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Latest News How to account for inflation in your retirement planning

How to account for inflation in your retirement planning

How to account for inflation in your retirement planning

When planning for your retirement, you need to make sure you have enough money to support you through the years. Unfortunately, inflation can eat away at the value of your pensions and investments. For this reason, it’s essential to consider inflation in your retirement planning.

In this article, we look at why inflation is so important to consider, how it can affect your retirement savings, and what you can do about it.

How does inflation affect your purchasing power?

How much inflation eats away at your purchasing power will depend on how long you live after retirement. If you retire relatively early, you could reasonably expect to live in retirement for a further 30 years. To give you an insight into your future purchasing power, comparing today’s prices with those of 30 years ago is useful. As you can see, inflation has significantly impacted the cost of everyday items.

October 1993 October 2023 % increase
Milk (1 pint) 34p 65p 91%
Bread (800g white loaf) 51p £1.37 169%
Onions (1kg) 59p £1.07 81%
Cheddar cheese (1kg) £3.24 £8.87 174%
Granulated sugar (1kg) 64p £1.15 80%
Eggs (dozen, size 4) £1.02 £1.80 76%
Fresh, oven ready chicken (1kg) £2.25 £3.86 72%
Unleaded petrol (litre) 48p £1.55 223%
Diesel (litre) 46p £1.62 252%
Draught lager (pint) £1.25 £4.67 274%

Source: ONS

While the above increases are taken from the Retail Prices Index (RPI), many other costs rise over time. These include things such as rent, house prices, clothing, cars, insurance, and professional services such as accounting and legal advice. While wages also increase over time, retirement income doesn’t necessarily. That’s why accounting for inflation in your retirement planning is important.


How can inflation affect retirement savings?

Inflation can affect your retirement savings and income in multiple ways.

  • Inflation reduces our purchasing power. For example, if the inflation rate is 4.6%, an item that was £100 a year ago would now cost you £104.60. Unless your income and savings increase at the same rate as inflation, your purchasing power will decline.
  • If you have opted to buy an annuity for your retirement, this may also be affected by inflation. This is particularly true if you have opted for a fixed annuity rather than linking it to inflation. For people who remain invested during their retirement, the impact of inflation will depend on where the pension is invested.
  • Inflation can also devalue your state pension. The UK’s state pension is subject to the “triple lock”, which aims to increase the state pension each year by the highest of inflation (Consumer Price Index), average earnings growth, or a minimum of 2.5%. While this mechanism helps protect the state pension from the full impact of inflation, it does not guarantee that pension increases will always keep pace with the rising cost of living as a pensioner’s basket of goods may be different to that used by the CPI.
  • Inflation will affect the performance of your pension fund. If you have a defined contribution pension, it will be based on the performance of investment portfolios. If investment returns do not outpace inflation, the real value of the pension fund may decrease.


Should you consider inflation in investment and retirement planning?

Absolutely, considering inflation is a crucial aspect of investment and retirement planning. Ignoring inflation can lead to underestimating future expenses and, consequently, falling short of financial goals during retirement. The following are all good reasons for taking inflation into account:

  • Preserving purchasing power. Planning that increases the likelihood of your income and investments keeping pace with inflation may help you maintain your desired standard of living during retirement.
  • Retiring at your preferred age. If you don’t take inflation into account, you run the risk of retiring too early and not having enough money. Regularly reviewing the performance of your pensions and investments while factoring in inflation should allow you to make any adjustments needed. Although not guaranteed, by doing this, there will be a greater chance of you being able to retire at your preferred age with the lasting income you need.
  • Choosing the right investments and savings. Inflation affects investments in different ways. Cash savings accounts rarely offer enough interest to keep pace with inflation. Fixed-term investments such as bonds offer diminishing returns each year because inflation erodes the value of the fixed return you get. Investments in stocks and shares can generate returns that far outpace inflation. However, they are inherently riskier and can result in losses. Ensuring you have a diversified portfolio mitigates the risk and gives you a greater chance of generating returns that exceed inflation. It’s worth noting that some people choose to move their money into less risky investments as they approach retirement age. This reduces the likelihood of losing significant sums in a stock market downturn or a fall in property values.
  • Choosing the right annuity. When you’ve factored in inflation, it can help you purchase an annuity that’s right for you. While fixed annuities are usually cheaper, the income they give you each year is devalued by inflation. An inflation-linked annuity can help solve this problem, but they are more expensive to buy. Planning can widen your options and give you the potential to select an annuity that may provide the income you need throughout your retirement.


How can you account for inflation in financial planning?

Accounting for inflation in financial planning is crucial for creating a realistic and effective strategy that protects your purchasing power. The younger you are when you start planning your retirement, the more options you will have. Here are several steps to help you incorporate inflation into your financial planning:

  • Understand historic inflation rates. It’s a good idea to get familiar with historic patterns of inflation. Since the early 1990s, annual inflation has tended to be around 2.5% or lower. However, as we saw in 2022, unforeseen events can send inflation rates soaring. Having a realistic idea of average inflation rates can help you predict how much your investments and savings need to grow yearly.
  • Use real rates of return. When projecting investment returns, use real rates of return (nominal return minus inflation) rather than nominal rates. This approach provides a more accurate representation of the actual purchasing power of your investments.
  • Include future cost estimates. When creating a financial plan, project future costs for major expenses like healthcare, housing and travel. If you estimate how these costs may increase over time due to inflation, you’ll be better able to meet them when needed.
  • Get independent financial advice. Seek guidance from an independent financial adviser specialising in retirement planning. At Alan Boswell Group, our advisers can help you create a personalised strategy that accounts for inflation, aligns with your risk tolerance and goals, and works towards meeting your long-term needs.


What inflation rate should you use for retirement planning?

When planning for retirement, it’s prudent to use conservative estimates of future inflation rates. Financial advisers at Alan Boswell Group use cashflow modelling tools to show the impact of a variable rate of inflation on retirement plans. We also use a Monte Carlo simulator that plots over 10,000 retirement simulations and uses randomly generated inflation figures using the Gaussian distribution based on historical values. Using forecasting tools helps our advisers to give personalised recommendations to help you reach your retirement goals.

When looking at historic inflation rates, it’s also important to know that the UK measures inflation in several ways. These are:

  • Retail Prices Index (RPI). This is an older measure of inflation, which typically comes out highest because it is strongly influenced by house prices and interest rates.
  • Consumer Prices Index (CPI). This is generally lower as it doesn’t take housing costs into account.
  • Consumer Prices Index plus housing costs (CPIH). This is the same as CPI but adds in how much rent a homeowner would pay for an equivalent property.

To give you an idea of how these measures vary, in October 2023 RPI inflation was 6.1%, CPI was 4.6%, and CPIH was 4.7%.

It’s also important to note that CPI is used to calculate increases to final salary pensions, income from index-linked annuities, and income from some index-linked bonds. CPI is also applied to the state pension and public sector pensions.

As we’ve seen, it’s very important to consider inflation when planning your retirement. Underestimate its effects, and you may find that you don’t have enough money to fund your retirement or have to delay your retirement date. For this reason, it’s essential to regularly check how much your pension, other assets and investments are worth.

If you’d like more help with your retirement planning, we strongly recommend getting advice from one of our expert advisers. Our advisers use specialised systems, such as cashflow modelling, which can help you formulate a plan with the aim of achieving the retirement lifestyle you want. To find out more, give our team a call on 01603 967967.

Please note, the value of investments and any income from them can go down as well as up and you might not get back the original amount invested. The past is not a guide to the future.

None of the information in this article represents a recommendation about the income you may receive in retirement.



What happens to pensions when inflation is high?

High inflation is generally bad for pensions. Pensions with fixed annuities face a reduction in real purchasing power as the cost of living rises. Defined benefit pension schemes may encounter increased obligations to provide inflation-linked increases, affecting their financial sustainability. Pension fund investments, including those managed by private and workplace schemes, may face challenges in generating returns that outpace inflation. Although the UK’s state pension is subject to the “triple lock” mechanism, this becomes politically contentious at a time of high inflation, and it’s not guaranteed to remain in future.


What is the formula for calculating inflation?

The most commonly used formula for calculating inflation is the Consumer Price Index (CPI), which measures the average change over time in the prices consumers pay for a basket of consumer goods and services. You can find out about the formulas used to calculate CPI on the Bank of England’s website.


How much will you need to retire with inflation?

This really depends on the lifestyle you want to enjoy during retirement. For more help with this, see our article How much do I need to retire?


Is high inflation good for pensioners?

On the whole, no. High inflation can devalue income, investments, pension pots and savings. One positive may be that assets such as stocks or property can outpace inflation, but this is far from guaranteed.

Related products: Retirement Income Solutions Personal Pensions