Yesterday evening we heard Mervyn King, the Governor of Bank of England, explain that British people will be paying the price for this financial crisis for a generation. He described the £1 trillion cost of the government bank bailout as “breathtaking”.

In addition to the bank bailout, the Bank of England continues to embark on their ‘asset purchase programme’, at a total cost of £175 billion. The amount of money allocated to this quantitative easing was increased by £50 billion in August.

Looking at massive numbers like this is one thing, but what will the real cost of economic recovery look like? What impact will all of this spending and money creation have on our personal financial planning in the years to come? Here are some educated guesses.

Higher taxes

Having to pay more taxes, particularly if you are a higher earner, seems inevitable if the Government is going to be able to reduce massive levels of public borrowing in a reasonable length of time.

A new 50% income tax rate for people earning over £150,000 a year is being introduced on 6th April 2010. This replaced the originally proposed 45% income tax rate for higher earners, which was due to come into force for the 2011/12 tax year. Whilst this is only likely to have an impact on 1% of earners, it will mean around £220 per month in additional income tax for people earning £150,000 a year.

People earning over £100,000 a year will see their income tax personal allowance (the amount of earnings on which you pay no tax) removed in stages from next April. Those earning £113,000 or more will have no personal allowance. It will be removed at a rate of £2 for every £1 of earnings over £100,000.

But will these higher taxes for big earners go far enough? The National Institute of Economic and Social Research (NIESR) suggested today that the basic rate of income tax will also need to be increased from 20% to 27% to pay off national debts.

In January we will all see Value Added Tax (VAT) return from the current level of 15% back to 17.5%. There is every chance that it could go higher than that. Britain has one of the lowest VAT rates in Europe, with the average (according to research from KMPG) standing at 19.8%.

Later retirement

Working longer and retiring later formed a key part of Tory proposals for public finances during party conference season. They suggested raising the State pension age from 65 to 66 (for men and then eventually women) starting from 2016.

We are already on track to see the State pension age increased to 68 for men and women from 2044, but more recently commentators have been calling for these necessary increases to be brought forward and even extended to age 70.

The National Institute of Economic and Social Research (NIESR) said today that the State pension age will need to be 70 if national debts are to fall to acceptable levels by 2015. The Institute of Directors (IOD) has also called for the State pension age to be increased to age 70, ‘as soon as is reasonably practical’.

Increasing the State pension age saves a huge amount of money each year; money that could be used to both reduce national debt and improve pension payments to older people. However, any sudden rise in State pension age is likely to be very unpopular, particularly if it leaves little time for people approaching the current State pension age to plan for the changes.

Price inflation

We are living in a low inflation environment, with the Retail Prices Index (RPI) recording inflation including mortgage interest and housing costs at -1.4% for the year to September.

The Consumer Prices Index (CPI) measure of inflation fell to an annual rate of 1.1% for the twelve months to September, down from 1.6% the previous month. This remains below the Bank of England target of 2% and is significantly lower than the spike of 5.2% recorded just last year.

Analysts are divided on the eventual level of price inflation in the medium to long term, but many expect an moderate (if only temporary) increase later this year. Petrol prices and the cost of clothing are expected to continue to rise, and these items could contribute to an increase back towards the 2% level by the end of this year or early in 2010. The increase in VAT from the start of next year will also feed back into inflation figures.

We might continue to benefit from negative or very low price inflation for another year or so, but eventually various pressures – including the impact of the government printing money – will feed through and result in a return of inflation figures we have been more used to seeing historically.

Low interest rates

Last week we saw a prediction from the Centre for Economics and Business Research (CEBR) that the Bank Rate will remain at 0.5% until at least 2011 and then stay under 2% until 2014.

The historically low Bank Rate has not necessarily resulted in lower borrowing costs. For those fortunate to be on Base Rate Tracker mortgage deals, most of this year has been a very pleasant experience with mortgage payments slashed to tiny amounts as a result. New mortgage (and remortgage) deals remains reasonably expensive and difficult to obtain as the banks continue to repair the damage to their balance sheets.

Savers will also have to cope with this low interest rate environment. The only saving grace for savers is that negative or very low price inflation means the gap between the interest rates they can get and inflation is now at record levels. This results in the preservation of the ‘real’ buying power of their cash, although it is little consolation for those who rely on interest from their savings to supplement other income in retirement.

Public spending cuts

Reducing national debt is likely to mean substantial public spending cuts and then freezes on capital investment over the next few years. The various political parties might argue about where these cuts should fall, but the end result is less money within the public sector. In fact, the CBI has called for an extra £120 billion in public spending cuts to help bring the national budget into balance two years earlier than current government plans.

This might not have a major impact on all of us, although those in public sector employment are likely to experience only moderate pay increases and also job uncertainty.

If you are a user of public services (as the overwhelming majority of us are) then your experience of these in coming years is unlikely to be the same as it has been during the past decade. This could result in greater use of private sector alternatives for those who can afford them, particularly if we start to see key services such as the National Health Service (NHS) suffer.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice. You can follow BrilliantWithMoney on Twitter @brilliantmoney and Martin @martinbamford.

But what happens when debt is no longer so expensive?

Since March 2009, the Bank Rate (set by the Bank of England Monetary Policy Committee) has been at a historic low of 0.5%. Interest rates associated with debts and savings have generally followed suit in a downwards direction. Does it still make sense to pay off debt?

What is the alternative to debt repayment?

If you have spare cash then the alternative to paying off your debts might be to save it, invest it or spend it. Assuming you want to build your wealth rather than splash your cash on the High Street, the attractiveness of the save/invest option will depend on the return you hope to get and the tax treatment of that return.

Cautious people who are not prepared to accept risk to their money will probably want to stick with cash, and in the current environment that means a very low return. Savings rates are generally a lot lower than the interest charges on debts. The average instant access savings account was paying just 0.72% in August.

If you are more adventurous then even investing money is likely to result in lower than usual returns in this low-interest, low-inflation world.

Higher rate income tax payers have a greater hurdle when it comes to getting a better return on their savings than the cost of their debt. Even basic rate income tax payers have to factor in the cost of 20% income tax on their savings interest.

If you do utilise your annual Individual Savings Account (ISA) allowance to shelter your savings interest from income tax, you might not be in a much better position. During August the average cash ISA offered a measly 0.41%, down from a not much more inspiring 0.42% in July. It used to be the case that cash in an ISA would always beat cash in an ordinary savings account when it came to the interest rates on offer. Sadly this is no longer the case, at least for the time being.

A real life example

My own financial review last week, the first I have done for myself since the global financial turmoil of last autumn, revealed some useful figures for a real life example of savings versus debt repayment. For privacy and data security reasons, I’m not sharing the names of providers or specific amounts here, but the interest rates are real.

I was a bit disappointed to discover that the interest rate on my savings account had fallen to 0.1% gross. When I opened this savings account several years ago it was paying a market leading rate, which was maintained for several years, only to fall away dramatically when the Bank Rate started to get slashed.

As a higher rate taxpayer, the net interest on my savings was therefore 0.06%. Fortunately for the bank I opted to receive my statements electronically rather than via the post, or the cost of stamps each year would probably be higher than the interest they were paying!

For the most part, the interest rate being charged on my mortgage had fallen dramatically as well. It’s a Bank Rate tracker + 0.14%, so the interest rate is currently 0.64%, at least until the initial term runs out at the end of this year. After that it becomes Bank Rate + 0.99% for the remaining term, so 1.49% assuming interest rates don’t go up before then.

I also have a small further advance on my mortgage, with a less attractive interest rate as it was only taken out last year. This is charged at a Standard Variable Rate of 4.99%. The higher interest rate means it is a no-brainer as to where I should focus my future financial resources, even though this bit of the mortgage debt is much smaller than the main part.

In fact, in order to win with my cash in savings, I would need to find a gross interest rate of 8.32% (or gross interest of 4.99% within a cash ISA). With the Bank Rate at 0.5%, three month Sterling LIBOR not much higher and a banking sector desperate to boost their balance sheets, that’s not going to happen any time soon.

So, along with finding a more competitive interest rate for my savings, this analysis has shown me the real benefit of paying off debt rather than adding to my savings account over the next twelve months.

What about existing savings?

In addition to allocating future surplus income to debt repayment, there is also a strong argument for using existing savings to repay debt. On a pure financial basis, this would make sense. The net return on my savings (money set aside for my tax bill and an emergency fund) is beaten into submission by the cost of the further advance on my mortgage.

The only thing holding me back from doing this is the lack of flexibility it would create. Pre-credit crunch, it would have been a reasonably easy decision. I could have allocated savings (certainly the emergency fund) to mortgage repayment, safe in the knowledge that I could have accessed the cash again in the event of a real emergency. Today I am confident I could not.

Put simply, the availability and cost of new credit simply doesn’t make this course of action stack up today. I could use my emergency fund to pay off a bit more of the mortgage and I would be quids in immediately in terms of interest earned versus interest charges suffered. But if my boiler exploded or the engine fell out of my car, I would be at the mercy of bank lending policies.

Although the credit limit on my credit card has been maintained since the start of the crunch, there is no guarantee that this will not be reduced in the future at the whim of an increasingly desperate bank.

Two decisions at play

There are two dimensions to this decision – the financials and the emotions. From a pure financial perspective, debt repayment prioritised over savings continues to make sense. Debt costs are generally still much higher than net savings rates.

The emotional angle is what can make this a more challenging decision.

It can feel like a very risky move to take money from existing cash holdings and use them to repay debt, placing that cash beyond easy reach if you need it again in the future. In that case you might consider the extra cost of debt over the net return from savings to be the price you are willing to pay to retain access to your cash. There is nothing wrong with that, but make sure you understand what this course of action is costing you.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice.

If you are too optimistic with your assumptions, it is likely your Financial Planning will fall short of your targets. Make pessimistic assumptions and your Financial Planning could be unaffordable.

Because each assumption can have a big impact on the outcome of your Financial Planning, it is important to understand which assumptions to make and also how to make them.

Here are six Financial Planning assumptions you need to make and how you might make them.

1 – Your life expectancy

The likely date of your death will drive many elements of your Financial Plan. Understanding for how long you are likely to live helps you understand how much capital you will need to ensure you do not run out of money in your lifetime.

Life expectancy is the number of years you have left to live at a particular age. Average life expectancy varies between different countries, with the current world average estimated to be 67 years old.

Women typically live for longer than men. In the UK, the average life expectancy at birth is 76.5 years for men and 81.6 years for women.

The problem with looking at average life expectancy is that we tend not to be average. For this reason, whilst understanding your likely life expectancy is important for Financial Planning, a better number to use is 99 years old.

By picking an unlikely but possible age for your life expectancy you reduce the risk of running out of money too soon. This is a better outcome than living longer than planned and running out of cash in later life.

2 – Future price inflation

Goods and services typically become more expensive over time. We are all used to prices going up, although because these price rises tend to be quite gradual it can be easy to dismiss the relevance of price inflation for our Financial Planning.

The issue with price inflation is the compound nature of inflation over long terms. In the same way that compounding helps multiply returns from savings or investments, it also makes inflation incredibly damaging to your Financial Planning, unless you factor it in to your plans.

As a simple example, imagine you are 30 years old today and plan to retire in 35 years time at age 65. If you want an income in retirement equivalent to £25,000 in today’s money, inflation at 2.5% a year between now and age 65 means you need £59,330 of income to have the same purchasing power. That is the impact of inflation.

Of course inflation does not end when you retire. In fact, price inflation is typically higher for older people as a result of the types of goods and services they tend to consume.

We might be in a temporary period of negative price inflation (as measured by the Retail Prices Index – RPI) right now, but positive price inflation will emerge again. Start planning for it now by thinking about the real cost of living in the future.

3 – Interest rates

Understanding the rate of interest you can get on cash savings often forms a cornerstone of your Financial Planning. This is your ‘risk free’ return; the return you can get on your money without exposing capital to risk.

With the Bank Rate currently running at the historic low of 0.5%, it would be easy to dismiss cash savings as a sensible home for your money. It is important to always use cash as a starting point for your Financial Planning, and only consider taking investment risk if your financial objectives require a higher level of return (and you are prepared to tolerate the risk/volatility).

Interest rate assumptions also have a direct impact on the cost of servicing debts. Making reasonable assumptions about rates of interest in the future enable you to make important decisions about prioritising the repayment of debt over other financial objectives, such as investing for the future.

4 – Annuity rates at retirement

When you reach your selected retirement age, one way in which you can convert your pension fund into an income is to purchase an annuity. These financial instruments simply convert capital to income. They come in a variety of shapes, but can be a good starting point for understanding the income value of your accumulated pension fund.

Annuity rates vary depending on a number of factors including life expectancy, interest rates and gilt yields. They will also vary depending on the options you select, such as a benefit for your spouse or ‘indexation’ to reduce the impact of future price inflation.

A good plan to start when making assumptions about future annuity rates is the best rate you could obtain today, assuming you were at your selected retirement age. You should then keep this under regular review on at least an annual basis. It will change.

5 – Earnings inflation

Because the cost of living goes up (as measured by price inflation) we would usually expect earnings to go up over time as well. The preferred measure for this is the Average Earnings Index (AEI). This is published by the Office for National Statistics and is the key indicator of how fast earnings, or pay, are growing in Great Britain.

For the year to June 2009, AEI (including bonuses) rose by 2.5%, up from 2.3% in the year to May 2009. Over the long term we would usually expect to see AEI increase at a faster pace than the Consumer Price Index (CPI); the preferred measure of price inflation. For this reason you should link your price inflation and earnings inflation assumptions.

6 – Investment returns

Another important assumption for your Financial Planning is the return you are likely to get from your investments. This is another long-term assumption; unless you have a crystal ball you will not be able to accurately or consistently predict the investment return from a given market in a certain year.

We know that historically equities (company shares) have outperformed cash by a wide margin. Rather than selecting a single assumption for investments in general, you should make an assumption for each of the main investment asset classes – fixed interest securities, property and equities.

Based on these assumptions you can then work out an overall investment return assumption for the level of risk you are prepared to take with your money.

A final point

Because these assumptions can have such a big impact on your future financial well being, it is essential to keep them under regular review. Consider the assumptions you have made at the annual review of your Financial Plan to ensure they remain reasonable over the long-term based on current economic and investment market conditions.

If you keep your assumptions under regular review, and then adjust your Financial Plan accordingly when those assumptions change, you can keep your Financial Plan on track.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice.