In the UK we haven’t had double-digit inflation since the early 80s. Since 1992 annual inflation has been below 5%. So you might be forgiven for thinking that inflation isn’t worth worrying about anymore. But we had similar levels of inflation in the early 60s as now; and by 1975 inflation had peaked at 24%. Could the same happen again in a few years time? Although that’s possible in theory, the Bank of England can now set interest rates, independent of political control, which helps a lot.
The chances of future rampant inflation are now less than they were in the 60s. But we still need to factor inflation into our retirement planning.
Living on a fixed income
Retirees used to have to buy lifetime annuities with their pension pots. In recent years annuity rates have come down dramatically. This is largely due to falls in long term interest rates, and also to increases in life expectancy. The highest headline rates for annuities are for fixed annuities. These pay a fixed income stream for life, which never goes up. But inflation means that the spending power will diminish over time. For example, if the average rate of inflation is assumed to be 3%, spending power will halve in just 23 years.
Annuity providers can index-link an annuity, but the starting rate will be much lower. A 65-year-old might be able to get a fixed annuity yielding around 4.5%. But an equivalent index-linked annuity would only yield around 2.4%. Put another way, buying a fixed annuity for £100,000 might give a fixed income of £4,500 for life; an index-linked annuity would give a starting income of just £2,400, but rising each year in line with inflation.
There’s one type of fixed income that everyone is entitled to: the State Pension. It’s just like an index-lined annuity, underwritten by the government. The current level is around £9,300 a year. If you had to buy your own annuity to generate the same index-linked income, it would cost you up to £400,000. That’s serious money, more that a third of the pension lifetime allowance! Don’t deride the state pension, it’s worth a lot, and is protected against inflation.
Inflation and investments
Most of us would agree that the state pension is not enough for a comfortable retirement. Unless we have generous defined benefit pension schemes, we’ll need to make investment choices to help fund our retirement. Unfortunately, there’s no free lunch: the highest returns entail the highest risk. The lowest risk is from cash. Unless we stash cash under the mattress, we can earn interest; but it’s rare that interest rates exceed inflation. So living off the interest from cash would mean the erosion of spending power over time. And even if you never touch the principal, inflation will erode the real value of the principal over time.
At the other end of the spectrum, there are equities. These are rightly regarded as high risk. But over time they’ve always comfortably outperformed inflation. It’s important to understand why that is. Equities are part ownership of companies whose directors and employees are working hard to generate profits. The whole of our capitalist system depends upon the ability of private enterprise to generate growth. Even though there may be bad times, over the long term a basket of companies should perform well. Some companies may fail, while others may reach the stratosphere. And sometimes global or psychological factors may cause a market correction, or even a crash. As long as it’s not the end of the world, markets will eventually recover.
From an inflation-busting point of view, equities perform better than cash or fixed interest bonds over the long term. But not every investor has the same appetite for short-term risk. Some people want to reach for the sell button as soon as there’s a major market correction. Such people should have a balanced portfolio, so they’re able to tune out from the riskier side of the market. Each person’s ideal investment risk profile depends on their attitude to risk, and also on their age. If you’re still working, you don’t need to draw any income from your investments. So you can ride out the market, and maybe delay retirement if needed.
Other types of investment
Equities, bonds and cash are not the only types of investment. If you own your own home, then you’ve invested a fair chunk of your net worth into property. Over the long term, property has proved to be an excellent hedge against inflation. But like any non-cash investment, property is not risk free.
We could talk about more exotic types of investment, like emerging markets, equity derivatives, crypto-currencies, etc. But doing so would miss the point: higher potential returns means higher risk. There’s no free lunch.
Taking inflation into account
I wish there was a silver bullet to protect you from inflation. But it’s one of many risks associated with financial and retirement planning. We’ve already touched upon the risk of investments falling in value. There’s also the risk of outliving your savings. Then there are ‘black swan’ events, which are the unknown unknowns… until the they happen; then the repercussions affect everybody. The coronavirus pandemic is an example, as was 9/11.
So to manage inflation effectively, you need to manage risk in general. To do this, there are three basic things you’ll need:
- A general understanding of what risk means.
- An easy-to-use financial modelling tool that takes risk and uncertainty into account.
- A professional financial and investment advisor who understands risk and reward, but also understands your unique circumstances.
Some may prefer to jump straight to 3, and simply push the problem over to a professional. But we believe that you’ll only get the best results from a professional by first having some level of self-education; in other words 1, 2 and 3 should go together.
At EvolveMyRetirement, we can help with 1 and 2. Our website explains risk, and our retirement planning app puts theory into practice, helping you create a strategy. Your financial adviser can and should validate, and maybe tune, your strategy, before recommending specific investment choices. But remember that you own your own retirement.