Inflation could hit retired investors

Ahead of the Bank of England’s Quarterly Inflation Report out tomorrow, the National Institute for Economic and Social Research (NIESR) has predicted that inflation could hit 4% in the near term. Tom McPhail, head of retirement policy at Hargreaves Lansdown, looks at how this affects retired investors.

Inflation could hit retired investors

Increasing inflation is the wolf at the door for retired investors but perversely it could be good news for final salary pension schemes.

It is essential to protect your income in retirement from inflation as it can halve the value of your income over the duration of a typical retirement. The state pension increases automatically as it uses the triple-lock to ensure pensioners always get the best increases which match or exceed the rate of inflation. For your private pensions, one option is to buy an index-linked annuity but they don’t come cheap. A 65 year old with £100,000 could buy a level income of £4,781 but if they wanted their income RPI linked, the starting rate would drop to just £2,840.

An alternative strategy is to use drawdown invested in equities and equity income funds and to draw the natural yield (just the dividends and interest). This can produce a starting income of around 3.5% or £3,500 from a £100,000 pension pot and back-testing shows that such a strategy would have increased an investor’s income to around 3 times its starting amount over the past 27 years.

You can also mix and match your retirement income plans, by using a combination of annuities and drawdown, which works well to secure a base level of income to meet your essential needs, with variable income above.

For final salary schemes, rising inflation is likely to lead to falling bond prices and rising yields. Whilst this may lead to some capital losses on pension scheme bond portfolios, it will also lead to shrinking liabilities because these are valued by reference to bond yields. The overall effect is likely to be to bring down the record deficits we have seen in recent months.

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