Is ‘financial repression’ coming? Here’s how to beat it

Could your retirement plans be ruined by inflation? One of the world’s most respected financial planners has warned that inflation – not a bear market in stocks – is the biggest risk to savers who fund retirement by taking the income from their investments and supplementing it by the gradual sale of their assets (the ‘drawdown’ approach). And fears are growing that higher inflation is indeed on the way as governments around the world see it as the best way to deal with their enormous debts – inflation erodes the true value of those debts over time. We’ll examine these risks and suggest some investment strategies to counter them.

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Why inflation is the biggest threat to retired savers

Users of drawdown who leave their money invested in the stock market during retirement and withdraw a certain amount each year may quite reasonably regard bear markets as a key danger to their plans. But detailed financial modelling suggests that a bout of inflation during retirement is actually a bigger threat to a sustainable income.

Many retired savers base their plans on the ‘4% rule’, which suggests that they withdraw 4% of the value of their pension savings in the first year of retirement and increase the withdrawals by the rate of inflation each subsequent year. The inventor of this rule, an American financial planner called William Bengen, investigated what would have happened to savers who adopted such a plan in every year since 1926 and found that, no matter how adverse the circumstances they encountered in retirement, the 4% rule would have provided the income they expected at least until the age of 90.

In more recent analysis Mr Bengen has modelled the effects of bear markets and inflation on the use of his rule and discovered that, while savers’ pension pots could withstand a moderate bear market in the early years of retirement without needing to reduce their withdrawals or change their inflation linking, a bout of inflation would require them to change their plans if they wanted to prevent their funds from drying up before their 90th year.

Mr Bengen told Fidelity: ‘A retirement withdrawal plan requires active management. Adjustments may have to be made during retirement, although not all deviations from the plan require immediate action. Bear markets come and go, and many can be safely ignored. However, high, sustained inflation may be the justification for panic!’

Research by Fidelity’s Tom Stevenson earlier this month reached a similar conclusion. An article entitled Inflation: the hidden tax on your pension reported his analysis of the retirement plans of a colleague. He wrote: ‘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.’

Why higher inflation may be on the way

Governments and central banks everywhere say they are committed to keeping inflation low, typically at 2% a year. But some observers think they could soon be forced to allow inflation to rise. The problem is government borrowing – national debts. Governments spent enormous sums to support their economies after the financial crisis and through the pandemic. That money was borrowed. Annual budget deficits mean that their total debt continues to rise – a little more is added each year to an already gargantuan total.

As a result, national debts in Britain and America are about equal to their annual economic output; in some countries, such as Italy and France, debts comfortably exceed gross domestic product (GDP). The people who lend countries that money, international investors who buy their bonds, have started to fret about these countries’ ability to repay and are demanding more in interest to compensate for the risk.

The danger is of a self-fuelling spiral in which debt interest can be paid only by borrowing even more, then a rise in interest rates that makes the situation impossible – too much government money would be required for meeting debt interest and not enough would be left for essential services such as defence and education.

In these circumstances, some observers fear, governments would turn to central banks to print the money they need, or to lower interest rates in order to drag down the cost of government borrowing. Either course risks stoking inflation as more money in the economy chases a fixed supply of goods and services.

What then confronts savers is a rate of inflation that exceeds interest rates: people face a loss of purchasing power unless they put their money somewhere other than in cash. Such circumstances are sometimes termed ‘financial repression’ or, from a more macroeconomic standpoint, ‘fiscal dominance’ because the need of the government for money takes precedence over central banks’ previous focus on controlling inflation.

How to counter ‘financial repression’

Some investment funds specifically aim to make returns that beat inflation. One is Pyrford Global Total Return, which is on Fidelity’s Select 50 list of recommended funds. The fund says its aim is to ‘provide a stable stream of real total returns over the long term’ – the word ‘real’ here means after inflation, so that the purchasing power or ‘real value’ of investors’ money is preserved.

Outside the Select 50, several funds have similar aims. The Troy Trojan Fund, for example, aims to ‘achieve growth in capital (net of fees), ahead of inflation (UK Retail Prices Index), over the longer term (5 to 7 years)’. An investment trust run by the same company along broadly similar lines is Personal Assets. The CG Absolute Return Fund ‘seeks to preserve and over time to grow its shareholders’ real wealth’. Again there is a similar investment trust run by the same team as the fund called Capital Gearing. Another investment trust that takes a similar approach is Ruffer Investment Company. It states its aim as ‘to achieve a positive total annual return of at least twice the Bank of England base rate’ as opposed to explicitly beating inflation.

The stock market is generally regarded as offering good protection against inflation, but this may not apply once inflation really starts to take off. Research by Gavekal, a consultancy, found that stock market returns tended to be good when inflation was in the range –2% to +2% but tailed off rapidly outside that range.

‘Price stability (annual consumer price index changes of ­–2% to 2%) is ideal, while prices falling below –5% or rising above 5% are equally bad,’ according to the research, which used monthly data for the US consumer price index and the S&P 500 total return index since 1871. ‘If prices start rising above 3% a year, stock market returns can be seen to rapidly deteriorate.’

• Read: Pensioners must prepare for 1970s-style inflation
• Read: Inflation: the hidden tax on your pension
• Watch: Unpacking inflation: the secret threat to retirement plans

 

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investment trust shares are listed on the London Stock Exchange and their price is affected by supply and demand. Investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Eligibility to invest in a pension 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). Select 50 is not a personal recommendation to buy or sell a fund. 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.