Inflation scenarios: what 3.8% rate does to a pension

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest. 

We are now ready to see the impact of a higher rate of inflation on her savings.

Scenario B: 3.8% inflation

The impact of inflation running at 3.8% rather than the Bank of England’s 2% target is significant.

While Annie is still working, higher inflation is not really a problem. Because her earnings keep pace with rising prices, she is no worse off. In fact, higher inflation means that she earns more, can save more and ends up with a bigger pension pot at retirement.

The real damage is caused after Annie stops working and earning. From this point onwards, keeping pace with inflation means taking ever larger sums out of her pension pot. She is no longer paying into her pension. The only protection against running her savings down is to generate higher investment returns. This may not be possible - the performance of financial markets is anyway out of Annie’s hands.

Assuming no other changes in Annie’s financial situation, our analysis shows that her pension pot no longer lasts the course. In fact, Annie can expect to run out of money by her 80th birthday.

This scenario is shown by the orange line in the chart.

Here are the some of the key differences:

• Because her income is linked to inflation, she actually saves more during her working life and starts retirement with a bigger pension pot - £1.5m versus £1.3m.
• The state pension also rises by 3.8% a year rather than 2.5% thanks to the triple lock guarantee.
• However, in order to start her retirement with an income of two-thirds her final salary, even with the benefit of the state pension, Annie is taking out more from her pension pot than she is growing it right from the outset.
• This is unsustainable and the smaller the pot becomes, the more she increases her withdrawals to keep pace with inflation, the quicker her savings evaporate. She runs out of money in just 13 years.

Navigating a higher inflation environment

There are three things that Annie can do to make her money last. She can save more. She can earn a higher return on her investments. And she can work for longer.

We modelled all three to understand how they might help.

Scenario C: earning higher returns

The first thing we looked at was the impact of earning not 5% a year on Annie’s investments but 6.5%. This makes a significant difference.

This scenario is illustrated by the yellow line on the chart. It shows a couple of important things.

• Earning a higher return increases the size of Annie’s pension pot at retirement significantly. By increasing the annual return from 5% to 6.5% she is able to start her retirement with a pension pot worth £2.2m, even with the same starting pot and the same contributions.
• Starting with a higher pot size means that in the first few years of her retirement Annie is increasing her pot size by slightly more than she is withdrawing. Although the increases in the amount she withdraws (to keep pace with inflation) eventually mean she is taking out more than she is growing her pot, the delay is enough to ensure her money lasts. But only just. She runs out of money shortly after her 90th birthday.

Scenario D: higher returns and higher contributions

The previous scenario is an improvement, but still not enough to ensure a worry-free retirement. To achieve that, Annie needs to not only earn a higher return but to pay more in while she is working.

So, the fourth scenario (shown by the light green line) models what happens when Annie both earns 6.5% a year on her investments and also increases her contributions from 10% of income to 15%.

Doing this has a couple of impacts:

• The combination of a higher return and higher contributions results in a much bigger pension pot at retirement.
• As a result the amount she takes out of her pot is much less than the annual investment growth and so her pension pot gets bigger well into her 80s.

Scenario E: higher returns, higher contributions, working longer

To really ensure a comfortable retirement, Annie could not only earn higher returns and pay more into her pension, but she could also work a bit longer. This actually makes a huge difference because she starts her delayed retirement with a very significant pension pot which really only starts to dwindle very close to her 90th birthday after many years of inflation-linked increases in the amount she is withdrawing.

This scenario is perhaps overkill. Annie ends up with a large unused pension pot, which, given expected changes to the inheritance tax treatment of pensions, is not a sensible approach. This is illustrated by the light blue line in the chart.

Scenario F: slightly lower returns, back to retirement at 67

So, the final scenario is Annie’s sweet spot. Although she sticks with a 15% pension contribution while she is working, she can afford to earn only 6% on her investments and to go back to her plan A of retiring at 67.

On these assumptions, Annie will still end up with a comfortable pension pot at the age of 90 of over £800,000. This is the scenario illustrated by the purple line in the chart.

Conclusions

There are a few takeaways from this analysis:

• Even a small increase in inflation, if it persists throughout a working life and retirement, can have a dramatic impact on our retirement planning. We should applaud the Bank of England’s efforts to keep inflation under control. And we should understand the impact of inflation on our financial plans.
• Saving hard and early is the best protection against the ravages of inflation. Building a meaningful pension pot by our desired retirement age is the best way to navigate a higher inflation environment.
• Earning even a slightly higher return can make a big difference when compounded over the years. There are two ways to do this - invest in the best-performing assets over time (this has historically been shares rather than bonds or cash); and keep costs low - a 0.5% lower fee has the same impact as a 0.5% higher investment return.

See our current offers to help make your money go further

• Read: Six ways to fix your finances for the 100-year life
• Read: How quickly will UK pension ages rise?
• Read: What income might I get from a £250,000 pension?