How inflation affects your pension?
Approaching retirement, we all hope to have a solid pension that we can rely on to afford us a comfortable life post-employment. Inflation however, can be a significant threat to that dream. Inflation is the increase in the cost of goods and services over time. If pensions don’t keep up with the pace of inflation, pension payments lose value, leaving retirees with less purchasing power and less income to cover their expenses.
The UK has a state pension scheme which provides a basic level of retirement income. Adding to that, many people also rely on private or workplace pensions to supplement their retirement income. These can come in two forms: defined benefit schemes (DB) or defined contribution schemes (DC).
The state pension should increase in line with living costs in order to preserve a basic level of purchasing power for retirees. In order to work out annual increases, the government use a formula known as the triple lock, which was introduced in the 2011/12 tax year. Under this system, the state pension will rise according to the highest out of either: 2.5% (the target inflation level), inflation in terms of the CPI (Consumer Prices Index) or the average wage rises in the previous July every April. These means that during periods of low inflation, pension will actually beat inflation rates, while during periods of high inflation, the state pension should keep up.
According to the 2022 Autumn Statement, in the 2023/24 tax year, state pensions will rise in line with the inflation rate, in terms of CPI, in September 2022 – 10.1%. This will take the new full state pension from £9,628 p.a. in the 2022/23 tax year to £10,600 p.a. in 2023/24. As such, while the system isn’t perfect, state pensions are afforded a certain level of security during periods of high inflation.
A defined benefit (DB) scheme is a workplace pension where the amount you’re paid is based on how many years you’ve been a member of the employer’s scheme, and the salary you were earning when you leave or retire. This pays out a secure income during retirement, which should increase each year in line with inflation.
Issues can flare up, however, in times of high inflation. DB schemes generally have caps meaning that employers will increase pension payments during retirement in line with up to a maximum of 3-5% inflation. In a stable economy, this isn’t an issue, but of course in 2022, the inflation rate reached as high as 11.1%. This presents issues for retirees, who will be limited by the aforementioned inflation caps. Thus, the defined benefit scheme is a pension that, while being effective during low inflation, can have stark drawbacks when the inflation rate exceeds the caps.
With a defined contribution pension, the money you put into your pension pot is transferred into investments (e.g., shares), based on your discretion, by pension providers. The provides the possibility of the value going up or down depending on the performance of these investments. Unfortunately, DC pensions are not necessarily immune from rising inflation. In theory, members should be protected from inflation, provided that their salary increases in line with inflation. In practice, however, during periods of high inflation, such as the aforementioned 11.1% in 2022, it is very unlikely that salaries will keep up, especially in public sector jobs. Thus, high inflation leaves people with less income and decreases the value of the pension pot itself, meaning that those retirement savings begin to erode.
Another impact of inflation is that it changes many people’s investment focuses. During low inflation, many will invest in government bonds, as these are normally seen as a safe investment. It is important to note, though, that bond value has an inverse relationship with increases in interest rates. During periods of high inflation, the Bank of England increases interest rates, which in turn leads to many investors selling their bonds. This then leaves investors vulnerable to much more volatile investments, which have a much greater potential of giving a negative return. As such, high inflation will have an impact on pensions, leaving employees with less money to put in their pension pots, with the knock effect of less purchasing power in retirement.
Therefore, while state pensions should remain relatively unscathed, inflation can have a damaging effect for both DB and DC pension schemes. With DB schemes, inflation caps mean that employers don’t pay in line with high inflation rates. With DC schemes, when salaries lag behind inflation, members’ purchasing power is greatly decreased. A good first step to change this is to educate yourself and get advice. Understanding pensions, inflation and investing will give a good basis for planning your future, and being ready for any unprecedented events that could send inflation spiralling, while speaking to a financial advisor will provide a level of comfort when organising your pension.
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