Click here to print this page

 

The Impact of inflation


Considering inflation and its effect on Investments and Pension income

InflationWhen you consider either an investment or your future pension income it is crucial that you consider the impact of inflation on that investment. Below we consider both inflation when planning for retirement and inflation in retirement:
 

Inflation when planning for retirement

Most of us are well aware that investments which pay fixed interest rates often struggle to keep pace with inflation over time, especially if we are taking the interest as income and therefore the purchasing value of our original investment is depreciating all the time.

However asset backed investments, such as stocks and shares, have in general historically beaten inflation over the medium to long term.

Asset backed investments.

Asset-backed Investments are just about the best way for you to combat the effects of inflation on your investments, let us look at a historic example to illustrate the point.

Let us imagine that in 1992 you won £600,000 on the lottery. You decided to invest your winnings in the following ways:-

1. The first £200,000 you used to buy a home, outright ( a 3 bedroomed semi-detached house in a suburb of London).

2. As luck would have it, the property next door was also for sale and so you bought that and let it out, getting a rental yield of 5% (.i.e. £10,000.00 a year, or £833.33 per month).

3. The last £200,000 you deposited with the XYZ Building Society, getting an income of 8.65% (i.e. £17,300.00 a year).

Let us assume that you decided to retire and you spent the £20,000 income (i.e. both the rent from the house and the income from the Building Society) to fund your cost of living.

Now, let’s roll the clock forward 20 years to 2012 and see what has happened:-

1. Your house is now valued at £632,173 (figures from the Nationwide Property Index).

2. Your investment property next door is also valued at £632,173 and your rental yield is still 5%, i.e. £31,608 (approximately £2,500 per month).

3. Your deposit with XYZ Building Society is still only worth £200,000, but the income has now fallen to 2.75% i.e. £5,500 per annum (figures from Sources: 'Annual Abstract of Statistics' 2000 edition. Office for National Statistics. Building Societies Yearbook 1997-1998'. Official handbook of the Building Societies Association. Halifax and Nationwide web-sites)

Your cost of living has now gone up to £36,000.00 per annum, due to inflation over the 20 years (source: The Retail Prices Index (RPI) inflation measure is used — the historical inflation data comes from the 2004 paper ‘Consumer Price Inflation Since 1750’ (ISSN 0013-0400, Economic Trends No. 604, pp 38-46) by Jim O’Donoghue, Louise Goulding, and Grahame Allen).

The Lesson : Had you relied purely upon deposit based investments to fund your retirement, you would have a SERIOUS problem.

In our section on investments we attempt to explain in simple terms all the different asset backed investments open to the individual investor, from contribution levels right through to taxation treatment of each investment.

 

Inflation in retirement

Inflation is one of the biggest threats we face in retirement but few of us truly appreciate the speed with which inflation erodes value. Someone retiring at 65, will potentially have a period of their life whereby their income will be slowly eroded by inflation, unless they have their investments in assets as described above which are capable of keeping up with inflation (i.e. asset backed investments).

The inflation rate experienced in retirement has also been higher than that experienced by younger members of the population in recent years because of the profile of spending in later life on products and services that have risen more steeply. 

To get a feel for the impact of inflation just take a look at the table below:

 

Inflation impact
over 20 years
Income requirement After 20 years
Annual inflation of 3% £20,000 £35,070

It’s important to bear the scale of change in mind when we look at figures relating to income in retirement and decisions about levels of escalation we might need each year.

 

The Rule of 72

In finance, the rule of 72 is a method for estimating an investment's doubling time. 72 (i.e. the rule number) is divided by the interest percentage per period to obtain the approximate number of periods (usually years) required for doubling. Although scientific calculators and spreadsheet programs have functions to find the accurate doubling time, the rules are useful for mental calculations and when only a basic calculator is available.

Similarly, to determine the time it takes for the value of money to halve at a given inflation rate, divide the rule number (i.e. 72) by that rate.

Example : To determine the time for money's buying power to halve, simply divide the rule-number by the inflation rate. Thus at 3.6% inflation using the rule of 72, it should take approximately 72/3.6 = 20 years for the value of a unit of currency to halve, in real terms.

This is a very important principle for all of us approaching retirement to remember, as inflation is one of the biggest threats that we will face. So when we are putting our pension into service, for example by turning our pension fund into an annuity, we need to take inflation into account and probably build some level of escalation into the annuity payments.

NEXT STEPS

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 

 
Bookmark








Over 50s Travel Insurance
Obtain a quote online