With inflation set to hit 9% this week (The Guardian May 2022) – with the Bank of England forecasting a rise to 10%, which would be the highest since the 1980s – it is important to know what it means and how it can influence your pensions.
In layman’s terms, it is the way of measuring how much prices are increasing, calculated by looking at how the cost of everyday essentials are rising.
For example, if a loaf of bread rises from £1, to 1.05, then bread inflation is 5%.
Inflation deflates the value of your money over the course of time, leaving you with reduced purchasing power. Placing your money in a pension could mitigate this.
How inflation eats away at your money
Imagine you have £10,000 sitting in a briefcase in your bedroom for the next ten years. If inflation – as the government are pushing for this year – was at 2% for that decade, then the cost-of-living would be 20% higher today. Therefore, your £10k wouldn’t be able to buy you as much as it would have done years previously – meaning the value of your money has been decimated.
If you can find a savings account with an interest rate above inflation or invest your capital in the stock market and hope it grows faster than inflation, then you may be able to protect the value of your cash.
Traditionally, the stock-market has out-muscled interest rates as global stock markets have grown by an average of 7.6% per years, which is higher than UK inflation. However, there are no guarantees that this will continue, and you will have to consider associated investment fees.
How does the Bank of England keep inflation under control?
Inflation occurs when there’s more demand for a product, or if the product becomes more expensive to make. If many products rise in price at the same time, then the cost-of-living shoots up. This is where we find ourselves in the UK in May 2022.
The Bank of England uses an imaginary basked called the Consumer Price Index (CPI) to track products and their prices over time. If they observe the price of an item growing too quickly – an indication of inflation – they could increase interest rates. They may also lower them if prices are decreasing/not growing fast enough, which can cause an indirect knock-on regarding wages.
High street banks who borrow from the Bank of England will pass on their interest rates to customers. So, when these are raised, the banks will encourage their customers to save more and borrow less, but similarly if they’re lowered customers are likely to borrow more.
The government has asked the Bank of England to keep inflation at 2% for 2022 – which, quite frankly, looks unrealistic.
Your pension and inflation
Pensions are by no means immune to the effects of inflation, but they are a great way to investment money with the goal of growing your retirement pot over time.
In general, your pension money is invested in the stock market, which as previously touched upon is growing faster than the rate of inflation.
However, let’s say your pension grew by 4%, but inflation was at 2%, then it really only grew by 2%.
For example, if you had £100k in your pot and you were planning to retire in ten years, with inflation at 2% over that period. If your pension grew at 2% you would have £122,000 but as the price of everything rose by 2%, then you’d be no better off as your £100,000 could have bought you the exact same ten years prior. If it rose 4%, it would be worth £148,000 which means you would be better off.
Once in drawdown, it is important to leave your pension invested and make regular withdrawals. Inflation will continue but may be offset by the growth of your investment if they outpace inflation. An escalating annuity increased over time to keep up with inflation, so this could be an option for you.
Pensions tend to grow faster than inflation over time. Your employers will also contribute to your pension and the government will also provide tax relief. You will also benefit from the influences of compound interest. Therefore, they are a great way to reduce the effects of inflation.
Reeves Independent can help you get your pensions under control, putting you in the driving seat to achieve your retirement goals. Book a free review today to start your journey to a brighter future.
This article represents the opinion of Reeves Independent limited only, is for information only and should not be seen as advice or a recommendation to take action. Investments can go down as well as up and you may not get back the original capital invested.
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