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How inflation can reduce your pension and what you can do about it

When you think of risks to your retirement, do you include inflation? It can have a huge impact on your income throughout retirement. Yet, it’s often overlooked when creating a retirement plan.


Inflation refers to the rising cost of living. Day-to-day, it’s not something that you notice. However, over a longer timeframe, such as your retirement, the price of goods and services creeping up has an impact. It can mean your income and assets don’t go as far.


Over the last year, the pandemic has meant inflation has been relatively low. In February, the cost of living increased by just 0.7% compared to 12 months earlier. However, the Bank of England has a target of keeping inflation at 2%. A 2% increase doesn’t seem like much, but it does have a compounding effect over the years.


Even if you retired in the last decade, you’d notice that your income is buying less or needs to increase. A £30,000 income in 2010 would need to have increased to £39,337 just to maintain spending power, according to the Bank of England. Now think about the impact inflation could have on a retirement that spans several decades. You would find your income buys far less if it’s not something you’ve prepared for.


Inflation risk is higher following 2015 Pension Freedoms


Retirees today have to consider inflation risk far more than previous generations. This is because Pension Freedoms, which were introduced in 2015, have changed how and when you can access your pension.


In the past, there was a common route to retirement and creating an income: you’d save into a pension during your working life, and then purchase an annuity that would provide a guaranteed income throughout retirement. This income was often linked to inflation, so retirees didn’t have to worry about how their spending power would change.


Today, you can choose an annuity, but there are other options to explore too. This may include withdrawing lump sums or taking an adjustable income through flexi-access drawdown. In some cases, inflation could mean the value of your pension or other assets falls in real terms.


It’s now essential to consider inflation when retiring to create financial security in your later years.


3 ways to reduce the impact of inflation on your retirement plans


Inflation can have a huge impact on the type of retirement lifestyle you can afford but there are things you can do to manage the risk.


1. Purchase an inflation-linked annuity


Annuities have become less popular since Pension Freedoms were introduced, but they can still play an important role in creating financial security in retirement.


Some annuities are linked to inflation. This means the regular income they provide will increase each year in line with inflation, preserving your spending power throughout retirement. It means you don’t have to worry about how the rising cost of living will affect your lifestyle, as your income will rise to reflect this.


Retirees are often shunning annuities because they don’t offer the flexibility of other options. Your income will remain the same and you can’t adjust this. You also can’t leave an annuity behind as an inheritance for loved ones.


However, it’s important to remember you don’t have to use your entire pension to purchase an annuity. You can use a portion of your savings to buy an inflation-linked annuity, providing some income stability, while flexibly accessing the rest to supplement it when you need to. Understanding how your income needs will change during retirement can help you understand if an annuity is right for you.


2. Don’t take out cash if you don’t need it


When you retire, it can be tempting to withdraw money from your pension, even if you don’t need it. This may include withdrawing a 25% tax-free lump sum. However, withdrawing money is more likely to expose your savings to inflation risk.


Over a third (36%) of people that had taken a cash lump sum from their pension said they’d put the money in a savings account, according to a Canada Life survey. A quarter (24%) also said they’d put it in the bank. This money is likely to be in accounts that are paying an interest rate that is below inflation levels. In real terms, that means your money is decreasing in value. It’s important to have an emergency fund, but you should manage withdrawals to reflect your needs.


It’s also worth noting the impact tax can have. After your tax-free lump sum, any money withdrawn from your pension may be liable for Income Tax. Taking out lump sums could push you into a higher tax bracket. If you don’t immediately need the money, you may end up paying more tax than you need to.


3. Choose appropriate investments for your retirement fund


Investing can deliver above-inflation returns, helping your money grow even when you’re retired. However, you also need to consider investment risk and what investments are appropriate for you. The investments you select should reflect your risk profile, goals, and investment timeframe. If you’d like to discuss what investments suit your retirement plans, please contact us.


The Canada Life survey also highlighted that some retirees are withdrawing money from their pension to invest. Some 7% said they withdrew money to put it into stocks and shares. Your pension savings are likely to already be invested. Investing through a pension means your money can grow free from Capital Gains Tax, making it a tax-efficient way to invest. In most cases, investing through a pension makes financial sense, even if you’re withdrawing an income from your pension.


Building a retirement plan that manages risk


While you can’t remove risk entirely from life, we’re here to help you put a plan in place that manages risk, including inflation risk. If you’re nearing retirement or have already retired and would like to discuss how to access your pension to create an income, please get in touch.


Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.


A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available.


Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.


The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

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