How rising inflation can destroy your pension

Inflation has returned, driven by the weak pound and recovering oil price,” says Adrian Lowcock, investment director at Architas.

Kate Smith, head of pensions at Aegon, says: “This should set alarm bells ringing reminding people that their buying power can change over a relatively short period of time and this can be particularly hard for those on fixed incomes, including many pensioners.”

She adds: "Increasingly people are living 20 or more years in retirement and even low-level inflation can erode the value of retirement income over time. In under 20 years the value of £100 has more than halved, which could severely restrict pensioners’ spending power and quality of life.”

So what can you do? Read our Q&A on pensions and inflation to give you the background to help protect your pension from inflation.

Q. What is inflation?

Inflation measures the rise in the price of goods and services in an economy. There are three main ways of measuring inflation: the consumer prices index (CPI) is the official measure of inflation and is currently at 2.3%.

The retail prices index (RPI) is another indicator and tends to be higher - 3.1% at the moment - because it takes into account certain items (such as, council tax, mortgage interest payments, buildings insurance and house depreciation) that aren't included by CPI.

Then there is the third, new measure, CPIH. This is exactly the same as CPI except it covers owner occupied housing costs too. The Office of National Statistics (ONS) now uses this as the headline inflation rate and it is currently 2.3%, but the experts aren’t happy with the way it is calculated.

“CPI doesn’t take into account housing costs, so in an attempt to rectify this, the ONS will now use CPIH as its headline measure,” says Ben Brettell, senior economist at Hargreaves Lansdown.

In order to include owner-occupier costs the ONS has put council tax and a figure to represent how much a homeowner would pay to rent their home into the basket of goods used to calculate inflation for CPIH.

“Whether or not this is a good proxy is open to debate. The UK Statistics Authority, which regulates the ONS, still isn’t happy with the way owner-occupier costs are calculated, making CPIH a somewhat controversial number at present,” says Mr Brettell.

“For now I expect economists, the markets and the media to continue using CPI as their key measure of inflation, not least because the Bank of England will continue to target it.”

Q. Will inflation rates go up or down?

The Bank of England’s forecasts expect inflation to continue to rise, peaking at 2.8% in the first half of next year but remaining above 2% for the next three years.

But as well as rising inflation, while some experts also believe interest rates may rise in the near future – this is likely to only be to 0.5%, which isn’t a massive hike to counteract inflation.

Q. How does it affect my pension savings?

Any cash savings are hit because the low interest returns on savings accounts cannot compete with the rate of inflation.

Pension pots face a similar challenge with money losing value over long timescales.


Q. How can I stop the effect of inflation on my pension?

If your pension is still invested then the key is to opt for assets that offer inflation-busting growth, but without taking on more risk than you are comfortable with.

“People need to think seriously about how to use their savings to outrun the corrosive impact of inflation,” says Ms Smith. “At just 0.25%, interest rates are at an all-time low, and may not go much higher for some time. Stocks and shares have historically kept better pace with inflation, so are an option for those willing to take some risk and diversify their savings from cash.”


Q. How do I get an inflation-proof retirement income?

The good news is anyone approaching retirement isn’t going to be forced to buy an annuity anymore. This means you aren’t going to be lumped with a fixed income that may not keep pace with inflation.

Instead you can keep your retirement savings invested and draw an income from them at the same time. The problem with this is you remain exposed to the highs and lows of the stock market.

An annuity can still form a useful part of your retirement planning as they offer a guaranteed income for life. One option might be to use part of your retirement savings to buy an annuity that covers your essential expenditure.

If you are buying an annuity it's possible to opt for one that's index–linked, either to inflation or a set percentage such as 3% or 5%, to protect your money from inflation.


Q. Then why doesn't everyone get an inflation-linked annuity?

Although your money is protected, the initial income you receive will be a lot lower than a straightforward level annuity.

Q. Why then would anyone recommend this type of annuity?

Given how long it takes for an inflation–linked annuity to catch up with a more standard annuity you would have good reason for wanting to stick with a straightforward level annuity, that guarantees a set income for the rest of your life. However, you have to question how long you expect to get an income from an annuity.

If you start at 65 and live to over 100–years–old you are looking at nearly 40 years you need to cover. In that time inflation could have gone up dramatically and if you've tied yourself into a set rate there's nothing you can do to stop inflation eating away at your retirement income. If, however, you had an index–linked annuity your money would be protected.

I'm really confused, which one should I go for?

Given the uncertainty over future inflation rates, hedge your bets by going for a combination with part of your annuity index or inflation-linked and the other part level.

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Your Comments

Since the government policy is to target 2% inflation anyone who takes a level annuity is guaranteed to have a reducing income. Therefore I believe that all anuities should include at least 2% inflation protection.