Why rising inflation could impact your pension - and what to do about it

Retirees could see an impact to their pension following inflation rising by more than expected to 3 per cent in January.

The figure is now well above the Bank of England’s 2 per cent target and is at its highest level in 10 months, sparking concern about household finances.

The i Paper spoke to experts to find out what it means for retirement savings.

Although one high inflation figure in isolation does not mean a dramatic change for pension savers over the long term, rising prices can eat away at the value of your pension pot, experts have said.

For example, if your pension pot is worth £100,000 today, it would need to grow to £103,000 over a year to retain its value if inflation remains at 3 per cent.

While this might not be a pressing concern in the immediate future, over a 20- to 30-year retirement, the erosion of your pot’s value could be substantial.

Former pensions minister and partner at LCP, Sir Steve Webb, said it’s “easy to under-estimate” the length of your retirement and how far inflation can erode the value of your savings over the long-term.

He said: “The typical retiree can expect to live for two decades or more, and an increased cost of living means your pension pot and other savings will not stretch as far as you get older.”

Inflation is a long-term concern, which is why long-term investing is essential to protect the value of your pension pot, according to experts.

Tom Selby of AJ Bell said most people’s pension pots are invested in a default fund chosen by their employer’s pension scheme.

These funds are designed to cater to the broad membership, but they are not necessarily tailored to your specific risk preferences or retirement goals.

Selby said: “Reviewing your investments to make sure you are happy with them is a good starting point, while also keeping an eagle eye on your costs and charges.”

Pension savers need to make sure their investments have the potential for growth that outpaces inflation, especially if their retirement is many years away.

Webb agreed that reviewing your investments periodically is important, adding: “A key priority is to make sure that your money is working hard, rather than putting it all in ultra-low interest cash accounts or instant access accounts.

“Whilst we all need some ready cash for emergencies, if you don’t need access to your money immediately you can get a better rate of return, and this will have more chance of keeping up with inflation.

“If inflation is at 3 per cent, any account paying you less than 3 per cent is losing you money in real terms every year, so a periodic review of your investments is well worth while.”

There are three main ways you can access your pension: by getting an annuity, moving money into drawdown and taking lump sums.

Those with defined benefit (DB) pensions – which guarantee an annual payment each year – usually benefit from payouts linked to inflation – although it tends to be the September rate of CPI inflation that is used to set the increase.

But those with defined contribution (DC) savings who bought an annuity – an annual payment – with their pension will see their real income fall unless they purchased some form of inflation protection,

However, hose who want to buy an annuity now could get better rates, according to Adrian Lowery of wealth management firm Evelyn Partners.

He explained: “Higher inflation tends to mean that interest rates will stay higher for longer, so that could be good news for those who want to buy an annuity, as annuity rates (or the annual income you get at a certain price) tend to be higher when interest rates are higher.

For those already in retirement, the situation is a little more complicated than for those who are approaching it.

Rising inflation poses a more immediate threat, particularly for those who are drawing an income from their pension pots.

Craig Rickman, personal finance editor at interactive investor, said: “Prices may be ticking up at a much slower pace than the red-hot, double-digit figures we had to endure a few years ago, but savers and investors need to be wary of the corrosive impact inflation can have on their finances.

“The threat is particularly acute for those who are already retired and living off their accrued wealth.”

Rickman said retirees, particularly those using drawdown, should revisit their investment strategy when inflation rises.

He added: “Whenever price rises speed up, it means they’ll have to draw more from their accrued savings to sustain the same standard of living.”

Those relying on drawdown should ensure their investments are positioned to protect against inflation, either by increasing exposure to higher-growth assets or incorporating inflation-linked products into their portfolio, he explained.