The Impact Of Inflation On A Pension Fund
Once you are in retirement the value (in real terms) of your retirement fund can be affected by three main factors. Here we cover the first of those potential issues – the impact of inflation on a pension fund.
In simple terms, inflation is the increase in the cost of goods and services often measured by a specific basket of items over time. It is usually caused by increasing costs, increased demand or some combination of the two.
In this post, we only cover defined contribution type pension schemes. The issues for defined benefit (final salary) pensions are different.
The Impact Of Inflation On A Pension Fund – An Example
If we assume no investment growth in a pension fund over time then a pension fund worth £100,000 today would be worth approximately £88,400 in 5 years, £78,100 in 10 years and £61,000 in 20 years based on consistent 2.5% inflation over that period.
When I started drinking in bars over 35 years ago three pints of lager and three packets of Cheese and Onion crisps cost less than a pound. Today? Well it depends where you drink but perhaps you get the point.
Of course, it should be reasonable to expect the value of an investment to grow over time. In the above example if the pension fund grows consistently at 2.5% per annum then the value of the pension fund in real terms will remain static.
Predicting The Risk
Inflation is difficult to predict. You would perhaps expect the experts at The Bank of England to be as well qualified as anyone to make reasonable predictions but they have consistently got it wrong. On occasions they have confidently predicted a rise only to see the inflation rate fall.
In August 2007 the Bank of England predicted inflation in 2008 at around 2 to 2.5%. The maximum they predicted inflation would reach between 2007 and 2010 was around 3.5%. In September 2008 inflation was at 5.2% and there were worries it could hit 7%! Of course, this is an extreme example as the financial crisis hit in 2008 but it does illustrate the problem with predictions.
There is always a risk that some major economic or political event occurs resulting in a rapid rise in inflation. It could happen (and has happened in the past) but it is not something that can be planned for.
Retirement risks tend to act together. Inflation risk and longevity risk are interrelated. Let’s assume an individual lives for 30 years from retirement. Even a fairly benign inflation rate could significantly erode the purchasing power of a fixed income throughout retirement. Is inflation likely to be consistently high for that entire period – probably not. High inflation could exist for 10 years or more but lower inflation over the remaining 20 years would balance out the potential negative impact.
Inflation risk is also linked to investment risk. if inflation is high at the point the value of investments are falling it can have a negative impact that can be difficult to recover from (especially over the short term).
Protecting Yourself From Inflation Risk
There are ways to protect yourself from the impact of inflation in retirement but they are not perfect and they do generally come at a cost. The options available depend on your retirement choices.
The potential impact of inflation on your pension fund should be part of your retirement planning. If your choice is Annuity you can factor in some protection from inflation. If Drawdown is your way forward your choice of investments and management of your withdrawal profile will be important.
Inflation is a key risk to the value of a pension fund. Its potential impact should be considered carefully when making choices at retirement. Once in retirement the options available to address the impact of inflation are limited but good advisers and investment managers should be able to help minimise the effects.
If you would like to talk through your retirement options please give us a call on 0800 043 8341 or complete the form below and we will call you back.
This blog is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investment or course of action. The past is not a guide to future performance. The value of investments can go down as well as up and you may not get back the full amount you invested. Tax and financial regulations can change. Any figures quoted above are at the date of publication.