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An inflated sense of worth?


Published: 27 Sep 2022

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This week’s somewhat surprise announcement from the Office for National Statistics shows headline inflation at 9.9% in August, down slightly from 10.1% in July.

This week’s somewhat surprise announcement from the Office for National Statistics shows headline inflation at 9.9% in August, down slightly from 10.1% in July. While, on face value, it’s good news, this is likely to be a transient moment of calm in a continuing storm, primarily driven by easing fuel prices. Even with the slight easing, the inflation rate remains near a 40-year high; food prices rose at their fastest pace since 2008 as the war in Ukraine continued to help drive up prices at supermarket tills. 

What does this mean for pension savers and other investors? The temptation for pensioners, as inflation rises, is to draw down more from their pensions to battle the cost of living. Volatility in equities and a rise in the value of portfolios that include fossil fuels means that some pension savers and other investors may see gains. Equities are relatively positive but can fall as inflation rises, rates rise, and growth is threatened, with a potential recession forecast at the end of the year.  

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. David Henry, investment manager at Quilter Cheviot, told Forbes: ‘During periods of rising inflation, real assets – namely stocks and shares, property and commodities – tend to perform better than cash or bonds. Gold, for instance, was the best performing asset during the 1970s. 

‘In sterling terms, we recently looked at the performance of both UK and international stocks during periods of rising inflation since 1970 and found that UK markets tended to outperform global peers during these periods. UK stocks generated annualised returns of 12.9% on average during times of rising inflation, versus 7.7% for global markets. 

‘This is most likely due to the UK market’s long-standing, relatively high exposure to energy and commodity sectors. An obvious ‘hedge’ to the current cost of living crisis would be to hold shares in an energy producer.’ 

Meanwhile, Adrian Lowery, investments analyst at Evelyn Partners, comments: ‘In such uncertain times, there are some steps investors can take to shore up returns. Equity funds that will reliably thrive in the current conditions are hard to come by, but some will do better than others and investors can also look to increase exposure to assets and strategies typically uncorrelated with equities. Among equity funds, those that target income will provide investors with stable returns, whether capital growth disappoints or not.’ 

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.  

‘The big picture is, not all pension schemes respond to inflation in the same way,’ explains John Dunn, PwC's head of funding and transformation. ‘There is a bit of a lottery depending on where you build your pension up, what the rules of that pension will say about what inflation protection you get, but also the mix of pension you've got between the state and the private sector.’ 

The latest Department for Work and Pensions figures show that for the average single person, over 50% of their pension comes from the state. ‘So, the state is a really important pillar of our pension provision for the average pensioner in the UK,’ Dunn adds.  

‘Most pensioners will be eligible for the State Pension,’ agrees 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 the higher 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.’ 

Therefore, the only issue for those people on state pensions is that they will have to wait. ‘You've got that period between inflation being high and people feeling it and having to wait for the pension increases, which are typically awarded in April,’ says Dunn. 

There are more serious concerns for those with defined contribution 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. 

‘If someone is currently saving in a Defined Benefit scheme, inflation will not really have a direct impact on their future pension income,’ says Peaple, ‘especially if their salary increases in line with inflation. Moreover, if they are already retired, they are likely to have some inflation protection, although often this is limited to between 2.5% and 5%. The exact details will depend on the plan and the years in which the saving was undertaken.’ 

Dunn, though, 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.  

‘It is individuals that have recently retired and moved into drawdown that are most at risk,’ agrees Herbert. ‘While we should expect a range of positive and negative returns when investing for the long-term, the order in which they occur is important when drawing down your pension, something referred to as sequencing risk. When savings fall in value, a greater proportion of savings needs to be drawn to deliver the same level of income. This can be managed by reducing the level of pension drawn, however with living costs rising some individuals will be finding this challenging, resulting in them spending a greater proportion of their savings today and as a result their savings could run out later on in life.’ 

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. 

‘The UK inflation outlook is highly uncertain,’ says the report. ‘Our scenario analysis suggests headline inflation could peak at 17% in the first half of 2023. But if the government chooses to freeze household energy bills, then this could see inflation peak at between 10% to 13%. A persistent inflation scare is possible, but equally, productivity is trending positively. Either way, investors should avoid the tendency to focus exclusively on a negative outcome. ‘ 

Recommendations in JP Morgan’s Long-Term Capital Market Assumptions report say investors should ‘concentrate on building portfolios that capture today’s above-trend growth and are nimble enough to adapt as the environment evolves. Above all, investors will want to avoid assets that are serial losers across multiple potential future states of the world, and strengthen exposure to assets that are serial winners – even if this means exploring new markets and carving returns out of a wider range of risk premia.’  

The current situation and whatever the future holds should, at the very least, make people stop and reconsider. ‘Inflation has tended to be benign in the UK and people tended not to think of it as a risk, but when you get a period of high inflation, it focuses everybody's minds on what could happen,’ says Dunn. ‘I haven't got a crystal ball as to whether it will lead to people buying more inflation-protected products in the future - we'll have to see - but you certainly could see that scenario.’  

‘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.’