Guide · Savings & Investing
Inflation and Your Money: What It Costs You in Real Terms
A savings account earning 4% feels like progress — but if inflation is running at 3%, your real purchasing power is only growing by 1%. Here is how inflation works, how to measure its true impact, and what to do about it.
Nominal vs real returns
The distinction between nominal and real returns is the most important concept in long-term financial planning, and it is frequently ignored.
The real return formula
Real return ≈ Nominal return − Inflation rate
Precisely: Real return = (1 + nominal) ÷ (1 + inflation) − 1
A savings account paying 5% when inflation is 2% gives a real return of roughly 3%. The same account paying 5% when inflation is 6% gives a negative real return of around −1%. Your balance is growing in pounds, but you could buy less with it each year.
The long-term cost of even modest inflation
At 2% inflation (the Bank of England target), purchasing power halves every 36 years. At the 2022 peak of over 11%, it would have halved in under 7 years. Here is what that means for £50,000 of cash savings:
| Years | At 2% inflation | At 4% inflation | At 8% inflation |
|---|---|---|---|
| 5 years | £45,288 | £41,096 | £34,029 |
| 10 years | £40,966 | £33,779 | £23,160 |
| 20 years | £33,564 | £22,819 | £10,733 |
| 30 years | £27,474 | £15,415 | £4,972 |
These are real-terms values — what that £50,000 could buy relative to today. The nominal balance stays at £50,000 (assuming 0% interest). All values in today's purchasing power.
What actually protects against inflation
Over long time horizons, the main asset classes perform very differently in real terms:
- Equities — Global equities have historically returned 5–7% per year above inflation over multi-decade periods. Companies pass rising costs to consumers, protecting shareholders' real returns. This is the primary reason financial advisers recommend equities as the engine of long-term portfolios.
- Index-linked gilts — UK government bonds whose principal and interest payments are explicitly linked to RPI. A direct inflation hedge, though with low real yield (often near zero or negative). More relevant as a hedge for those close to or in retirement.
- Property — Has broadly kept pace with inflation over long periods in the UK, though with enormous regional variation, illiquidity, and transaction costs that erode real returns.
- Cash — Short-term: easy-access accounts at 4–5% AER can keep pace when inflation is at target (2%). Long-term: cash consistently underperforms inflation because savings rates lag rising price levels.
How to adjust your financial plans for inflation
When planning for goals that are 10+ years away — retirement income, a property purchase fund, a pension — always work in real terms (today's money). If your retirement calculator assumes you need £30,000/year in today's money and you are 30 years from retirement at 2% inflation, you will actually need £54,000/year in nominal terms at that point. But if you plan in real terms throughout, the inflation adjustment happens automatically.
Similarly, use real return rates (nominal minus inflation) when projecting portfolio growth. A 7% nominal return with 2% inflation is a 5% real return — and it is the 5% that reflects actual growth in purchasing power.
Frequently asked questions
What is inflation?
Inflation is the rate at which the general price level of goods and services rises over time, which means each pound buys less than it did before. In the UK, it is measured primarily by CPI (Consumer Prices Index) and CPIH (which includes housing costs). The Bank of England targets 2% CPI inflation annually.
What is the difference between CPI and RPI?
CPI (Consumer Prices Index) is the UK's official inflation measure, used for the Bank of England's target and many benefit upratings. RPI (Retail Prices Index) is an older measure that includes mortgage interest payments and historically runs 1–2 percentage points higher than CPI. RPI is still used for student loan interest, rail fare increases, and some index-linked gilts. CPIH adds owner-occupier housing costs to CPI.
How does inflation affect savings accounts?
Inflation erodes real returns. If your savings account pays 4% AER and inflation is running at 3%, your real return is only 1% — your purchasing power grows by just 1%, not 4%. When savings rates are below inflation (as they were during 2021–2022), cash savings actually lose purchasing power in real terms, even while the nominal balance grows.
What investments have historically beaten inflation?
Over the long run, equities (stocks) have historically returned 5–7% above inflation in real terms. Property has also beaten inflation over multi-decade periods, though with high transaction costs and illiquidity. Index-linked gilts (government bonds) are explicitly tied to RPI, making them a direct inflation hedge. Cash typically underperforms inflation over long periods, though high-rate savings accounts can keep pace in the short term.