Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
It’s been a long time since the spectre of inflation has loomed quite as large as it does today.
CPI has doubled in the space of a month and, with the end of lockdown hopefully a month away, there is the real prospect of a ‘Roaring 20s’ spending frenzy in the UK, fuelled in part by people who have managed to save a pile of cash after spending 14 months doing not very much.
While a dose of mild inflation is nothing to be scared of and can simply reflect a healthy, growing economy, significant price rises would have a disastrous impact on those taking an income in retirement – particularly if they last for years rather than months.
Investors need to remember that, while price rises may still be relatively low at the moment, inflation expectations are at their highest level for over a decade.
It is therefore sensible to consider how a prolonged period of higher inflation might affect your spending power in the future. In particular, anyone with a significant portion of their pot in cash who doesn’t take action soon risks locking into a substantial real terms loss.
Taking an income through drawdown
Take someone with a pension worth £100,000 who needs to take an income of £5,000 a year from their fund to cover their retirement costs.
In order to maintain their lifestyle, they will need to make sure their income rises each year in line with prices (i.e. inflation). Let’s assume investment returns after charges are 4% per annum.
If inflation runs at 0% then they can withdraw exactly £5,000 a year from their fund and maintain their spending power, with the fund eventually running out after around 37 years.
If inflation runs at 2% then they will need to increase withdrawals by 2% each year to maintain their spending power. So, after a year they will need £5,100, while after 5 years they will withdraw £5,520. Under these conditions, the fund could run out after 25 years.
If inflation runs at 4% - unthinkable in the current economic environment but relatively common historically – then they will need to increase withdrawals by 4% each year to maintain their spending power. This means after a year they will need £5,200, while after 5 years they will withdraw £6,083. Under these conditions, the fund could run out after just 20 years.
Buying an annuity
If you’re planning to buy an annuity, you can usually choose between an income that stays flat throughout retirement or one that increases to track inflation. Regardless of which option you go for, you need to make sure your provider knows of any underlying health or lifestyle factors that might reduce your life expectancy as this should allow you to boost your rate.
Take a healthy 66-year-old with a £100,000 fund who wants to buy an annuity. If inflation of 0% is factored into the quote, they could receive an annual income of £5,326.
However, if inflation of 2% is factored in this figure tumbles 25% to £3,979, while an annuity increasing by 4% a year would pay just £3,068 – over 40% lower than a flat-rate annuity*.
*All quotes obtained from the Money Advice Service annuity calculator on 19th May 2021
These articles are for information purposes only and are not a personal recommendation or advice.