Last month, as the Bank of England (BoE) released its economic forecast for the rest of the year, the BoE’s chief economist warned of a possible “inflation tiger”.
The BBC reported a doubling of inflation in April, jumping to 1.5% from just 0.7% in March.
The most recent figures confirm that inflation rose again in May, to 2.1%, breaching the BoE’s forecast (1.8%) and its target of 2% – the first time it has done so in two years.
Many factors have contributed to the rise, including a surge in oil prices, household gas and electricity bills, and the cost of footwear and clothing. Increased prices for pub and restaurant meals and drinks have contributed too, along with a rise in the online sales of computer games.
The easing of coronavirus restrictions has also played a part. Consumers are believed to have accumulated around £150 billion of savings during the various lockdowns since March 2020 and are now eager to spend at least some of this “accidental” wealth.
Some economists worry that this could lead to a sustained rise in the cost of living.
What do the BoE’s economic forecast and this latest rise in inflation mean for your retirement pot, and how can HA&W help you inflation-proof your pension?
What is inflation and what effect does it have on your savings?
Inflation is the rising cost of goods and services over time, or, to put it another way, it is the reduction in the buying power of your money.
The accumulated fund in your pension pot needs to supply an income for the rest of your life, which is why any reduction in its real-terms value is bad news.
Life expectancies are on the rise, meaning the length of your retirement could increase too. Your pension might need to support you for another 30 or 40 years after you retire.
Let’s imagine you retire now, at age 55, and with a pension income of £40,000. In just 10 years, you would need more than £48,700 to achieve the same level of buying power. For a 40-year retirement, your £40,000 would need to rise to around £88,300 per year in 2061.
Both of these examples assume inflation at 2%. As we have seen, it currently stands at 2.1%.
Inflation-proofing your pension
There are two main ways you can mitigate the impact of rising inflation.
1. Choose a pension that rises every year
The simplest way to protect your pension from inflation is to choose an annuity that rises each year. This is known as “pension escalation” and is an added benefit of an annuity. You might opt for a pension that increases by 3%, 5% or 7% each year for example, or one linked to the Retail Prices Index (RPI).
This is especially useful where your annuity will cover regular expenses. A regular annuity that increases each year should make budgeting easier, allowing you to employ flexible options to cover discretionary expenditure elsewhere.
It is worth remembering though, that added benefits such as escalation (as well as spouse pensions and guaranteed periods) lower the annuity you receive in the early years of your retirement, to “pay” for the added cost of the increased pension later. You might need to receive your pension for many years before you reap the benefits of the escalation.
It is worth noting, too, that thanks to the triple lock, your State Pension already rises each year in line with the highest of inflation, average earnings growth, or 2.5%.
2. Opt for drawdown to keep your fund invested
When you take flexi-access drawdown, you can access 25% of your fund as tax-free cash and then take withdrawals from the remaining amount, which stays invested.
Depending on the markets and your attitude to risk, you might opt to take flexible withdrawals while relying on investment performance to mitigate the impact of inflation.
The value of your investment can, of course, go down as well as up, but we know that the general trend of the markets is upward.
Stocks and shares have historically provided inflation-beating returns over the longer term but remember that past performance is not a reliable indicator of future performance.
To take this higher-risk approach you will need to be sure that you have regular expenses covered elsewhere – via an escalating annuity or through your State Pension, for example – and that you have sufficient income from other sources to cover any potential losses.
Get in touch
Seeking advice as you approach retirement will allow HA&W to take a holistic view of your circumstances, helping you to work out the best way to take your retirement income.
Please contact us if you would like to discuss inflation-proofing your pension, or if you have any questions about your long-term financial plan.
Please note
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
