Inflation: the hidden tax on your pension

The government’s review of pensions is asking some of the right questions. Top of the list is the age at which they should start to be paid. It is not a given that the state should fund the last third of someone’s life, regardless of need. That is a choice, and a recent one. When the Old Age Pension began in 1909, it was paid from 70, you had to have lived in the UK for 20 years and to be of ‘good character’. It was means tested, too - you needed to earn less than £21 a year to qualify.

So, Liz Kendall, the work and pensions secretary, is right to look first at the state pension age. And right to commission a report on the proportion of adult life spent in retirement. When the modern state pension was introduced in 1948, a 65-year-old could expect to receive it for just 13 years, about a sixth of their life expectancy.

She is right, too, to investigate ways to boost pension savings - 8% of earnings is not enough - and to broaden the number of people putting money aside for their retirement. Only half of working-age people are doing that, a fifth of the self-employed and fewer still of some ethnic minorities. That’s not good.

• Get updates on markets, ISA funds, pension saving and much more

As ever, when it comes to pensions policy, there is also a cake and eat it problem. The government spends about 5% of gross domestic product (GDP) on pensions - more than £120bn last year - but it persists with the fantasy that the amount paid to pensioners can rise into the future by the highest of earnings, inflation or 2.5%. The triple lock is unaffordable.

The unavoidable truth about pensions is that small changes in a range of unpredictable variables make a big difference when they are compounded over the decades that we now expect to live after we have stopped working. This is true for the good changes that government policy and personal choice can deliver. And for the bad ones that we can’t do much about.

That’s why the government is asking only some of the right questions. There are three others it needs to address, all of which are difficult. The biggest pensions challenge may well be one that no-one is talking about.

This all became abundantly clear to me recently when I helped a colleague out with a deceptively simple question. He wanted to know what rate of investment return he needed to aim for in order to achieve the comfortable retirement he was hoping to enjoy.

To answer that, I employed my pathetically rudimentary Excel skills to build a spreadsheet with a few variables that we could play with until we arrived at a plausible plan. I plugged in: how much he had saved; how much he intended to put aside in future, and for how long; when he planned to wind down into semi-retirement and when he would stop completely; when he would take the state pension; and the return he would aim to achieve on his investments both before and after he stopped working. I ran the numbers from his current age of 52 until, with luck, he turns 90.

Crucially, I had to make some quite big assumptions, the most important of which were that the triple lock would continue throughout his life and that the Bank of England would succeed in hitting its 2% inflation target.

By tweaking all these variables and assumptions, we were able to monitor their impact on the cumulative size of his pension pot. As you might expect, saving more for longer in an only moderately inflationary environment ended well. Working for a bit longer made a big difference. Accepting a lower income in retirement helped. None of this is rocket science, and probably doesn’t require a Pensions Commission to confirm.

That said, I was surprised by some of the things we discovered. One was the remarkable power of starting early. The principal reason that my colleague was pleasantly surprised by his required rate of investment return was that he had spent the previous 30 years studiously paying into his company pension, supported by a generous employer. The first additional question the government needs to find an answer to is how to get young people engaged with their pensions. It may be boring, but it is not as boring as being old and poor.

• See our current offers to help your money go further

The second thing the spreadsheet taught us was the power of delay. Working just a few more years, even in a part-time capacity, can transform the arithmetic of our pension savings. Paying in for longer and taking out for less time, together with a few extra years of compound investment growth, is a magical combination. Find what you enjoy and keep doing it.

But the biggest eye-opener for me was the devastating impact of even a modest uptick in inflation. A quick and easy way to make your money run out is to stop work and then try to maintain your standard of living by increasing the amount you draw down from your pension in line with rising prices. For my colleague, nudging up the assumed inflation rate from 2% to 3% was the difference between a £700,000 pension pot at the age of 90 and running out of cash completely a couple of years earlier.

The pensions crisis that no-one is talking about, therefore, is on the face of it nothing to do with pensions at all. Yes, more people need to save more, to start earlier and to carry on for longer. The government has a role to play in encouraging all of those. But it, and the Bank of England, has an even bigger task. To keep inflation at a level where it doesn’t blow our plans out of the water.

This article originally appeared in The Telegraph

• Read: What’s my required rate of return?
• Read: The ‘£299,325’ cost of matching the State Pension
• Read: How might the government change pensions?

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA and tax treatment depends on personal 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.