Why is inflation back in the news? – Prices are rising at the fastest rate since before the pandemic.
Should we worried about inflation? – Yes, it reduces spending power of a fixed income
What can be done? – Invest in equities / real assests
Last week the newspapers were full of stories about rising inflation. I was quoted in the Telegraph on Saturday 22nd May commenting about the impact of inflation on annuities.
The media was writing about inflation because the annual UK inflation more than doubled in April, as jumping from 0.7% in March to 1.5%. Inflation as measured by the Consumer Prices Index (CPI) is rising at the fastest rate since before the pandemic.
So, should we be worried about inflation or is this a temporary blip?
I think we should be worried because according to a well-known quote from Scottish economist, Frederick Leith-Ross, "Inflation is like sin; every government denounces it and every government practices it".
At the moment it doesn’t seem the Government is to blame for inflation because prices are rising in large part to increased demand and supply bottlenecks as the UK slowly eases out of lockdown restrictions.
However, the effects of inflation hits people in different ways. Those whose income or pensions increases with inflation are not badly affected as the rise in everyday prices is offset by their higher pay.
But those without inflation adjusted incomes, for instance those relying on a level annuity or a fixed income will be badly affected.
Most people have become complacent about inflation because in recent times inflation has been benign. Since 2003 the Bank of England has set the target of keeping inflation around 2% and at this historically low level, inflation has not been much of a worry for most people.
But if inflation were to increase much above this level it could mean many see a reduction in their standard of living, especially those with a fixed retirement income.
It takes just 14 years to reduce the spending power of a static pension if inflation was a constant 5%
There is handy rule of thumb called the rule of 72 – simply divide 72 by the rate of inflation and you will find out when the value of your money is halved. For example, 72 / 5 = 14.
There are basically two ways to protect against inflation:
The government issues index linked gilts but these are in short supply and expensive so in the main they are bought by large financial institutions and pension schemes .
it is possible to purchase inflation linked annuities, but again these are very expensive and not very popular for individual investors .
The starting income from an inflation linked annuity is about 40% less than from a level annuity, no wonder most people prefer the higher income from a level annuity.
Equities are viewed as an effective hedge against inflation. The theory is simple: a company’s revenues and earnings would also rise with inflation over the course of time. However, as we all know the value of shares can fall as well as rise.
One of the rationales for investing in drawdown and drawing a percentage of the fund as income is that if the value of the pension pot increases because of investment growth, the amount of income taken out can increase to compensate for inflation.
Inflation is unlikely to go away so everybody should take it seriously and plan to have a retirement income that keeps pace with inflation in order to maintain the purchasing power of their income.
It is tempting to ignore inflation and be attracted to the higher returns from a level annuity or a relatively high level of drawdown income. This might be fine in the short term but in the longer term, if prices rise, you will not be able to afford to maintain your lifestyle.