How does inflation affect pensions and investments?

After years of staying relatively low, it looks like inflation is on the up. So what does that mean for your money?

By Aman Athwal, financial adviser

There’s never a slow news day at the moment, and one of the financial headlines you may have read is that inflation seems to be rising. We’ve had an unusually long period of stable, low inflation 1, which means we’ve had the luxury of not having to think about it. But in June 2021, the Office for National Statistics reported a 2.4% rise, which is above the 2% target set by the Bank of England. That inevitably impacts investments, pensions – and any cash kept under the mattress.

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Aman Athwal

What inflation means

So that we’re all on the same page, let’s make sure we know what a 2.4% rise in inflation actually means. Inflation measures the change in the value of money. Essentially, if a lovely chair was £100 a year ago, it means that today, that same lovely chair is sold at £102.40.

On a national scale, the inflation rate is worked out by the Office for National Statistics. They use a shopping basket of 700 items , both goods and services, to chart any rises (or falls, in theory) – this is called the Consumer Price Index (CPI).

It matters because if you have £100 in savings with a 1% interest rate, it means you could use it to buy the lovely chair one year, but the next year it won’t be enough because your funds are being ‘eroded’ (in other words, they’re losing their value).

When you’re saving

If you’re pre-retirement and inflation is at usual or high levels, you might want to make sure  that any income that you’re not keeping for easy-to-access cash or a rainy day fund gets put into pensions and investments. That’s because that cash will buy you less and less over time, whereas pensions and investments will hopefully have a growth rate that combats the effect of inflation by giving better returns . That said, remember investments are usually recommended for medium-to-long-term savings. That’s because the value of your investments can go down as well as up and you may get back less than invested.

Where you have funds that are managed by fund managers, as with most pensions, you don't need to worry too much about how inflation will change things. Beating inflation is one of their key considerations, as well as providing overall growth, although, of course, there's no guarantee that they'll always be able to meet their objectives.

But because it’s a little trickier to make sure your funds are growing in real terms (as opposed to just with inflation), a time like this is a good opportunity to check that your fund is doing exactly what you want it to – for example, that you’re maximising its growth where you can, and the risk is right for you.

If you’re at the start of your pension-saving journey, you might have more appetite for risk, which has a higher earning potential if all goes well and you have longer to make up for any falls in value along the way. If you're close to retirement, you might want to take less risk, to lower the chances of any sudden falls in value as you get ready to take your money.

If you’ve invested some money by yourself, it’s definitely worth checking that the rate of return is the same or higher than inflation. Because just like keeping cash, if your savings aren’t keeping up with inflation, the value will get eroded.

When you’re drawing on your pension or investments

How inflation impacts your pension will depend on the type of pension you have.

If you have a defined benefit pension 

If you’re taking income from a defined benefit pension scheme (as opposed to a defined contribution pension scheme), you won’t need to worry about inflation because the amount you get is already going up with inflation, just like the state pension.

If you have investments or a defined contribution pension 

If you’re withdrawing funds from an investment or defined contribution pension scheme (which is what most pensions are these days), and inflation is high or your fund has had a bad year in performance, that’s a crucial time to review your finances. Mainly, you have to think about whether the amount you’re drawing is sustainable in the long run.

Often, a customer wants to take out a chunk of money from their pension and live off that for a bit. To stop your funds from being eroded, it’s good to keep as much of it in a place where it’s growing at least as much as inflation, and just check that it will last you the rest of your retirement. That’s the skill of a financial adviser – they can explain what’s sustainable so you can review your finances in an informed way. It might be that you’re taking out more than you spend, or there are things you can easily cut back on to make sure the fund is preserved for longer.

One thing an adviser might suggest if inflation is a concern, is to convert your pension to an annuity (a financial scheme that gives you a guaranteed income for the rest of your life) that can link to inflation. That way, you have protection against any ups and downs.

Time to check your finances?

Certainly, the prediction is that inflation could increase in the future, so it’s the right time to check that your finances are in a good position to deal with any changes. You can go through the paperwork yourself, or chat to an adviser for a clear picture and advice on next steps.

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