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When setting out your retirement finances, understanding what you can sustainably afford to withdraw is essential. One of the key elements to this is longevity; how long will you need to draw on your pension for? But another, related challenge to managing pension income that you may have overlooked is inflation.

Inflation means the cost of living is rising. It may not be something you notice when it comes to your day-to-day spending. However, when it comes to planning your retirement income, you may be planning your finances for the next 30 or 40 years. As a result, the impact of inflation will be far more obvious and needs to be taken into account.

If you haven’t considered how inflation will affect your retirement lifestyle, it’s time to do so.

The rising cost of living

When you look at the pace of inflation on an annual basis, the rise can seem relatively small.

Using the Consumer Price Index, which is one of the measures to calculate inflation, the cost of living increased by 2.5% in 2018. Whilst you may have noticed the cost of your grocery shop or utility bills rising, a 2.5% increase is unlikely to have had a significant impact on your lifestyle.

But over several decades, that rate of inflation can add up. The Bank of England inflation calculator gives you an idea of the long-term impact.

Let’s say you retired 30 years ago in 1990 and planned an annual income of £25,000. The last three decades have had an average interest rate of 2.9%. So, in order to maintain your lifestyle, your pension would need to deliver an income of £57,251.26 today.

Correspondingly, if you haven’t factored inflation into your retirement plans, you could find that your plans aren’t achievable.

In addition to the length of retirement having an impact, low-interest rates are also an issue for modern retirees. Since the 2008 financial crisis, interest rates have been historically low. The Bank of England base rate is currently just 0.75%. This is below the rate of inflation, so in real terms, cash savings are losing value.

Protecting your retirement income from inflation

Inflation can have a huge impact on your retirement income if it’s not something you’ve planned for. However, with appropriate retirement planning, it’s something you can anticipate and reduce the impact of. There are many ways you can reduce the impact of inflation on your retirement, these should consider your wider financial circumstances and goals. Four to consider are:

1. Set more aside for retirement

If retirement is some years away, this may be a viable option for you.

Take some time to assess the current retirement lifestyle your pension and habits will afford you. Working with a financial planner can help you understand how your wealth and necessary income will change over time. If there’s a shortfall, increasing pension contributions or other retirement provisions can bridge the gap. With the right planning, you can gradually increase the amount of income you take from a pension to maintain the lifestyle you’re aspiring to.

2. Plan to reduce spending in later years

This solution might sound simple, but it’s one that follows a retirement spending trend.

Retirees often find that they spend more in their early years of retirement. As well as your day-to-day costs, you may spend more on one-off purchases, such as luxury holidays or renovating your home, as well as indulging in your hobbies. However, as you move through retirement, many find their spending starts to fall, before levelling off as they settle into their new lifestyle.

As a result, planning to spend less in later years could match your retirement plans.

However, one thing to consider here is care. As we live longer, more people need some form of care in their later years, whether this is support at home or a nursing home. Should you need care, it’s likely your outgoings will climb significantly. No one can know if care will be needed, but it’s wise to plan for it as this can help ensure your wishes are followed.

3. Choose an Annuity linked to inflation

If you have a Defined Contribution (DC) pension, one of your options is to purchase an Annuity.

This is a product that you purchase which will then provide you with regular payments for the rest of your life. An Annuity is the only way to create a guaranteed income throughout retirement when you have a DC pension.

There are many different Annuity providers and products to choose from, with different features. If inflation is a concern, choosing an Annuity that will rise in line with it can ease concerns. You’ll often find you receive a less competitive rate by selecting an inflation-linked product, but it can be worth it when you assess your finances with a long-term view.

4. Leave a portion of your pension invested

Since 2015, Pension Freedoms have provided retirees with more flexibility in how and when they access their pension. Using Flexi-Access Drawdown can help mitigate the impact of inflation.

With this option, your pension savings are transferred to a drawdown product. This allows you to make flexible withdrawals to suit you. Importantly, the remainder will usually be invested until you access it. This gives your savings a chance to grow in line with inflation and perhaps outpace it.

If you choose to leave your pension invested, it’s important to manage investment risk. All investments come with some level of risk and you need to understand what’s appropriate for you. It’s also crucial that you manage withdrawals in line with performance. Making the same withdrawal when markets are in a trough as you would do normally, for example, can deplete your savings more rapidly. Working with a financial planner can help you manage withdrawals.

As you approach retirement, you should have confidence in your financial future moving forward. This is an area we can help with. Please contact us to discuss how inflation could affect your retirement income and what your options are to manage this.

Please note: A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulations, which are subject to change in the future.