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."
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An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
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.
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).
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).
This type of insurance covers the structure and fabric of your property – the bricks and mortar, not the contents (for which you need contents or home insurance). If you have a mortgage, the lender will insist you have a suitable buildings insurance policy in place. Many lenders offer their own building insurance policies, but you don’t have to buy it from your own lender but you have the option of shopping around. The insurance covers you for the rebuilding costs, not the market value of the property.
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).
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.