How rising inflation can destroy your pension

Inflation is eroding the value of pensions over time, and experts are warning pensionholders to be more astute with their retirement income or risk losing out over the long term.

"Anyone who has bought a fixed annuity [which provides a regular income for life] could see the value of their pension erode significantly over time," says Dr Ros Altmann, director general of Saga.

She adds: "The longer they live, the poorer these pensioners become, as the real value of their fixed pensions is reduced by inflation."

So what can you do? Read our Q&A on pensions and inflation to give you the background to help protect your pension from inflation.

Q. What is inflation?

Inflation measures the rise in price of goods and services in an economy. There are two ways of measuring inflation: the consumer prices index (CPI) is the official measure of inflation and is currently at 5.00%.

The retail prices index (RPI) is another indicator and tends to be higher - 5.4% at the moment - because it takes into account certain items (such as, council tax, mortgage interest payments, buildings insurance and house depreciation) that aren't included by CPI.

Q. Will inflation rates go up or down?

Bank of England forecasts expect inflation to remain at high levels for much of 2012 but as Tom McPhail, head of pensions research for Hargreaves Lansdown, explains, it's difficult to predict what will happen in the future. "In theory, the Bank of England is in control of the rates but there are all kinds of factors influencing inflation - some overseas which mean we can't accurately know what will happen to rates."

If inflation levels do increase however, then the Bank of England could find itself powerless to stop an upward spiral, argues Altmann: "Monetary policy may stay consistently behind the curve, tightening too little, too late."

Q. How does it affect my pension savings?

Any cash savings are hit because the low interest returns on savings accounts cannot compete with the rate of inflation.

Pension pots face a similar challenge with money losing value over long timescales.

Watch our Moneywise TV episode: Get more money from your pension

Q. How can I stop the effect of inflation on my pension? 

When it come to drawing your pension, McPhail suggests opting for a mix and match approach "between income drawdown invested roughly 60% equities, 40% bonds and a level annuity" for those with larger pension funds.

When picking an annuity it's possible to opt for one that's index–linked, either to inflation or a set percentage such as 3% or 5%, to protect your money from inflation.

Q. Then why doesn't everyone get an inflation-linked annuity?

Although your money is protected, the initial income you receive will be a lot lower than a straightforward level annuity.

Q. Why then would anyone recommend this type of annuity?

Given how long it takes for an inflation–linked annuity to catch up with a more standard annuity you would have good reason for wanting to stick with a straightforward level annuity, that guarantees a set income for the rest of your life. However, you have to question how long you expect to get an income for an annuity.

If you start at 65 and live to over 100–years–old you are looking at nearly 40 years you need to cover. In that time inflation could have gone up dramatically and if you've tied yourself into a set rate there's nothing you can do to stop inflation eating away at your retirement income. If, however, you had an index–linked annuity your money would be protected.

I'm really confused, which one should I go for?

Given the uncertainty over future inflation rates, hedge your bets by going for a combination with part of your annuity index or inflation–linked and the other part level.

"I think it's really prudent to exercise that choice, once you've locked into a particular annuity rate that's it and if inflation suddenly goes through the roof, you'll have no protection."

What will happen to future annuity rates?

It's highly plausible that the inflationary impact on our retirement incomes will have a knock–on effect to annuity rates down the line. If inflation is higher than anticipated, it's likely level annuity rates will go up, says Laith Khalaf, pensions analyst at Hargreaves Lansdown.

"But insurers would probably cut index-linked annuity rates to protect themselves from the possibility of run away inflation."

If you feel you are getting a raw deal from your pension, sign our petition and join our campaign to get fairer annuities for all.

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Your Comments

Since the government policy is to target 2% inflation anyone who takes a level annuity is guaranteed to have a reducing income. Therefore I believe that all anuities should include at least 2% inflation protection.