How 4% inflation could derail your retirement

I popped in to see my parents last weekend - and saw first-hand why Rachel Reeves is bending the Cabinet’s ear about growth and inflation. My father is 92 and my mother 88. Thankfully independent, as healthy as can be expected and marbles largely intact, they are the personification of the Chancellor’s challenge as she grapples with how to balance the books in ten weeks’ time. Dad last worked around 1990. He’s enjoying a long, but far from unusual, retirement.

I’m less worried about my parents than my daughter. She is nearly 32 and she won’t benefit from the final salary pensions that have protected her grandparents from the ravages of inflation. Two index-linked teachers’ and one air force pension have left them relaxed about rising prices. That and getting on the housing ladder for less than £5,000 in the 1960s, of course.

• Tom crunches the numbers six ways to show you the effect a persistently higher rate of inflation can have on your retirement savings.

At 62, I sit bang in the middle, a late boomer who, like my parents, benefited from relatively low house prices in the 1990s but who, like my daughter and her brothers, will have to hope my defined contribution pension pot lasts me out. My gene pool suggests it would be prudent to look at 30 or 40 years in retirement if I want to be confident of not running out early.

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The inter-generational challenges of the Stevensons are not the Chancellor’s top concern. She is more focused on getting long bond yields down from a 30-year high to ensure that keeping my parents in pensions, pills and appointments does not break the bank. Short of taking a leaf out of Donald Trump’s playbook and reversing the Bank of England’s independence, she is only going to do that by getting on top of inflation.

Inflation is a killer. And inflation compounded year after year through a 30-year retirement is particularly brutal. What I suspect few people really understand is how much more damaging a 4% inflation rate is over that time period than a 2% one. As that is what the Office for National Statistics is likely to unveil next week, it’s not a bad time to start thinking through the consequences of persistently above-target price rises.

To understand the impact of higher inflation, I revisited the spreadsheet that I created a few weeks ago, and wrote about in below, to help a colleague think about his retirement planning. This time, I imagined a 32-year-old - let’s call her Annie - just setting out on her financial journey.

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One of the variables I am able to flex in my model is the inflation rate, so it was simple enough to see the impact of replacing the Bank of England’s 2% target inflation rate with the actual 3.8% recorded in July and due to be exceeded next week for August. It was a sobering analysis. It took a plausible retirement plan for Annie - and blew it out of the water.

The scenario I looked at was simple. Annie is a middle-income earner in her early thirties. She is doing the right thing, putting 10% of her salary into a pension. Her earnings rise in line with inflation, and they are boosted every five years by a small pay rise. Annie works until she is 67, when she retires. At this point, she starts to draw the state pension topped up with a drawdown income from her pension pot. She starts out with an income of two thirds of what she was earning in her last year of work and increases her withdrawals in line with inflation all through her retirement.

And this, of course, is where the problem lies. While Annie is still working, the impact of inflation is hidden, because her salary rises in line with prices. But once she stops, only the state pension is protected from inflation, thanks to the triple lock guarantee (which I assumed, perhaps rashly, will remain in place). The extent to which her drawdown income handles the impact of inflation is determined by the kindness of the market.

First, the good news. At a 2% inflation rate, Annie’s pension savings comfortably last the course. By the time she retires, on the basis of quite reasonable assumptions, she has accumulated a pension pot that will pay her the income she needs well into her nineties.

But substitute a 3.8% inflation rate and the arithmetic goes south alarmingly quickly. Although higher inflation during Annie’s working life gives her a bigger starting pension pot at the age of 67, the more rapid growth in her withdrawals as she tries to keep up with the spiralling cost of living, quickly eats into her savings. She is barely into her eighties when she runs out of money.

There are three things that Annie can do to achieve a better outcome. She can save more, she can work longer and she can earn a better return on her investments. The good news is that over such a long period of time, even small adjustments can make a massive difference.

Saving hard and early is the best protection against the ravages of inflation. And sitting between my parents and my children this is the key lesson I can pass down the generations. Building a meaningful pension pot is the only way our children can replicate the comfortable retirement our parents have enjoyed.

People don’t tend to talk about a social contract anymore but when the Chancellor reminds her cabinet colleagues about the need to keep inflation in check that is what she is describing. My children can work and save hard - I’m sure they will. But it is for those in power not to play fast and loose with the cost of living and not to muck about with the incentives to do the right thing. Controlled inflation and a stable pension framework. Now that would be something that all three generations of my family could get behind at November’s Budget.

This article originally appeared in The Telegraph

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