What does inflation mean for you and your savings?
After a long period of remaining relatively steady, there’s been lots of information in the news about inflation rapidly rising. It exceeded the Bank of England’s (BoE) target of 2% in December 2021 and was reported at 6.2% by February. It is expected to remain high for the rest of the year.
What is inflation?
Simply put, inflation is the increase in the cost of living. When there is more demand for a product or service, or the cost of producing it rises, that product or service becomes more expensive to buy. When we see an increase in cost for a range of products and services, this pushes up how much it costs for us to live – hence, the ‘cost of living’.
Several things have impacted this surge in inflation: increasing energy costs, rising prices for petrol and diesel and supply chain issues caused by the combined logistical challenges of Brexit, the pandemic and the war in Ukraine.
For the UK, the inflation rate is worked out by the Office for National Statistics. They use a shopping basket of 700 items (of both goods and services) to monitor changes in price – this is called the Consumer Price Index (CPI). The BoE is tasked by the Government to keep inflation at around 2% each year.
How inflation is usually controlled
The BoE keeps a close eye on the CPI. If the cost of these items increases too quickly, they may decide to raise interest rates. Higher interest rates make it more expensive to borrow money and can have the effect of encouraging people to save, as their money can earn more interest. On the flip side, the BoE may lower interest rates if it’s not increasing quickly enough as this can have an impact on wages.
What this means for your retirement savings
Rising inflation, or an increase in the cost of living, doesn’t just impact what you can afford today, it also affects your purchasing power in the future. This is because if its more expensive to live, and the cash in your savings doesn’t keep pace with that cost, then the real value of your savings reduces.
If you spent £100 on a car service this year, inflation at 7% a year could mean that the same service costs you £107 next year. If you’ve saved your cash in a savings account that is earning 1% interest a year, £100 would only be worth £101 the following year. Therefore the real value of the cash you’ve put aside would have reduced compared to the money you need to purchase the same goods or services.
One of the best ways to combat inflation is to save your money somewhere it can grow.
By investing your money in a diversified, long-term investment like a pension fund, you could improve your ability to achieve growth that beats inflation over time. Over the long-term, investing in stock markets has the potential to outperform the rate of inflation.
However, investments carry risk and there is no guarantee that your investment will grow. However, with inflation rapidly increasing and looking to remain high for the foreseeable future, keeping your savings in cash deposit accounts also carries certain risks. As in the example above, over time, the real value of your savings effectively reduces because the cost of what you can buy with them rises.
However, pensions are a great way of maximising your savings potential. Not only is your money invested with the aim of growing over time, but you also benefit from tax relief added by the government and potential contributions from your employer, to really give your pot a boost. It is worth noting that pensions are designed to be a long-term savings vehicle, which can ride out the ups and downs experienced by investment markets. However, investment performance is not guaranteed, and the value of your savings can go down, as well as up.
What to consider if you’re taking or thinking about taking your pension benefits
How inflation impacts your pension income will depend on different factors.
Accessing a defined benefit pension
If you’re taking income from a defined benefit pension scheme (which you may also know as final salary), you might not need to worry about inflation because most arrangements were set up to increase with inflation each year. However, some may have a maximum amount of increase even if the rate of inflation is higher.
Thinking about an annuity
An annuity offers you a secure income, payable for the rest of your life or a fixed-term. You can choose to link the amount you receive to inflation or to increase by a set percentage. However, this means that the amount you start off with will be less than a non-increasing annuity, because the ability to increase in the future has been taken into account.
Once your pension savings have been used to buy an annuity you can’t change your mind at a later date. You may want to consider how you can combine other pension options available to cover your different income needs, through different stages of retirement.
Another option for retirement income is taking cash directly from your pension pot – either in one lump sum, several smaller lump sums or as a regular income. Whilst it is generally a good principle to keep some cash aside and easy to access for emergencies, it’s important to consider the amount you need at any one time. Interest rates are still currently lower than inflation, meaning cash held in bank accounts will reduce in real-value terms as the cost of living continues to rise.
If you’re taking or thinking about taking cash from your pension then you’ll need to monitor the investment returns of your pension savings, against the withdrawals you’re making to make sure it lasts as long as you need it for.
All investments can fall as well as rise in value and you may not get back what you invest.
How does inflation impact the State Pension?
The State Pension has just increased by 3.1% for pensioners this April, based on last year’s rate of inflation. However, given inflation is now over double that, there is still going to be a cost-of-living challenge faced by those relying on their State Pension provision.
To protect the value of the State Pension against the rising cost of living, the government has established a three-stage guarantee to keep pension payments in line with inflation. They have committed to increase the State Pension each year by the highest of: the rate of inflation, average earnings growth or a minimum of 2.5%.
However, this isn’t always guaranteed as the government could change the rules.