Countering Inflation in Retirement

By Nigel Callaghan | 18 Jun, 2008 

The Consumer Price Index (the government’s measure of inflation) increased from 3% to 3.3% p.a. in May – prompting Mervyn King to write an explanatory letter to the Chancellor. Without planning, higher inflation can have a disastrous effect on income, particularly in retirement.

For example, based on current life expectancy data, a typical 65 year old man will live to his 86th birthday. Assuming that inflation was 3% p.a. throughout, £1,000 of income today would be worth just £527 in 21 years’ time.

There are a number of retirement options available to counter inflation.

Investors can choose to have their annuity increasing each year, either by RPI or by a fixed rate – commonly 3% p.a. This will mean that your starting income is lower than if you choose a level income throughout, but it will help to maintain its buying power in the years to come.

Some investors choose income drawdown to act as a hedge against inflation. The objective is to provide some protection against rising prices by investing in equities. By drawing only the dividend yield as income, investors hope that the equities' capital value will increase. Over the long term, equities have more than kept pace with inflation. However, drawdown is only suitable for those who are prepared to bear the investment risk and who typically have other assets.

It's fairly common for retiring investors to adopt a “mix and match” strategy. You can use part of your pension savings to buy a flat annuity (to produce the highest possible income today) and the balance to buy an annuity that rises each year by say 3% p.a. or to invest in income drawdown.