How do I protect my retirement from inflation?

Inflation is a fact of life, but for those drawing down pensions it can mean a constant erosion of spending power during the years of retirement. How can investors counteract the impact?

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

Inflation (the increase in the cost of goods and services in an economy) is a difficult thing to prepare for. Over the past ten years it has ranged from a high of 5.1% in September 2008 to a low of -0.2% in April 2015, causing the price of everyday essentials to rise and fall accordingly, and forcing many pension savers to reconsider their investment options.

Last September, inflation reached a five-year high of 3% – a full 1% higher than the Bank of England’s target of 2%. While this was undeniably bad news for consumers because it meant prices for everyday goods and services were rising at a faster rate, the timing was almost impeccable for pensioners getting the state pension. Each year, the Department for Work and Pensions recalculates the UK state pension in accordance with September’s inflation figures, and the new rate kicks in on 5 April the following year. That means that for anyone over the age of 65, the state pension is about to increase by £4.78 a week to £159.55 per week, per person. This amounts to an extra £248.56 over the course of the year, boosting the annual state pension to £8545.50.

While this may seem like a bonus for anyone over the age of 65, it is not quite as straightforward as it might seem on first glance. Most retirees cannot afford to survive on the state pension alone. Even accounting for the higher 2018 state pension figures, the average retired couple is entitled to just £17,091 — yet according to recent data from consumer group Which?, the average couple needs an income of at least £18,000 a year to cover household essentials such as food, utilities, transport and housing costs, £26,000 if European holidays and hobbies are included, and £39,000 for couples who want to upgrade their car every five years and take long-haul trips abroad.

This means that most pensioners will need to supplement their state pension with personal savings, investments, and annuity funds. And while the state pension actually benefits from higher inflation rates, savings and investments tend to suffer.

So, how can you protect your retirement savings from the impact of inflation?

Reassess your risk profile

It may be tempting to play it safe by keeping all your savings in a low-risk, low-yielding bond or gilt, but these investment vehicles are particularly vulnerable to inflation. At the time of writing, the National Savings and Investments (NS&I) top-rated bond was offering just 2.2% over three years. Unless inflation dips below 2% by the time the bond reaches maturity, any money which has been locked away in this fund is set to lose value in real terms.

As a result, some savers may feel more comfortable investing in a balanced portfolio where a few higher risk funds (for instance, emerging markets or alternative finance) sit alongside UK equities (e.g. FTSE 100 tracker funds) and lower-risk bonds. Most investors find that their risk profile varies considerably over time, so be sure to review your portfolio at least once a year, to account for any changes in your own personal circumstances, or fluctuations in the rate of inflation.

Stay invested

Ultimately, the best way to beat inflation through private pension savings is to keep yourself invested for as long as possible. According to Mark Carney, the governor of the Bank of England, inflation is expected to remain above the 2% target for at least another two to three years, thanks to imported price pressures and Brexit-related economic uncertainty. However, by keeping your money invested and reinvesting any dividends, you can benefit from compound interest, which may go some way towards offsetting any negative impact as a result of inflation.

Opt for index-linked annuities

A number of annuity providers offer inflation-linked products, whereby their annual rates are determined by the Retail Price Index (RPI). This is a sure-fire way to protect your pension from inflation, but it does come with a few key caveats. First of all, some annuity providers have placed a cap on the amount that they are prepared to pay out – Just Retirement, for instance, will only pay up to 5%.

Furthermore, when inflation falls, so do your returns. And if inflation drops into negative territory, as it did in early 2015, you could actually end up losing money. If you do choose to invest your retirement fund in an index-linked annuity, make sure you read the small print so that you understand your liability should deflation occur. 

Make the most of your ISA allowance

UK taxpayers can invest up to £20,000 per year in a variety of tax-free wrappers, including cash ISAs, stocks and shares ISAs, innovative finance ISAs and lifetime ISAs. By making the most of this annual allowance, even in retirement, you can protect your interest from taxation. And if you are making regular payments, and receiving inflation-beating returns on an annual basis, it will only be a few years before the tax-free benefits start to kick in. These savings can then go some way towards offsetting the impact of rising inflation, while maximising any returns that you earn along the way.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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