Why you may be kidding yourself about kids savings

Posted by David G. Evans

Great! You've got a savings account set up for your children and it even has a balance in there. They've taken the first steps toward better financial habits – thanks mum and dad. If they keep going at this rate they will have university, deposit for a flat and even a gap year holiday taken care of and think of all that interest and interest on interest they will be earning.


Hang on.... Let's not kid ourselves. Unfortunately this is not going to be that easy. Opening a bank account and getting into the habit of saving is a great start, no matter how small. We cannot emphasise how much we are in favour of savings goals, nest eggs, rainy day funds etc. Just taking this step already puts you ahead.

But – I hate to be the one to have to inform you - but you savers are being oppressed! Financially oppressed that is. This is economic-speak to say that you are earning a negative "real" interest rate. In other words the interest you will earn on those savings will be less than the price increases due to inflation. You will be able to buy less items in the future because the rate of inflation is greater than the rate of interest received (ignoring taxes).


Let's look at some numbers to help illustrate. If I had £100 today I could purchase £100 worth of goods.

If Inflation is 3% but my bank only pays an interest rate of 1% per annum then in 1 years time my situation would be as follows:

I have £100 (£100 + £1 interest), but my goods are now worth £103 (£100 + £3 price increase due to inflation). In short I could not purchase the item as it is now too expensive.

I have been oppressed!

Instead I can only purchase about 98% of the item (which really means a cheaper or only part of the item).

The next year looks even worse. . . 

My £100 has grown to £102.01 but my goods are now worth £106.09, so I can only purchase 96% of it.

After 10 years I will have £110.46 to buy an item now costing £134.49 taking me down to 82%.

However had I not have saved anything I would have to cough up the full £134.49 rather than just the (oppressive) difference of £23.93!

You may say, well why not purchase the item today as you can afford it? In some cases (such as immediately used or consumed items) that would be fine, noting that they may not be around minutes after purchase let alone in 2 or 10 years. However in other cases, particularly more expensive items, they are for the future (car, house, university etc). There is no point buying a car for a 5 year old because it is cheaper now as it will just deteriorate and require maintenance and it's not possible to pay university fees today no matter how good a cost savings idea it might be.

What's that? You've got a better rate than 1%. Super. But lets take a look..... based on what is currently in the market, the best rates (see below) for children's bank accounts are 3% which is approximately the inflation rate that we were using. This means that you're keeping pace with inflation. Good news is that you're not losing as in the previous example, but you're not actually making any REAL money. All the interest that is received is compensation for the fact that the price of everything is going up. You're not getting ahead, so to speak, but you're a lot better off than in the previous example and miles ahead of the person that is saving nothing.

Source: This is Money (Percentages represent tax bands)
Source: This is Money (Percentages represent tax bands)

Remember to also ensure that you have your Form R85 filled in, so that they don't get hit with the 20% income tax that banks impose. Also bear in mind the tax rules and limits for children's interest  – see here for more details.

There are better deals for regular savings, which require putting money aside each month and not touching it, if this is for you.

Cash Junior ISA's?

Same story applies. The best current rates (see below) are still only a fraction over 3%, so while you don't have to worry about whether you are being taxed or not, the account is at best keeping pace with rising prices.

Source: This is Money (Percentages represent tax bands)
Source: This is Money (Percentages represent tax bands)

We will leave the subject of stock and share ISAs for another post, as they require a conversation about the risks of investing in shares.

Other things to consider

UK RPI Short Term

Why is 3% the magic number? It's not. It's just a number that we chose for Inflation. However if you look at where Inflation in the UK has been recently, it's not a bad starting point. The issue that we should be aware of is what the inflation rate is (or will be) when we are making our investment decisions. 


UK RPI Long Term

If Inflation turned negative as it did in 2009 then even a return of zero (keeping your cash under the mattress) is positive in this sense as it means that you will be able to buy more in the future than you can today.

The flip side of that is that if Inflation rises, so too does our “break-even” rate - the rate that we need to earn to keep up with inflation. Lets take a look at longer term inflation and what happened in the 1970s. Although unlikely, it is not impossible to imagine an environment with higher inflation in the future.

Interest Rate to rise

Or so the papers tell us. Anything can happen but if we believe what the papers and central banksters want us to hear, a rise is on the cards in the not too distant future. Welcome news for savers, unwelcome news for borrowers but will this help us? Yes is the most obvious answer. As long as interest rates are above the rate of inflation we will be ahead, but there are some exceptions.

The UK Base Rate (the Bank of England rate that it charges commercial banks for lending) is at 0.5%, but we have seen the best savings accounts are paying 3%. We'll leave the reason for this difference for a later time but for now acknowledge that it is possible that interest rate increases are not completely passed onto savers.

Further fixed rate investments will not see a change in their returns. They are fixed for the life of the investment regardless of what interest rates and inflation do. Generally shorter term savers will be fine, but in the longer term as interest rates move, so too does inflation - not exactly but close. Therefore in an situation of abnormally low interest rates we want to be careful about locking up our money in a fixed rate investment for a period of time when inflation may catch up and eat away all the returns.

The take away?

Where does this leave us? When your bank manager tells you what a great rate they are offering on deposits, hopefully you'll think twice about how great it is. Interest rates can change, as can inflation, but it is important to consider the latter when we think about just how great that rate really is. Clearly maximising the interest rate or rate of return is the ultimate goal, but understanding the difference will tell you how much is really being earned - or isn't.

Source: The World Bank
Source: The World Bank


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