Inflation is on the up: the Consumer Prices Index (CPI) - the official measure of the cost of living - jumped to 3.5% in January, from 2.9% in December 2009.
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.