How to Protect Your Retirement Income from Inflation
With inflation high on the agenda just now, you may be wondering how this will affect your retirement plans. If you are reliant on your capital or a fixed income, increasing prices can be a source of worry.
But inflation, along with unpredictable life events and investment volatility, is one of the factors we need to take into account when thinking about retirement plans. Even in normal conditions, inflation can rise at 2-3% per year, which means that after 10 years, £10 will only be worth £7 in today’s terms. As most people don’t increase their spending at a fixed rate every year, it can be easy to forget that inflation erodes the real value of your money.
In the current climate, when the rate of inflation is more likely to be 5-8%, the reality becomes more difficult to ignore.
There are a number of things you can do to protect your retirement income from inflation.
Make a Plan
The first step is to make a plan for your retirement. This doesn’t need to be complicated, but you need to have a rough idea of how much you are likely to spend. Don’t forget to account for irregular spends such as home improvements, cars, or gifts.
Assuming you have built up a National Insurance record, the State Pension will form part of your plan. You can check your State Pension entitlement here. If you have a shortfall, you might be able to make up some years of contributions. This is worth doing, as the State Pension benefits from a triple lock to protect your income against inflation.
If you have a defined benefit pension, this will also form part of your retirement income. Most defined benefit pensions have some form of inflation protection, although this may be capped. As this income is guaranteed for life, defined benefit schemes are extremely valuable. If you transfer out of your scheme, you will not only lose the guaranteed income, but also the prospect of future increases.
After accounting for your State Pension and any defined benefit pensions, you can use private pensions, savings, and investments to top up your retirement income.
The returns on your investments are not guaranteed, but you can make reasonable assumptions over the longer term. You can use online investment calculators to estimate how much your fund could be worth when you plan to retire. However, it’s important to factor inflation into your assumptions. If you think your investments will return 7% per year, you can assume growth of 3% or 4% in your projections to arrive at an after-inflation return.
If you start to plan early enough, you will have plenty of time to adjust if your retirement is off-track. This could mean spending less, saving more, adjusting the risk profile of your investments, or adapting your goals.
Keep Up with Contributions
Common sense indicates that the more you contribute to your pensions and investments, the greater the potential value of your retirement pot.
But it’s very easy to let other priorities get in the way. Buying a home and raising a family can take up most of your budget, particularly when prices are increasing at the current rate.
But if you put off building up your retirement pot, you will need to make higher contributions later on to make up for lost time. Smaller contributions, started early and invested for longer, can be more effective than making larger contributions later in life.
Pensions are extremely tax-efficient, but they are not the only option. You can also use ISAs, LISAs, investment accounts, and bonds to supplement your retirement income. The best combination will depend on your goals and the need to balance flexibility with tax benefits.
Take Some Risk
If you keep your retirement fund in cash, the value will be stable, but you won’t see any real growth. And assuming inflation typically rises at around 3% per year (or even up to 8% per year when market conditions are extreme) your cash pot will be losing value in real terms.
Equities offer the best chance of keeping up with inflation. However, they can also be volatile and may lose money in the short term.
To gain the greatest benefit from investing in equities:
- Invest in a wide range of shares across different regions, business sectors and company sizes.
- Depending on your risk appetite and your investment timeframe, it may also be appropriate to diversify your portfolio using bonds, property, and cash. These are more stable asset classes that can help to cushion some of the equity volatility, although long-term returns are likely to be lower. You may want to start incorporating some lower risk investments from within 10 years of your planned retirement date.
- Avoid trying to time the market or staking large amounts on judgement calls. It is very difficult to beat the average market return, and the more changes you make, the more likely you are to miss out. Staying invested in a diverse portfolio is the best way to grow your fund.
- Remember that when you retire, you might still need to take some risk with your investments. At the very least, you will want your fund to last for the rest of your life, possibly even with some left over to pass on.
Plan Your Income
There are several different ways to fund your retirement income from your pensions and investments, for example:
- Taking withdrawals from your pension fund. This can comprise a tax free lump sum of up to 25% of your pension pot, as well as a taxable income. You can withdraw an annual income, ad hoc lump sums, or even take your entire pension pot in one go (although this would not necessarily be recommended).
- Buying an annuity. While annuities have fallen out of favour in recent years, you can build index linking into your contract to protect your income against inflation. However, annuities cannot be changed later on, and many investors value flexibility over guarantees.
- Drawing dividends and interest from your investment pot. These are not guaranteed and not necessarily linked to inflation. But if your fund value rises, there is a good chance the income will increase as well.
- Taking capital withdrawals from your cash and investments. This option offers flexibility, but you need to be careful to avoid eroding your fund.
Most retirement plans comprise a combination of the above, along with any ongoing income such as State Pensions, defined benefit pensions, property rental, and dividends from any business interests.
Stick to Your Budget
Of course, all the planning will go to waste if you overspend. Keeping on top of your budget, shopping around for deals, and avoiding large unplanned expenditure can help to keep your retirement on track even when inflation is at a high level.
A financial planner can help you, not only by helping you create your retirement plan, but also by holding you accountable for sticking to it.
For further information or advice please contact one of our Wealth Managers or call us on 01395 207350.