In a previous post, we discussed how the value of a Pension Fund could be affected by three main factors. In this post we discuss the first of those factors – the impact of Inflation on a pension fund.

In general terms inflation (increase in the cost of a basket of items) is caused by increasing costs or increased demand. Costs of manufacture (and therefore buy price of an item) can be forced up by a wide variety of factors such as commodity prices or wages. Demand side inflation may be fuelled by more consumer disposable income or a mass of other factors.

The Impact Of Inflation On A Pension Fund – The Numbers

In this post, we discuss defined contribution type pension schemes. The issues for defined benefit (final salary) pensions are different. Inflation can impact on final salary pension scheme deficits as discussed elsewhere on this blog.

If we assume no growth in a pension fund over time then a pension fund worth £100,000 today would be worth approximately £88,400 in 5 years, £78,100 in 10 years and £61,000 in 20 years based on consistent 2.5% inflation over that period.

Of course, it may be reasonably expected that the value of an investment (a pension fund) will grow over time. If the fund is growing consistently at greater than 2.5% per annum then inflation is not a major reason for concern.

But growth is difficult to predict in periods of high inflation. Some asset groups will perform better than others and investment managers may switch out of some asset classes into others. This process is not an exact science and relies on historical information that may (or may not) be reliable. Historically, shares and bond have not performed well in periods of high inflation but that has not always been the case.

There is always a risk that some major economic or political event occurs that results in a rapid rise in inflation. This could take investment managers by surprise. It could happen (and has happened in the past) but it is not something that can be planned for. However, depending on the particular circumstances the impact can be significant.

Retirement Risks Tend To Act Together

Inflation risk and longevity risk are interrelated. Let’s assume an individual lives for 30 years from retirement. Is inflation likely to be consistently high for that entire period – probably not. High inflation could exist for 10 years or more but lower inflation over the remaining 20 years would balance out the potential negative impact.

If an individual only lived for 10 years and inflation was consistently high over that period it may be more of a problem. It depends on the retirement route selected, was it annuity? Or was it drawdown? If the annuity was the chosen route then what type of annuity and under what terms? The impact of inflation can vary depending on the option selected at retirement.

Inflation risk is also linked to investment risk. The value of investments generally shows some volatility over time. Depending on economic conditions and the asset mix in an investment portfolio over some periods of time investments value may be growing strongly.

Unfortunately, the reverse is also true and at some point, the value of investments may fall. Ultimately the aim should be long term growth but what if inflation is high at the point the value of investments are falling. This can have a compounding effect.

What if it is necessary to make higher than average withdrawals from a pension fund when inflation is high. Again this can have a compound effect that can be difficult to recover (especially over the short term).

Forecasting Inflation Can Be Difficult

The past does not repeat itself, but it rhymes (Mark Twain). Although the past is no guide to the future it can be a guide. That said inflation is difficult to predict. In August 2007 the Bank of England predicted inflation in 2008 at around 2 to 2.5%. The maximum they predicted inflation would reach between 2007 and 2010 was around 3.5%. In September 2008 inflation was at 5.2% and there were worries it could hit 7%! 

Of course, this is an extreme example as the financial crisis hit in 2008 but it does illustrate a point. During 2017 and 2018 Bank of England inflation predictions have regularly been wrong. That said the errors have tended to be fractions of one percent.

Inflation is a key risk to the value of a pension fund. Its potential impact should be considered carefully when making choices at retirement (annuity or drawdown). Once in retirement the options available to address the impact of inflation are limited but good advisers and investment managers should be able to help minimise the effects.

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