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.
Protecting your pension income from inflation
Markets are getting increasingly worried about inflation, with the US recently registering consumer price rises of 4.2% in a year. Here in the UK, CPI still stands at just under 1%, but inflation expectations are mounting, thanks to the strong economic rebound expected in 2020.
Indeed looking at prices in government bond markets, inflation expectations have climbed to their highest levels since 2008.
INFLATION PARTICULAR PROBLEM FOR PENSIONERS
High inflation isn’t a friend to anyone, but it can be particularly harmful for pensioners, because they are typically no longer earning wages, or building up their savings, so they rely on the inflation protection built into their retirement assets to help to offset price rises.
Savers hitting retirement therefore need to carefully weigh up their options in terms of protecting their pension pots from inflation.
Those lucky enough to have final salary pensions entitlement built up will happily find that their income in retirement rises each year with inflation. State pension entitlement also rises with the minimum of inflation, wages or 2.5%, so there’s some protection from rising prices there too.
However personal pensions don’t have any inflation-linking built in, so you need to engineer it yourself, particularly if you’re planning to use some, or all, of your pension pot to buy an annuity.
HOW ANNUITIES ARE AFFECTED
Annuities offer savers the ability to turn money held in a personal pension or SIPP into a guaranteed income for life. However, a standard annuity comes with no inflation protection, it pays the same amount of income each year for the rest of your life. If you’re retiring at 65, and live to 85, that’s a 20-year period, over which even modest inflation can seriously erode the buying power of a fixed income, let alone the higher rates of inflation which are increasingly troubling markets at the moment.
You can buy an inflation-linked annuity, where the income you receive increases each year in line with consumer prices. This protects you from inflation, but the cost of this insurance is high.
Whereas a standard level annuity will pay a 65-year-old around £5,000 a year for each £100,000 pension pot, an inflation-linked annuity will only pay out around £3,000 a year to begin with. Of course this will rise over time with inflation, but investors need to be very patient for the pay off, to say the least.
Another option which has become much more popular since the pension freedoms were introduced, is to keep your pension invested, and draw an income from your portfolio. Dividends from the stock market should rise over time, boosting your income, and providing useful ammunition in the fight against inflation.
However, unlike an inflation-linked annuity, there’s no guarantee they will keep pace with inflation. They are also variable, and in some years, like 2020, will fall. However, combined with the risk and potential reward of a fluctuating capital value, as share prices go up and down, there is the potential for investors to come out ahead of inflation over the long term.
A MIX AND MATCH APPROACH
A retirement income strategy should always include a consideration of the effects of inflation, but right now, as we hopefully emerge from the pandemic, it’s a particularly relevant issue. Pension savers approaching retirement don’t have to choose just one of the three income options highlighted above.
In fact, a mix and match approach probably has the best chance of striking the right balance between inflation protection for the future, and enjoying a decent income stream in the here and now.