Inflation-proof your pension
Meanwhile, the Retail Price Index (RPI) - which some economists say is a more accurate measure of inflation as it includes housing costs - has risen from 2.4% to 3.7%.
Rising inflation tends to hit retirees the hardest because most of their incomes are fixed and a large proportion is spent on necessities such as utilities and food, which are currently rising in price the fastest. Some experts suggest pensioner inflation could be as high as 9% a year.
But even if you haven’t yet retired, there is still a strong risk that inflation is eating into your pension provision potentially leaving you with less to spend at retirement.
Your pension fund is likely to be invested heavily in equities up until 10 years before you retire, which, as a long-term strategy, helps ride out any volatility. Over the past 50-years, equity markets have achieved average annual returns of 7.2%, compared with gilts (2.4%) and cash (just 2%).
But unless you increase your pension contributions every year then inflation can erode the value.
While members of workplace pensions see their pension contributions increase with their salary rises each year, those who make their own private pension provisions should consider taking action to increase their contributions if they want to dodge inflation.
According to IFA Hargreaves Lansdown a £300 monthly contribution will reduce to just £92 over a 30-year period, assuming 4% inflation a year.
If you have already retired, then one way to dodge rising inflation is to buy an escalating annuity.
Around 87% of people currently opt for level payment annuities. But Tom McPhail, head of pensions research at Hargreaves Lansdown, says this could evaporate their spending power as inflation rises.
He estimates that by the time a man aged 65 reaches normal life expectancy his £1,000 annual income will be worth just £440 if inflation is at 4%.
If you are concerned about beating inflation then you could consider an inflation-linked annuity that escalates in value over time.
Be prepared for your income to start low – currently £100,000 will buy a 65-year-old man a level income of £7,764 or an inflation linked annuity starting at just 4,778.
However, by the age of 78 the annual income from the inflation-linked annuity will overtake the income from the level annuity, and by age 88 the total payments received from the inflation-linked annuity overtake the total received from the level annuity.
A 65-year-old man also has a 25% chance of living until he is 95, at which point the payments from the inflation-linked annuity would be twice as big as the payments from the level annuity.
McPhail says: “As ever, shopping around for an annuity makes sense, not only to lock into a better rate, but also to make sure you can get a quote for an escalating as well as a level annuity.”
Before you buy an annuity, make sure you take the time to shop around and exercise your right to buy from the open market. According to the Financial Services Authority, there is a 20% difference in value between the most competitive and the least competitive annuity.
If you have a large pension fund or final salary benefits then you could consider opting for a drawdown plan which will keep you exposed to the equities market. Although this is a riskier product than an annuity, it will allow you to draw an income while increasing your chances for growth.
Drawdown plans also offer you the choice to take your 25% tax-free cash and leave the rest invested for further growth.
Hargreaves Lansdowns recommends a conservative drawdown investment strategy such as opting for a cautious managed fund with up to 60% invested in equities and 40% in bonds and cash.
McPhail says: “You must also manage your income withdrawals carefully to avoid stripping out your fund.”
Are inflation-linked annuities worth it?
an RPI-linked annuity protects your retirement income from inflation. Although payments will start off lower than a standard annuity, they will increase over the years enabling you to beat rising inflation.
But experts warn this type of pension income is not necessarily the best option. According to Hargreaves Lansdown, inflation needs to run at 5% a year for an RPI-linked annuity to be worthwhile.
If the UK were to re-enter a period of deflation - where prices fall rather than rise - then people with RPI-linked annuity will actually see their income reducing.
Hargreaves Lansdown suggests a 3% annually escalating annuity is currently better value and is guaranteed to increase even in the event of deflation.
Nigel Callaghan, pensions analyst at Hargreaves Lansdown, says: “Inflation-linked annuities are both prohibitively expensive and can expose investors to a falling income in the event of deflation.
”A 3% escalating annuity is currently a preferable way to protect your pension income against inflation because it offers better value and the security that your income payments will increase come what may.”
Callaghan adds that investors who wish to inflation-proof their pension annuity must currently accept a starting rate of income that is 40% lower than if they did not.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.