Rising headwind? Inflation and your pension


Inflation is an old enemy that is almost forgotten in many countries. But should we start worrying again, and what impact could that have on our pensions?

In extreme cases, inflation has been a historic nightmare. Germany faced ruinous hyperinflation shortly after World War I when it printed money to pay off war debts and heavy reparations. A loaf of bread, which cost 160 marks in 1922, rose to an unbelievable 200 billion marks in the following year. People burned banknotes to keep warm, their currency was worthless.

Nobody claims that this phenomenon will repeat itself today in OECD countries, including the UK. However, inflation has increased. US prices rose 5.3% in August 2021 compared to August 2020. Average house prices in the UK rose 8% over the course of the year through July 2021, according to the Bureau of National Statistics, up from 13.1% in June 2021. That was the highest annual growth rate the UK has seen since November 2004.

Inflation is the moth that is eating up your savings and income

The consumer price index (including owner-occupier housing costs) is also a cause for concern, up 3% in August 2021, up from 2.1% in the 12 months to July. That was six times the August 2020 figure of 0.5%, with fuel, used cars and groceries soaring over the course of 2021.

But how real is this inflation figure? Measures rely on baskets of goods and services, and statisticians have not caught up with our pandemic-induced spending changes: less on airfares, coffee / sandwich bars and commuting, more on technology, gadgets and home improvement. In addition, it is difficult to determine the spending profiles of a universal loan applicant and a wealthy suburb.

Wall of money

But there are strong headwinds. As the pandemic subsides, a wall of money is waiting to be spent, with UK savers saving £ 220 billion as of February 2020. This excess cash combined with supply shortages is driving prices up. Indeed, the Bank of England is forecasting inflation to hit 4% by the end of the year, with pressure from the phasing out of the reduced VAT in hospitality and hotels on March 30th. Also in the pipeline is a massive hike in Ofgem’s gas cap on October 1 by £ 139: this will affect 9 million customers after record gas hikes.

However, the Bank of England thinks inflation is a temporary spike that will subside in 2022. The worries remain, however. Some even believe that the quantitative easing program – launched by the Bank of England in response to the 2009 financial crisis – put $ 895 billion in bonds.

The pandemic was an even bigger economic shock. Alistair McQueen, Head of Savings & Retirement at Aviva, notes that “UK GDP fell by a quarter in the first few months of 2020. In response, the UK government spent an additional £ 350 billion. This is on top of “UK governments spending £ 850 billion a year before the pandemic”.

In fact, the national debt has hit a peace high of £ 2.2 trillion in the past 18 months – the equivalent of £ 80,000 for every UK household. One bright spot is that, thanks to low inflation and low interest rates, credit has never been so cheap.

But at some point debts will have to be paid back, or Britain could end up being just another Weimar Republic. If the inflation storm still blows next year, interest rates must rise.

Manage inflation risk

Most defined benefit pension plans manage inflation risk by hedging with a liability-based investment strategy. Some systems also use indirect inflation hedging investments, such as infrastructure and real estate investments, that have some inflation linkage.

“If the current fear of inflation spreads, the demand for portfolio protection in this form will likely increase,” predicts Tappan Datta, head of asset allocation at Aon pension advisors. “Commodities could then also look attractive again, which pension funds have tended to avoid due to their relatively poor and very volatile returns.”

What about retirement savers?

Saving money is not a good way to finance retirement. Most accounts only pay 0.1% interest per year, or 10p on £ 100. According to Moneyfacts, no standard savings account can beat today’s inflation rate of 2.1%. Last year, 91 deals exceeded the then inflation rate of 1%.

Ian Burns, director and actuary at Buck pension firm, advises workers “to fight inflation on pension savings as a percentage of their salary instead of a fixed amount or a one-off contribution. Your pension contributions will then rise with salary growth, which will likely be higher than inflation throughout your career. “

Stocks are typically viewed as a natural investment for real returns relative to inflation, he says. Dividends on stocks can also be attractive and grow with inflation, with the dividend yield currently being around 3.4% of the FTSE 100.

“Investors need to be willing and able to invest for the long term (10-15 years or more) and also be aware of market prices at the time of investment,” says Burns. “Investing a regular amount every month is very different from investing a large lump sum.”

For retirees

Retirees shouldn’t leave too much cash in the bank beyond what they need for two or three years. This is because inflation can devastate household budgets, especially those of private sector workers who rarely have index-linked defined benefit schemes. Anyone lucky enough to have such a pension should normally increase it every year, broadly in line with inflation.

Incidentally, “inflation is the moth eating up your savings and income,” said Andrew Tully, Canada Life technical director. For the nearly 7 million people who retire on a steady income, such as a retirement pension, he warns that 3% inflation will cut purchasing power in half in just 20 years.

Tully advises “using some form of equity investment as part of a balanced portfolio. The combination of drawdown and annuity can give people the flexibility to deposit a guaranteed income to pay the bills while keeping money invested to pay for the little luxuries in life and protect themselves from inflation. “

Finally, a bulwark against inflation is the state pension, the basis of people’s pension income. This increases through “the triple lock” – the highest of inflation, earnings and 2.5% – and at least keeps pace with inflation. But there are no guarantees. McQueen warns, “Rising price and wage inflation could add billions of pounds to the cost of public pensions. This has forced the government to step back from its manifest commitment to maintain the triple ban for a year. “

Be prepared for gusts.

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