of markets through volatility.

Inflation is a key reason why equities are better for long-term investments. Cash and bonds may sometimes seem likely to yield a higher income at less risk, but historical returns show equities nearly always perform better over multiple decades, and so are a superior defense against the corrosive impact of inflation.

But what about if you want to take short-term evasive action to stop inflation from eroding your wealth – or to balance your portfolio in that direction?

Equities are just one option. Here are ten ways to beat inflation.

1. Higher interest

If you’re earning 2% on your cash savings and inflation is running at 3% on your chosen measure, then in real terms you’re losing 1% a year – even though your bank balance is going up.

This is because the spending power of your cash has declined in real terms. If it cost £1,000 to buy what you want one year, and next year it costs £1,030 due to inflation, then growth in your savings to £1,020 isn’t good enough.

You may need to lock away your money for a year or more to get a sufficiently high savings rate to beat inflation. Sometimes (such as the start of 2011) it may even be impossible, but such periods don’t usually last long.

2. Tax shelters

Carefully consider whether you’re best using the tax shield of ISAs to protect your cash savings or your equities.

You should certainly be doing one or the other. A 2% return on cash becomes a 1.6% return after tax is deducted, and just 1.2% if you’re a 40% rate payer.

These reductions make it even harder to beat inflation. Don’t suffer them unless you’ve used up all your shelters.

3. National Savings certificates

If you’re after simple inflation-proofing with a 100% government backed guarantee, then National Savings certificates are impossible to beat.

These certificates are basically bonds issued for the mass market by the UK Treasury, via its National Savings and Investments arm.

They come in three and five year flavors – though you can cash them in at any time – and they guarantee a real return above RPI inflation, usually in the order of 1% a year. Capping it all, the return is tax-free!

But the certificates have two drawbacks.

Firstly, you can only put put a certain amount of money into each issue – latterly £15,000 – and since there are only 1-2 issues a year, that severely limits how much you can stash away.

Secondly, as I write they have been withdrawn from sale since July 2010, because everybody wanted them so demand outstripped supply. You can sign up at the NS&I website to be alerted should that change.

4. Index-linked bonds

Both governments and companies issue bonds that offer inflation-proofing that’s superficially similar to National Savings certificates, in that there’s an adjustment for inflation, plus some sort of return on top.

In practice there are a lot of differences. The most crucial one is that these bonds are traded in the market, and so the price will fluctuate as the outlook for inflation changes. Unless you buy them when they’re first issued and are prepared to hold them until they mature – which will be many years away – then you could lose money.

This price oscillation means too you’re not guaranteed to get inflation protection, if the market has judged it wrong and so priced the gilts incorrectly.

I can’t even begin to cover the complexity of these vehicles in a short summary:

• Try Fixed Income Investor for more on index-linked gilts.
• Learn more about index-linked corporate bonds (where you also face the risk of a company defaulting).
• Read up about the relatively new index-linked corporate bond funds such as M&G’s. (That’s not a specific recommendation, by the way.)

Another option are certain ‘step-up’ securities issued by banks and building societies (in the latter case as PIBS), which have the ability to reset to a premium over base rates if they’re not called by the issuer beforehand.

Even that sentence would take a whole new post to explain, but if you’re a sophisticated investor who understands the risks, you might want to investigate them further. Fixed Income Investor covered a couple recently.

5. Special inflation-linked ‘savings bonds’ from banks

Banks and building societies are starting to offer savings products tied to the inflation rate. It’s clever thinking on their part, as the demand is likely to be huge.

For instance, as I write Birmingham Midshires is offering a five-year inflation bond paying 0.25% above the RPI inflation rate as it stands every January. A further benefit is that unlike with index-linked gilts (but as with NS&I certificates) your original investment cannot go down in value. The catch is you have to lock your money away for five years – there’s no early withdrawal.

I think we’ll see more of these in the next few months, especially if NS&I leaves its shutters closed, so keep your eyes peeled if you’ve got cash that you want to safely tuck away for years.

6. Buy property and other real assets

Property is a so-called ‘real’ asset; it is a tangible good that does something useful, that you can see, touch, and use.

That’s in stark contrast to the opposite, a ‘nominal’ asset, like a pillowcase stuffed full of banknotes, or a bond that pays a fixed income.

If inflation takes off, an owner of property will typically be able to increase the cost of using that property –a landlord will increase rents, while a residential owner will judge that the next house buyer will pay more to ‘consume’ the accommodation provided by the property. Both will jack the purchase price up!

Remember, our renter will typically be able to pay the higher rent, because her salary will have gone up too, due to inflation. (Unless the renter is a poor pensioner relying on a fixed annuity, of course. You see why the old rightly fear inflation?)

Real assets are preferable to nominal assets in inflationary times, provided they retain their pricing power. But don’t expect the inflation-protection to come in on the nose like with RPI-linked certificates.

Real assets are illiquid, and the pricing is often opaque, so the moves will be jumpy. But in the long-run, many things that are useful, tangible, rare and/or precious can keep their value through inflation (assuming the State itself holds up – think 1970s Britain, not 1920s Germany!)

7. Get into debt

Inflation is great if you’re in debt.

Anyone of limited means who tells you that buying a property with a huge mortgage is trivially easy almost certainly bought in the 1960s, ’70s, or early ’80s. During much of this period, inflation eroded the real value of their debt.

A £100,000 mortgage will halve in value in just 14 years to barely £50,000 in real terms if inflation is running at 5%.

True, interest rates will likely rise to combat the inflation, increasing the monthly cost of repaying the mortgage. The important number to watch is the real interest rate, which is the interest rate you’re paying minus the rate of inflation.

As I write, you can take out a fixed-rate mortgage charging under 4%. CPI inflation is running at 4%, and RPI inflation is over 5%. The net result is that anyone with a 4% mortgage is paying a zero or even negative real interest rate – they’re potentially making a profit by being in debt!

8. Buy equities

Equities are a far better bet against inflation than cash or bonds. I don’t say a perfect bet, and I don’t say over all time periods, but the fact is that over the long-term, total returns from equities have run far ahead of inflation in most developed markets.

This shouldn’t surprise us: The stock market represents a traded chunk of the real economy, and ultimately the economy is where the inflation happens.

To give just one example, if the average basket of groceries goes up in price by 5%, then all things being equal Tesco’s turnover and profits will eventually go up by 5%, too.

Now, there may be time delays. It may be that fuel costs hit first and price rises have to be implemented gradually – all sorts of things can happen that means your shares won’t go up lockstep with inflation. And in hyper-inflationary times, you’re probably better off with a shotgun or a passport. Otherwise, equities should make up the bulk of most long-term savings, in my view.

Note: Reinvesting dividends received is the key to inflation proofing via equities. Share price rises alone have matched inflation over the very long term, but they can lag for decades.

Occasionally you’ll see articles arguing that bonds offer superior protection than equities over some periods.

This will certainly be true sometimes, simply because equities are volatile. If shares plummet 40% in a year then, guess what, you weren’t protected from 5% price rises!

Otherwise, I’d guess that most of the time it only happens when bond yields start very high – not like now when you’re still getting less than 4% on 10-year gilts.

Anyway, you can also find analysts arguing that short-term inflation cycles are good for stocks. I suggest eschewing the data and using common sense.

9. Gold

There’s a lot of debate about whether gold is a great inflation hedge or not.

I find it ironic, for instance, that the same gold bulls who tout its virtues as protection against rising prices also point to the fact that in real terms gold is still far below its early 1980’s peak as an argument against it being too pricey.

Hm, so gold hasn’t done such a good job protection against inflation over the past three decades then, has it?

Gold enthusiasts will also tell you that over the very long-term, an ounce of gold buys about the same amount of goods and services as it did in 1850-wotsit, or that it’s worth the same as a good man’s suit, or that it reverts to some ratio to the Dow Jones Industrial Average.

I’m not sure if any of this is helpful, but there’s no doubt that as a coveted real asset, gold has the ability to escalate in price when inflation strikes. As such, it’s not going to hurt to hold some gold in inflationary times.

But as I said at the start, you ideally want to buy your inflation protection before most other people do. I can only leave it to you to decide whether that’s true of gold, after a more than five-fold advance in a decade of generally low inflation.

10. Game the system

Not everything in the baskets of goods that make up the CPI/RPI statistics is rising in price. Some goods and services are shooting up, but others are seeing price falls.

If you tilt your spending towards the stuff that is going down in price or where prices are static, then inflation isn’t as big a deal for you, especially if it proves temporary.

For instance, there’s a good chance the price of imported goods will become cheaper in a year or two, since the pound still seems to be trading at historically depressed levels to me. Defer your spending for a year or two, and you might buy the same things cheaper.

Who knows, perhaps they’ll even reverse the VAT rise? Well, we can dream.

I don’t want to overdo this argument – as I mentioned above, inflation in the economy eventually touches all things. But as another method of reducing the impact of price rises, it’s as well to be extra-vigilant.

Do you have any views on how to stop inflation destroying the value of your savings? Please share in the comments below!

Everybody hates taxes, especially the obscure, stealthy kind that you didn’t even know you were liable for. Enter off-shore funds1 – including many ETFs and index funds – that are subject to a weird and not-so-wonderful tax regime that could land you with a nasty tax bill.

The headline is that if you own an off-shore fund that isn’t either:

1. A reporting fund, or
2. A distributing fund

Then any capital gain you make on that fund is taxed as income rather than capital gains, when you sell.

That’s grisly for three reasons:

1. Income tax is much higher for most people than capital gains tax (CGT).
2. You can’t escape the tax using your tax-free CGT annual allowance.
3. Nor can you use capital losses elsewhere to offset the gain.

CGT is charged at lower rates than income tax.

The upshot is that if you’re paying capital gains at income tax rates then you could be in for a tax bombshell that completely destroys the point of investing in low cost funds.

How do I avoid paying income tax on capital gains?

First, check:

• Where your fund is domiciled. If home base is anywhere other than the UK then it’s an off-shore fund. This will also determine whether you need to take action against withholding tax. You’ll generally find domicile information in the fund factsheet, or in the fund ‘Management’ section of Morningstar.

• Make sure the fund is classified either as a distributor fund or reporting fund. If it is, then there’s nothing to worry about.

• If the funds are non-reporting / non-distributing but are safely tucked up in an ISA or pension then you can breathe a sigh of relief. Your assets are off the tax radar as far as Her Majesty’s Revenue & Customs (HMRC) is concerned.

If you’ve bought funds listed abroad, then you probably do own non-reporting or non-distributing funds.

Funds must apply to HMRC for reporting / distributing fund status. But vehicles intended for the US or other foreign investor markets are unlikely to have qualified. Why would they bother with the administrative costs if the funds aren’t aimed at UK investors?

You will be liable for income tax on capital gains in such cases – although only when you sell, and if they’re not tax sheltered.

Where does my fund hide its status?

The key info might be buried anywhere, depending on the product provider’s whim.

• The first place to look is on the fund’s factsheet or individual web page.

• Others bury reporting / distributor status in the prospectus or some other fund supplement. Even then it’s not always clear the fund qualifies, as opposed to just having sent the forms to HMRC.

• You can check a list of distributor or reporting funds maintained by HMRC.

Scroll down to the Distributing Funds and Reporting Funds sections. You’ll need to download the relevant spreadsheets, then search by company name or the fund’s ISIN number using Excel’s Find function.

Beware the order isn’t always strictly alphabetical and the lists aren’t necessarily up-to-the-minute. That’s government cuts for you!

If you’re not sure about your fund’s status then contact the product provider and ask.

Can reporting / distributor status be revoked?

It’s entirely possible for a fund to lose its reporting status, though not as likely as it used to be when distributor status was the only option. As HMRC say, in their highly entertaining 209-page manual:

A fund, once granted reporting fund status, may rely on that status going forward subject to continued compliance with the reporting funds rules, which include making reports as described above for each period of account. A fund may exit the reporting funds regime on giving notice and there are rules that permit HMRC to exclude a fund from the regime for serious breaches or a number of minor breaches, subject to an appeals process.

So it could happen, but it would be suicidal for any index tracker to fall foul of the rules, which were designed to increase the attractiveness of the UK investment market, after all.

It’s also worth noting that reporting fund status is replacing the older distributor fund designation. Currently we’re in a strange either/or transitional phase. Distributor status should have been entirely swept away by mid-2012.

For our purposes, it doesn’t matter whether a fund has reporting or distributor status, as long as it has one of them.

Ignorance is no excuse

If you’ve inaccurately filed your tax return, blissfully unaware of the implications of the offshore tax regime, then HMRC are going to want any outstanding tax back with interest. And it could tag on an inaccuracy penalty, too, if it judges you filled in your form without due care and attention.

As a passive investor, my solution is simple. Avoid non-reporting funds like ebola-carrying monkeys, unless you can hide them away in an ISA or pension.

Take it steady,

The Accumulator

1. As always I’m batting for passive investors here. Some off-shore funds are exempt from this rule, but are unlikely to form part of a passive investing strategy. [↩]

Some good reads from around the web.

A couple of decades ago, a friend of mine wrote a short semi-spoof mathematical proof on relationships and sex.

I don’t remember the specifics – something about numbers of dates versus the chances six months later of certain steamy sexual acts – but for five minutes it was very popular on the Internet (which meant it got emailed around a lot: that was the Internet two decades ago!)

We’ve come a long way since then. Today my friend’s proof would be spread by Twitter and Facebook, and, equally, nobody would bat an eyelid. Applying esoteric academic theory to love and marriage has gone from an undergraduate joke to mainstream respectability.

Personally, I remain very partial to explanations of why I am so much more attractive in my 30s to women than when I was 21 (it’s certainly not my sports car!) or why so few men try to chat up the one ‘Perfect 10‘ in a bar.

Such theories are full of holes, of course, and desperately short of romance. Yet like all economic theory, pretending the world is populated by Vulcans making purely rational choices (rather than by us nutters who really do inhabit it) can yield interesting insights, and make you feel less frustrated about your partner’s obviously compromised mental state, as this article from Salon explains:

Imagine, for example, a woman who has hooked up with a guy and has to weigh the cost and benefit of either staying the night or sneaking out to get a better night’s sleep in her own bed.

Either way, it’s all about resources and trade-offs,” says Paula Szuchman, author of the upcoming Spousonomics.

“If you start thinking instead like, what will he think if I leave, how will I be perceived if I don’t leave, etc., etc., you muddy the waters. If you take out the static and focus on the actual trade-off — sleep or no sleep — you’ll make the right decision. In theory.”

So take heart, mon petit: There’s an equation out there somewhere to mend it!

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