Why inflation really matters to your money when you’re retiring

The rate of inflation slowed dramatically in the past year, as Covid forced the UK economy into its biggest recession since 2007.

However, there have been suggestions that inflation will start to rise as the economy reopens and recovers from the impacts of the pandemic.

Inflation may seem like a far-off issue that only affects banks and businesses. But actually, the rising cost of living could have a substantial effect on the kind of retirement lifestyle you’re able to afford.

Here’s why inflation really matters to your money when you’re retiring – and, more importantly, what you can do about it.

Inflation can slowly erode the value of your savings

In a low-interest rate environment such as the current one, inflation can have an eroding effect on savings accounts. This is because interest rates don’t keep up with the rate of inflation at the moment.

The UK’s central bank, the Bank of England (BoE), targets inflation of 2% per year. To achieve this goal, it makes changes to its base rate.

The BoE’s base rate is the amount it pays in interest to high-street banks and building societies who hold money with it. In turn, this determines the interest rates you receive.

When spending in the economy is low, the BoE lowers the base rate to discourage financial institutions from saving with them. As a result, this encourages them to lend to people in the form of loans and mortgages, stimulating the economy and increasing the rate of inflation.

Conversely, when spending is too high, the BoE raises the base rate. This encourages financial institutions to stop lending and save their money, reducing spending and slowing inflation.

Over time, inflation slowly eats into the value of your savings, as it means they’ve lost value in real terms.

Consider the BoE’s target growth rate of 2%. If you have £1,000 saved in an account that pays 1% interest, you’ll have £1,010 in the next year.

But, if the BoE successfully increases inflation to 2%, goods and services that cost £1,000 one year should cost £1,020 in the next.

In real terms, your money has less spending power than it did the previous year.

A longer retirement means more time for value to decrease

An increase of 2% doesn’t sound that significant. But over long periods, your savings could lose out if they don’t keep pace with inflation.

Consider this example using the Consumer Price Index Inflation Calculator from in2013dollars.com, showing how the value of £30,000 changes over 25 years with an inflation rate of 2%.

£30,000 in 2021, adjusted for inflation

Source: In2013dollars.com

According to this prediction, by 2046 you’d need £49,218.18 to pay for the same amount of goods and services as £30,000 can buy you in 2021.

If you want to retire early, it’s not unreasonable that you’ll need your savings to last for 25 years. And, as people are generally living longer, that figure could be even greater if you retire at 55 and live to be 90.

Essentially, the longer you go with inflation eating into your pot, the more expensive it becomes to afford the things you want to do in retirement.

Using saving and investing to achieve your retirement goals

To battle the rising costs of living that comes with inflation, you need to save and invest in a way that targets the future figure for what you’ll need, rather than focusing on your current level of spending.

Fortunately, there are plenty of strategies available that you can use to protect your retirement savings and make sure you have enough to live on in the future.

Fixed-rate savings accounts

Fixed-rate savings accounts allow you to “lock” up your money with a bank for a fixed period, usually offering a higher interest rate than most savings accounts.

This can be a good option for making sure your savings keep up with inflation, while also keeping your money somewhere safe so you aren’t tempted to spend it.

Of course, you need to make sure that you find a savings account with an interest rate that’s at least level with the rate of inflation.

Investing across the market

General investing across a range of stocks, shares, bonds, gilts and other investments could help to keep your money ahead of inflation.

Of course, as with any investment, there’s a risk that you’ll get back less than you put in the market. Equity investments do not afford the same capital security as deposit accounts. Make sure you have a well-balanced, diversified portfolio that’s suited to your personal tolerance for risk, so your investments have the best chance of beating inflation.

Contributing to your pension

If you’re not yet at retirement age, you could consider boosting your pension contributions.

You’ll receive tax relief of your marginal rate of Income Tax on your pension contributions up to the pension Annual Allowance of £40,000 or 100% of your salary, whichever is lower.

Alongside this tax relief, pensions are typically invested across a range of funds, meaning they should also achieve steady growth in line with the markets.

Most pension providers allow you to choose a fund that suits your tolerance for risk, some of which contain riskier investments and potentially offer you the opportunity of greater returns. Of course, as a result, they also carry a greater chance of incurring losses.

Bear this in mind before you choose a riskier fund as it could affect your retirement lifestyle. If your investments perform badly, your pension pot’s value could fall behind the rate of inflation.

You also need to be careful not to go over the pension Lifetime Allowance (LTA) of £1,073,100, as this could increase the amount of tax you owe when you come to draw your pension. You may be subject to a tax charge of 25% if you draw income from a pension that exceeds the LTA. And, if you withdraw a lump sum, you may be subject to a tax charge of 55%.

Purchasing an annuity

If you’re concerned that inflation will reduce your savings to the extent that you don’t have enough to live on, you could consider purchasing an annuity.

Annuities work by giving you a fixed rate of income in return for a lump sum. The amount you receive is calculated from risk factors such as how old and how healthy you are.

Some annuities are specifically inflation-linked, meaning the amount you receive increases each year in line with inflation.

This can be a good option for keeping up with inflation, as well as offering guaranteed income.

However, bear in mind that this is typically irreversible. You may end up taking less in income than you pay in, and you’ll likely be unable to go back on your decision. Make sure this is the right choice for you before purchasing.

Find out what inflation means for you

If you’re concerned about how inflation might impact on your retirement savings, please get in touch with us at Novus. We can provide personalised advice that works for you in your circumstances.

Email info@novusfs.co.uk or call 01423 870731 to speak to us.

Please note:

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028).  Investments carry risk. The value of your investment (and income from them) can go down as well as up and you may not get back the full amount you invested which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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