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An inflated sense of worth?

Author: ICAEW Insights

Published: 27 Sep 2022

A fall in headline inflation to 9.9% in August down slightly from 10.1% in July is likely to be a transient moment of calm in a continuing storm. So what does rising inflation mean for pension savers and other investors?

The effect of inflation on investors

Rising prices create uncertainty, making it difficult for investors to work out the value of a company. Higher input costs can decrease profitability for companies that are unable to efficiently pass those costs on to customers and can lead to lower consumer demand overall.

At the same time, rapidly rising inflation can be a negative for both stocks and bonds. Bonds are generally issued with fixed rates of interest, so rising inflation reduces the purchasing power of those fixed interest rates. The longer the rate is locked in – with a 30-year bond, for example – the more sensitive a bond’s price is to a change in inflation. With stock prices, inflation’s effect is different but no less negative.

The pensions lottery

But what about pension savers? With inflation expected to continue rising this year, below-inflation pension increases look set to become the norm. At the very least, some consideration of the impact on schemes is likely to be needed.

“Most pensioners will be eligible for the State Pension,” says Nigel Peaple, Director of Policy and Advocacy at the Pensions and Lifetime Savings Association (PLSA). “It benefits from the ‘triple lock’, which increases the amount of income pensioners receive in line with [which figure is] higher out of inflation, wage growth, or 2.5%. The annual rise is based on September’s inflation number, which is expected to be more than 10%, which would mean the State Pension would increase to more than £10,500 per year.”

There are more serious concerns for those with defined contribution (DC) and defined benefit pension schemes.

Members of DC pension schemes are facing a double impact on their pension savings. “Firstly, the cost of goods and services are increasing at a rate not seen for over 40 years, and secondly the value of their savings has fallen materially since the start of the year, in part due to the rises in interest rates used by central banks to bring inflation under control,” says Paul Herbert, Head of DC Investments, WTW.

Those saving in a defined benefit scheme are likely to have some inflation protection, although often this is limited to between 2.5% and 5%.

However John Dunn, PwC's Head of Pensions Funding and Transformation, points out that even though there is a 2.5% or 5% limit on inflation protection in those schemes, they were designed in that way to protect the scheme itself and in times like this can have a significant impact on the members. “Those people will see the real value of their income eroded,” he warns.

The lowdown on drawdowns

Then there is the thorny issue of drawdowns. For older savers, the higher cost of living as well as stock market volatility may mean that now is not the best time to begin drawing a pension in any form.

“Delaying retirement by a year or deferring taking pension income for a short period can have a significant positive impact on retirement benefits, especially as higher forecast interest rates will improve the purchase value of annuities. Anyone close to retirement who is unsure what to do should consider seeking financial advice,” advises Peaple.

The future

PwC’s latest UK Economic Outlook does not make for easy reading. It predicts the UK will enter a recession as early as this year, largely due to surges in inflation as the cost-of-living crisis impacts all demographic groups. However, the shape of any recession is more important to businesses and policy makers than whether a recession is recorded in the national accounts.

“There are no easier answers,” adds Herbert. “With costs of goods and services rising faster than the incomes of most of us, whether in work or retirement, people will be forced to tighten their spending belts – which is the desired outcome of recent central bank interest rate increases, in order to bring future inflation under control.”

Visit ICAEW’s Inflation hub for a closer look at the impact of inflation on people, businesses, accountancy and the wider economy.

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