Inflation Risk and Retirement Incomes

Key takeaways

• Inflation is a critical retirement risk because it reduces purchasing power over time, meaning retirement income needs to increase to keep pace with rising costs of goods and services.
• A successful retirement strategy must balance three interconnected risks: longevity risk (living longer than expected), inflation risk (rising living costs), and sequencing risk (poor market performance early in retirement impacting pension sustainability).
• Inflation reduces the future purchasing power of retirement income, making it essential for pension investments to generate growth that keeps pace with rising living costs.
• Holding too much of a pension pot in cash or low-return assets can make it more difficult to provide a sustainable and increasing income throughout retirement, as these assets typically offer lower long-term returns than investments such as stocks and bonds.

We have written about the key risks when taking a retirement income. Longevity risk relates to nobody knowing how long they will live and the need for retirement income to be sustained over many years. Sequencing risk refers to how market movements potentially reduce the number of years a pension pot may last for if the timing of retirement coincides with a period weaker markets. Inflation risk is about purchasing power falling over time as the prices of goods and services go up (inflate) over time. Retirement solutions need to address all of these risks simultaneously. In this article, we will focus on the how inflation can impact people in retirement.

Back to basics - what's important for retirement?

There are three key risks that need to be navigated to ensure a client can look forward to a comfortable retirement

• Longevity
• Inflation
• Sequencing

Why does inflation matter?

In retirement, inflation impacts people in two key ways. Firstly, a pension pot has to not only produce an income for a significant number of years but that income has to rise because the prices of goods and services tend to rise over time. The Bank of England has a 2% p.a. inflation target but, as we have seen in the last few years, inflation can rise sharply and spend years above target levels.

The risks explained

Longevity risk: the risk that clients run out of money; they outlive their savings. Their pension plan assumed a life expectancy of 85 and they live until 95.

Inflation risk: even an inflation rate of 2.5% means that a client's money will lose roughly one third of its value over 15 years and so purchasing power diminishes for them.

Sequencing Risk: sequencing risk is the risk of poor investment returns at the start of a client's retirement. If markets fall early on when your client is taking an income, they may be forces to sell investments at lower values, leaving less capital to recover over time. This can have a lasting impact on how long their savings will last, even if markets perform better later.

Let’s say inflation averages 2.5%; even that low and stable level of inflation means that the purchasing power of £100 would have fallen by more than a third over 15 years. This means that at the end of the period, people would need around £140 to buy what £100 bought at the start of the period. The need for pension pots to deliver incomes which grow over time, to cope with inflation, is clear. Inflation risk matters because it means retirement income solutions need not just to deliver a certain amount of money but a growing amount of money because prices facing consumers tend to rise over time.

Why does inflation matter for how people invest their pension pot in retirement?

As discussed, what £100 can buy in the future is likely to be less than its purchasing power today. This matters as pension pots have to generate a growing income, as discussed. It also matters because the higher the proportion of a pension pot held in cash or equivalents, perhaps to cover income needs for a couple of years, the harder the task of generating a growing income sustainably becomes; this is because cash and equivalents tend, on average, to be making relatively low returns and / or  inferior returns when compared to other investments such as stocks or bonds. The greater the proportion of a pension pot held in low return assets, the greater the likely difficulty in meeting the need for a growing nominal income over a long period in retirement.

Conclusion

Inflation is expected to average around 2% in the UK; that is the target of the Bank of England. Rising prices are a reality which retirement income solutions have to be able to deal with. People taking an income from their pension pot need both a rising nominal income, as prices facing them go up over time, and that income to be sustainable over many years. Pension pots have to be invested to meet both needs and also cope with market volatility.

Glossary:

Inflation: The rise in prices over time, which means retirement income needs to increase to maintain the same standard of living.

Purchasing Power: How much your money can buy, which decreases as prices rise.

Nominal Income: Your income before accounting for the impact of inflation.