Effects of inflation on pensions

There has been a spate of economic data over recent months concerning the rising cost of living. Mortgage, food shopping and petrol costs have jumped forcing the annual rate of inflation over 3.3% p.a.

How should pension investors best cope with inflation?

Pre-Retirement

1. Invest in equities

Up until 10 years before retirement I believe your portfolio should be invested heavily in equities. As a long term investor you can ride out any volatility in the equity markets while enjoying the higher returns that equities generally provide. Over the last 50 years have returned an average annual real return of 7.2%; gilts have returned 2.4% and cash just 2%[1].

2. Increase your pension contributions

Each year a pension contribution falls in value in real terms unless it is increased. After 30 years, a £300 monthly contribution is worth just £92 if inflation rises at 4% a year. For members of workplace pensions, their pension contribution rises with their salary rises each year. However, those who make their own private pension provisions in place of, or as a supplement to a workplace pension, could find themselves rapidly left behind if they fail to increase their contributions each year.

Below we show what a £300 monthly pension contribution would be worth in real terms if it was increased by 4% every year, compared with what it would be worth if contributions were increased in line with inflation at less regular intervals, or indeed, not at all.

Contributions increased every	Value after 30 years
1 year	£130,928
5 years	£121,365
10 years	£110,924
Never	£81,552

Assumptions: 7% fund growth, 1.5% AMC

At Retirement

Inflation is even more of a worry for pensioners as their expenditure includes more of those items that are rising in price fastest: in particular food, fuel and council tax. Some estimates have put pensioner inflation as high as 9% a year.

1. Shop around when buying an annuity

Never automatically buy the annuity your pension company offers you - it may be dreadful value for money. By scouring the annuity market, you can increase your retirement income by about 15%. Given that the average 65 year old has over a life expectancy of 20 years, this can easily amount to thousands.

There are lots of annuity comparison websites that make this an easy thing to check taking a few minutes or you contact a specialist annuity Independent Financial Advisor.

2. Buy an escalating annuity

If you take a level income at retirement, your spending power evaporates as inflation rises. For a man age 65, by the time he reaches normal life expectancy £1,000 annual income will be worth just £440 with inflation of 4%. However 87% of annuitants opt for a level payment.

Meanwhile an inflation-linked annuity will mean that you start off with a smaller income to start off with. Currently £100,000 will buy a 65 year old man a level income of £7, 818, but an inflation linked annuity of just £4,809.

This is a big difference but bear in mind that there is over a 40% chance of a 65 year old seeing there 90th birthday and a 1 in 5 chance of reaching 95.

Many investors split their pension savings to buy different types of annuity to create an income stream in retirement that best suits their own circumstances.

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.

3. Consider a Drawdown plan

For investors with bigger funds and/or final salary benefits elsewhere a drawdown plan might be an alternative. Although much riskier than an annuity, a Drawdown plan gives you the opportunity to maintain exposure to the market while drawing an income. Or you can draw no income at all if you just want to take your 25% tax-free cash and leave the rest invested for further growth.

It allows you to retain ownership of your investments.

You continue to manage your pension fund and make all the investment decisions. Providing the fund is not depleted by income withdrawals or poor investment performance, it may be possible to increase your income.

However, there are no guarantees. If your pension savings are decreased by withdrawals or poor performance, your income will be reduced. You bear all the investment risk - unlike an annuity. You need to be happy to accept this risk. If you're not, it may be sensible to buy an annuity instead.

What Next...

Some research and considered action now can ensure that your retirement can be all that you want it to be. Many investors prefer the benefits of using a discount broker, who can provide clear information and a speedy service. However, if you are uncertain at all, then please contact a specialist Independent Financial Advisor.

Nigel Callaghan is a Pensions Analyst for Hargreaves Lansdown, one of the UK's leading independent financial service providers and asset management specialists. Their experts can simplify and streamline your affairs and free up your time by helping you to choose, buy, sell, hold and manage your investments. For more information visit Hargreaves Lansdown or call their helpdesk on 0117 900 9000.