As the cost of living rises and interest rates stay at a record low, financial adviser Ian Lowes takes a look at how to make your investments grow.

IN this article I want to highlight several items of news that are inextricably linked and affect the amount we can save and the return we get on those savings. The first item of news concerns inflation. The Office for National Statistics (ONS) last month revealed figures showing that inflation in the form of the Consumer Price Index rose to 5.2% in September.

The CPI is a basket of goods and services (such as food and utilities) that affect our household expenditure. The latest CPI is the highest year on year rise since the index was first measured in 1997.

The Retail Prices Index (RPI), which is constructed of slightly different basket of consumer goods including Council Tax and mortgage payments, as you might expect was higher at 5.6% – the highest in over 20 years (June 1991).

Behind the figures the ONS commentary showed that overall inflation is being driven by the rising cost of transport, housing and household services, and food, which between them account for over half of all inflation.

The second piece of news is that despite these above-forecast inflationary pressures, it is expected that while the UK economy is slow to grow and the effects of the eurozone crisis continue to play out, the Bank of England’s Monetary Policy Committee will favour stimulating the economy (which is why we have seen the Bank inject another £75bn of Quantitative Easing into the economy) rather than raise interest rates to tackle inflation. This means savings rates are not likely to increase in the near future.

Now for some ‘good’ news. This is that as the underlying factors in the rise in inflation – higher taxes, energy bills and food prices – start to work their way out of the equation over the next year – the expectation among leading commentators is that inflation will start to come down. When the effect of the rise to a 20% VAT rate this year moves out of the system inflation should reduce – although as we know nothing in economics can be guaranteed and there are plenty of reasons why such a view could turn out to be incorrect.

The second piece of good news arises from the recent increase in inflation. How can this be good news? Simply because as the result of CPI rising to 5.2%, the amount we can invest in ISA wrappers will increase for the 2012-2013 tax year. The ISA limit was indexed to inflation for the first time in 2010. Initially this was to RPI and from 2012 onwards the limit will increase in line with CPI, which is usually, although not always, lower than RPI.

However, because inflation spiked in September, the Treasury’s governing month for setting the ISA limit figure, for the 2012-2013 tax year the annual ISA allowance will increase by £600 from £10,680 to £11,280.

This means that next year investors will be able to put the full £11,280 in a stocks and shares ISA, or £5,640, half the full ISA limit, in a cash ISA and half in stocks and shares.

To make it easier for investors, the Treasury has calculated the figure to the nearest £120 to make it easily divisible by 12 to help those with monthly savings plans – allowing £940 to be saved tax efficiently each month.

While it is beneficial to be able to save and invest more in the tax efficient ISA wrapper, as mentioned above, at the same time inflation is eating away at savers’ purchasing power. While interest rates remain low they are preventing savers’ ability to make gains above the rate of inflation unless they take some risk with their cash. For example, just for the value of their capital to have stood still in real terms, a basic rate taxpayer would have had to have earned over 6.5% over the last year, and of course there are very few deposit accounts paying anywhere near even half that amount.

One way or another, in the current climate, potentially beating inflation means investing in alternatives such as stock market-based investments. There are various risks involved with stock market (or equity) investing, but careful planning and investing across a range of different areas and investment vehicles – which is what we recommend at Lowes – can help reduce the negative impact of individual risks should they occur.

The most commonly used investments include actively managed equity funds, where the fund manager looks to beat the stock market by careful selection of stocks and shares; passive or tracker funds, where the fund holds the companies in the index and looks to stay close to the performance of that benchmark; corporate bond funds that invest in company debt; and funds that invest in government debt. Equity funds and debt funds are expected to act in different ways to different market conditions, which can help to spread risk in an investment portfolio.

Another way to spread risk is to use different investment vehicles. One of the vehicles we like to use at Lowes is structured products. Simply put these are investment contracts held for a set period that tell you what return you will get depending on the performance of the stock market at the time the contract matures. For example, a product might offer 55% return after five years as long as the FTSE 100 is at the same level or higher than at the time the investment started. This would equate to a compound annualised return of over 9% per year - well above the current rate of inflation.

There are risks involved with this product – if the FTSE finishes the five years term 50% or more lower or the bank underwriting the contract goes bust it will produc a loss. However, there are many variations on these products and there are some available that can protect your capital from any stock market fall although the gains are lower as a result of that added protection.

We use structured products in our clients’ investment portfolios to diversify the types of investments and vehicles used, and so provide a balance to the portfolio.

Most structured products can be put into an ISA or used under capital gains tax (CGT) rules. This means you can make use of both the (current) £10,680 ISA tax allowance and the £10,600 CGT allowance.

:: Ian Lowes is managing director of Jesmond-based Lowes Financial Management.