How to protect your retirement income from inflation

Any parent knows that you never stop worrying, you just change the things you worry about. It is the same with investing. You spend your whole working life fretting that you haven’t saved enough for your retirement. Then you get to your sixties and worry that, despite all you’ve squirrelled away, inflation is going to undo your good work.

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You are not the only one to be concerned. The Bank of England held interest rates last week even as the Fed and ECB raised theirs, but three of the nine rate-setters wanted to tighten too. Inflation is already 3.1% and the Bank expects it to rise above 4% early next year. It says the risks are skewed to the upside.

The period since inflation was last a problem has been easy. My parents - now in their nineties - enjoyed disinflation during the crucial early and middle years of their retirement. That wasn’t the experience of my grandmother in the 1970s, and I suspect it won’t be many people’s experience in the decade ahead. Inflation is once again a major retirement risk.

Here’s the problem. Imagine you are 65 and want to spend £50,000 a year in retirement and maintain that lifestyle until you are 95. At a steady 2% inflation rate, you will need £90,000 a year in 30 years. At just 3%, it is £121,000. It’s £162,000 at 4% and more than £200,000 at 5%.

Put it another way, the purchasing power of your £50,000 becomes £28,000 at 2% inflation and less than £12,000 at 5%.

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Navigating this compounding liability means addressing three separate risks: longevity, sequence of returns and inflation itself. And the trouble is that the answer to each one of these is not necessarily the answer to the others. The trick is to eliminate the risks you cannot afford to take so that you can take more of the risks you can.

Buying an annuity gets rid of the longevity problem but going into drawdown exposes you to it. Equities are no guarantee against an inflation shock - they can suffer badly when inflation suddenly rises - but over decades, ownership of businesses offers a much better chance of keeping pace with rising prices than holding cash or fixed income.

You might think an index-linked annuity is the answer, and it does tackle both longevity and inflation at the same time. But it is expensive. At today’s prices, you might have to accept a couple of thousand pounds a year less in income on a £100,000 annuity purchase. It can take decades for the cumulative payments from the inflation-linked annuity to catch up. There really is no free inflation hedge.

There are four broad ways to tackle the problem. Increasingly, one of these stands out for me.

The first might be called the seductive option - buying a level annuity and hoping for the best. If you have £1m in your pension pot, you might be able to buy an £80,000 income for life at age 65. You have eliminated market, sequence and longevity risk at a stroke. The problem is the remaining inflation risk. At 4% inflation, your comfortable income will be worth less than £25,000 in today’s money when you are 95. And you’ve no money left with which to respond. You swapped it for the income stream 30 years ago.

The expensive insurance option is to buy the inflation-linked annuity. With this, you might get a much lower starting income of, say, £59,000. That’s a big hit to start with, and if inflation does settle at the 2% target you may regret it. At 4% inflation, however, your income would rise above £80,000 within about eight years and continue climbing thereafter. More importantly, its purchasing power would be protected while that of the level annuity steadily eroded.

The third option is what might conventionally be called a conservative drawdown portfolio - say 40% shares and 60% bonds and cash. From this you could choose to take a starting income of £40,000 - the familiar 4% rule of thumb - and increase it with inflation. But you are still taking a couple of significant risks here. First, there is still some residual longevity risk. There is no guarantee that your £1m will last for 30 years. Second, there is loads of sequence risk. Poor returns in the first few years of your retirement would blow a hole in your plan.

The mistake is to think that retirement suddenly turns you into a short-term investor. It doesn’t. Some of your money is needed next week; some of it may not be spent until 2056. The two should not be invested in the same way.

So, the approach I’m starting to favour is what we might think of as ‘insure to invest’. You insure your essential spending with the smallest index-linked annuity you can get away with, protect your near-term spending with a combination of cash and short-term bonds, and then put your foot to the floor with the rest.

On our £1m pot, that might mean: spending £400,000 on an index-linked annuity, providing perhaps £24,000 of starting income, alongside the state pension when it arrives; holding £100,000 in cash and short-term bonds; and investing the remaining £500,000 predominantly in shares.

Minimising the risk in part of your portfolio allows you to maximise it elsewhere. The more you are lucky enough to have accumulated, the smaller the proportion you need to devote to securing the basics, and the more you can afford to invest for long-term growth. Your retirement portfolio can now do three jobs simultaneously. It can insure your longevity risk, cushion the sequence risk, and invest against the inflation risk.

There’s a final symmetry here. Retirees face sequence of returns risk in their investments and sequence of inflation risk in their spending. A burst of inflation at 67 is much more damaging than the same price rises at 92 because the higher cost of living then compounds for the rest of your retirement.

It would be great if inflation did not characterise my retirement years. But with potentially 30 years ahead of me, making everything superficially safe may be the riskiest strategy of all. I may need both insurance and investment risk at exactly the same time.

The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

This article was originally published in The Telegraph.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.