Rising headwinds? Inflation and your pension

Infla­tion is an old foe, now almost for­got­ten in many coun­tries. But should we be wor­ried again, and what impact could it have on our pen­sions?

In extreme cas­es, infla­tion has been a his­tor­i­cal night­mare. Ger­many faced ruinous hyper­in­fla­tion just after the First World War as it print­ed mon­ey to pay off war debts and oner­ous repa­ra­tions. A loaf of bread that cost 160 marks in 1922 surged to a stag­ger­ing 200 bil­lion marks the fol­low­ing year. Peo­ple burnt ban­knotes to keep warm, their cur­ren­cy worth­less.

No one’s sug­gest­ing we’ll see a repeat of that phe­nom­e­non today in OECD nations, includ­ing the UK. How­ev­er, infla­tion has been tick­ing up. US prices rose by 5.3% in  August 2021 over August 2020. UK aver­age house prices increased by 8% over the year to July 2021, accord­ing to the Office for Nation­al Sta­tis­tics, down from 13.1% in June 2021. That was the high­est annu­al growth rate the UK has seen since Novem­ber 2004. 

The Con­sumer Prices Index (includ­ing own­er occu­piers’ hous­ing costs) is also an area of con­cern, ris­ing by 3% in the year to August 2021, up from 2.1% in the 12 months to July. That was six times August 2020’s fig­ure of 0.5%, with the cost of motor fuel, sec­ond-hand cars and food all soar­ing over the course of 2021.

But how real is this infla­tion fig­ure? Mea­sures rely on con­sump­tion bas­kets of goods and ser­vices, and sta­tis­ti­cians have not caught up with our pan­dem­ic-dri­ven spend­ing changes: less on air­fares, coffee/sandwich bars and com­mut­ing, more on tech­nol­o­gy, gad­gets and DIY. What’s more, the spend­ing pro­files of a Uni­ver­sal Cred­it claimant and an afflu­ent sub­ur­ban­ite are dif­fi­cult to aver­age out. 

Wall of money

But there are strong head­winds. As the pan­dem­ic wanes, a wall of mon­ey is wait­ing to be spent, with British savers putting away £220bn since Feb­ru­ary 2020. This sur­plus cash, com­bined with sup­ply short­ages, boosts prices. Indeed, the Bank of Eng­land projects that infla­tion will hit 4% by the end of the year, with pres­sure com­ing from the phased end­ing of reduced VAT in hos­pi­tal­i­ty and hotels on 30 Sep­tem­ber, when it will go from 5% to 12.5% until 31 March. Also in the pipeline is a mas­sive hike of the Ofgem gas price cap on 1 Octo­ber, up by £139: this will affect 9 mil­lion cus­tomers fol­low­ing record gas price increas­es.

The Bank of Eng­land, how­ev­er, believes infla­tion is a tran­si­to­ry blip, eas­ing in 2022. Yet wor­ries per­sist. Indeed, some believe the quan­ti­ta­tive eas­ing pro­gramme – through which the Bank of Eng­land bought bonds worth £895bn as a response to the finan­cial cri­sis in 2009 – has already caused an asset bub­ble in prop­er­ty and shares. 

The pan­dem­ic was an even greater eco­nom­ic shock. Alis­tair McQueen, head of sav­ings & retire­ment, Avi­va notes that “UK GDP fell by one quar­ter in the open­ing months of 2020. In response, the UK gov­ern­ment spent an extra £350bn. This is on top of the “UK gov­ern­ment spend­ing £850bn a year before the pan­dem­ic”. 

Indeed, pub­lic debt has reached a peace­time high of £2.2tn over the past 18 months – the equiv­a­lent of £80,000 for every UK house­hold. One bright spot is that it has nev­er been cheap­er to bor­row, thanks to low infla­tion and low inter­est rates. 

But even­tu­al­ly debts must be repaid, or Britain could end up as anoth­er Weimar Repub­lic. If the infla­tion gale still blows next year, inter­est rates will need to rise.

Managing inflation risk

Most defined ben­e­fit pen­sion schemes man­age infla­tion risk by hedg­ing, using a lia­bil­i­ty-dri­ven invest­ment strat­e­gy. Some schemes also use indi­rect infla­tion hedg­ing assets such as infra­struc­ture and real estate invest­ments that have some infla­tion link­age.     

“If the cur­rent infla­tion scare becomes more pro­nounced, there will prob­a­bly be more demand for port­fo­lio pro­tec­tion in these forms,” fore­casts Tap­pan Dat­ta, head of asset allo­ca­tion at pen­sion con­sul­tants, Aon. “Even com­modi­ties might at that stage look appeal­ing again, which pen­sion funds have tend­ed to avoid on account of their rel­a­tive­ly poor and very volatile path of returns.” 

What about pension savers?

Cash sav­ings are poor­ly suit­ed to fund retire­ment. Most accounts pay just 0.1% inter­est a year, or 10p on £100. Accord­ing to Mon­ey­facts, not one stan­dard sav­ings account can out­pace today’s infla­tion rate of 2.1%. Last year 91 deals could beat the then 1% infla­tion rate.

Ian Burns, prin­ci­pal and actu­ary at pen­sion con­sul­tants Buck, advis­es work­ers to “con­tribute a per­cent­age of salary rather than a fixed amount or a one-off con­tri­bu­tion when com­bat­ing infla­tion in pen­sion fund sav­ings. Your pen­sion con­tri­bu­tions will then increase in line with salary growth, which will like­ly be high­er than infla­tion over the full course of your career”.

Equi­ties are typ­i­cal­ly viewed as a nat­ur­al invest­ment to gen­er­ate real returns rel­a­tive to infla­tion, he says. The div­i­dends pro­vid­ed by equi­ties may also be attrac­tive and could grow in line with infla­tion, with the div­i­dend yield cur­rent­ly around 3.4% on the FTSE 100.

“Investors need to be will­ing and able to invest for the long term (10–15 years or more) and also need to be cog­nisant of mar­ket pric­ing at the point of invest­ment,” Burns says. “Invest­ing a reg­u­lar amount every month is very dif­fer­ent to invest­ing a large lump sum.” 

For retirees

Retirees shouldn’t leave too much cash in the bank beyond their needs for two or three years. That’s because infla­tion can wreak hav­oc with house­hold bud­gets, par­tic­u­lar­ly those of pri­vate sec­tor work­ers who rarely have index-linked defined ben­e­fit schemes. Any­one lucky enough to have such a pen­sion should usu­al­ly see it increase each year, broad­ly in line with infla­tion.

For the rest, “infla­tion is the moth that eats away at your sav­ings and income”, says  Andrew Tul­ly, tech­ni­cal direc­tor at Cana­da Life. For the near­ly 7 mil­lion peo­ple liv­ing off a fixed income in retire­ment, such as a lev­el annu­ity, he warns that infla­tion of 3% will halve spend­ing pow­er in just 20 years. 

Tul­ly advis­es they use “some form of equi­ty invest­ment as part of a bal­anced port­fo­lio. Using a com­bi­na­tion of draw­down and annu­ity can cre­ate the flex­i­bil­i­ty for peo­ple to bank a guar­an­teed income to pay the bills, while also leav­ing mon­ey invest­ed to pay for life’s lit­tle lux­u­ries and help pro­tect against infla­tion.”

Final­ly, one bul­wark against infla­tion is the state pen­sion, the bedrock of people’s retire­ment income. This increas­es by “the triple lock” – the high­est of infla­tion, earn­ings and 2.5% — and at least keeps pace with infla­tion. But there are no guar­an­tees. McQueen warns: “Ris­ing price and wage infla­tion could add bil­lions of pounds to the cost of the state pen­sion. This has forced the gov­ern­ment to step back for one year from its man­i­festo com­mit­ment to main­tain the triple lock.”

Be pre­pared for squalls.