Inflation hit a 30-year high of 7% in March and there are expectations the cost of living will surge even higher in April.

The extent of the impact of rising prices on savers and retirees will depend on a range of factors including income, spending patterns and how long spiralling prices persist.

When it comes to generating a retirement income, the flexibility of your pension and whether it provides protection against inflation will also be important.

Let’s start with the impact on retirement savers.

1. SAVING FOR RETIREMENT

If you are saving for retirement, the biggest challenge posed by the cost-of-living crisis will likely be maintaining your current pension contributions.

While setting aside money for the future might feel like a luxury you simply cannot afford, it’s worth taking some time to write down your incomings and outgoings and think about your priorities.

You might be surprised at the difference a few tweaks to your lifestyle can make to the money you have left to save at the end of the month.

When it comes to long-term saving the earlier you start, the easier it is. What’s more, employees contributing to a workplace pension not only benefit from upfront tax relief but also matched employer contributions through automatic enrolment.

Quitting your workplace scheme will effectively mean you are taking a voluntary pay cut – not something most would want to contemplate right now.

REVIEWING YOUR INVESTMENTS

While a short spell of inflation shouldn’t change your investment approach, it might be worth reviewing the risks you are taking and making sure you are comfortable with your strategy.

Younger investors should generally be able to shoulder more investment risk than older savers, with the aim of benefiting from market returns over the long-term.

One of the key benefits of taking investment risk should be at least keeping pace with – and ideally beating – inflation over the long-term, something which will clearly be a challenge in the current environment.

It is worthwhile for anyone invested in an automatic enrolment default fund to kick the tyres of their investments.

Default funds tend to operate a lower risk strategy than might otherwise be ideal for a younger investor, although you need to be aware that by increasing your investment risk you also increase volatility, particularly over the short-term.

How it works in practice

Take a 30-year-old who has just started a new job and has yet to make a pension contribution. Let’s assume they earn £30,000 a year and their salary goes up by 2% each year.

If they saved in their workplace pension scheme, then 8% of their salary would go towards their retirement. For simplicity we’ll base their pension contributions on total earnings.

If, despite the cost-of-living crisis, they decided to stay in the scheme and enjoyed 4% annual investment growth, they could have a fund worth £306,000 by age 68 (their scheduled state pension age).

If, however, they opt out of their workplace pension scheme and are subsequently re-enrolled in three years’ time – as required by auto-enrolment legislation – then their fund at 68 could be worth around £269,000.

In other words, putting off saving in a pension for three years has resulted in a final retirement pot worth £37,000 less.

2. APPROACHING RETIREMENT

The extent of any impact from inflation on those approaching retirement will depend on how they plan to take an income.

It’s worth remembering that while for some people retirement remains a fixed point in time, for many it is much more flexible.

To provide a bit of context, official figures suggest that around three people choose to take a flexible income through drawdown each year for every person who decides to buy a guaranteed annuity income from an insurance company.

OPTION A: Planning to buy an annuity or take all your pension as cash

For anyone planning to buy an annuity, the aim of the game in the years approaching retirement is to build in certainty.

This usually involves shifting away from equity investments and into bonds and cash as your chosen retirement date approaches.

One of the consequences of ‘de-risking’ during a period of high inflation is that you’ll almost certainly be locking in real-terms losses on your money.

OPTION B: Entering drawdown

For those planning to take an income via drawdown, there is less of a need to de-risk your fund as you approach retirement as the bulk is likely to remain invested for the long-term.

If you’re planning to take your 25% tax-free cash and have specific spending plans for that money, then you might want to de-risk that proportion of your portfolio.

It also makes sense to have at least 12 months’ spending in cash once you enter drawdown to fund your retirement plans.

How it works in practice

Take someone with a £100,000 pension who plans to buy an annuity in five years’ time. As a result, their fund is shifted into bonds and cash as part of a ‘de-risking’ strategy.

If during that period inflation runs at 5% a year and their fund after charges delivers returns of 1% a year, then in ‘real’ terms when they reach retirement their fund will have plummeted in value to just £82,000.

However, it’s worth remembering bond prices should, in theory, move in the opposite direction to annuity rates, meaning if returns on those investments are lower in the run-up to retirement then the annuity rate available should be higher.

For someone planning to cash out their entire pension then the de-risking principle is similar – assuming they have something specific they want to spend the money on.

Withdrawing all your pension in one go potentially brings into play a whole host of other risks, including paying too much tax on your withdrawals, having your fund eaten away even further by inflation, and running out of money early in retirement. It is therefore a decision that comes with a severe health warning.

3. TAKING AN INCOME FROM YOUR PENSION

The impact of rising prices on retirement incomes will depend in part on how that income is taken. Let’s take each of the major conventional pension income routes in turn:

Drawdown

Anyone keeping their pension invested via drawdown has the flexibility to adjust withdrawals to take account of rising living costs.

This has the advantage of allowing you to maintain your living standards even during periods of high inflation. However, ramping up withdrawals will also increase the risk of running out of money early in retirement.

What is sustainable will depend on your personal circumstances and investment returns. Anyone considering hiking withdrawals should make a budget if they haven’t already as inflation varies depending on how you spend your money.

Once you have done this, think about the sustainability of your withdrawal plan and see if there are any day-to-day lifestyle changes you can make to help your money stretch a bit further.

How it works in practice

Take a 70-year-old with a £200,000 pension pot in drawdown who last year took a flexible income of £10,000 from their fund. They ideally want to maintain their standard of living throughout retirement.

If inflation runs at 2% on average and they increase withdrawals at this rate each year, their fund could run out around their 93rd birthday.

However, if inflation runs at 5% on average and they increase withdrawals at this rate each year, their fund could run out by their 88th birthday – a full five years earlier.

Annuity

For those taking an annuity income, the impact of inflation will depend on whether they chose to bake inflation protection into the terms of their contract.

Anyone who bought an inflation-protected ‘escalating’ annuity is probably pleased with the decision right now – particularly as a few years ago the idea of price rises pushing towards double digits would have been fanciful at best.

On the other side of the coin, people in receipt of level ‘non-escalating’ annuities will be feeling the pinch in a big way, as rising prices eat away at their spending power.

How it works in practice

Take a retiree who is paid a level annuity worth £10,000 a year. If inflation runs at 2% a year, after five years the real value of this income will have dropped to £9,039.

However, if inflation runs at 5% a year, their spending power will plummet to £7,738.

1. Defined benefit pension

Those lucky enough to have built up generous defined benefit pension entitlements are likely to have at least some inflation protection built in, although the extent of this will vary depending on their scheme rules.

It’s worth checking the terms of your contract as even inflation increases capped at 5% could mean a real cut in your spending power over the short-term.

The Pension Protection Fund is responsible for paying out defined benefit pensions where the sponsoring employer has gone bust.

The inflation protection you might receive varies depending on the period during which you built up the benefits.

In most cases payments relating to pensionable service from 6 April 1997 will rise in line with inflation each year, but subject to a cap of 2.5% a year.

2. State pension

Finally, your state pension should have gold-plated protection in the form of the triple-lock – a manifesto commitment to increase the payment in line with the highest of average earnings, inflation or 2.5%.

However, a combination of the decision to scrap the earnings link for 2022/23 and the use of September’s 3.1% inflation figure to uprate this year means millions of pensioners will see their state pension spending power reduced over the next 12 months.

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