Eight ways to help inflation-proof your retirement income

With inflation at the highest level for years, Faith Glasgow looks at eight ways you can help to inflation-proof your retirement income.

It can be difficult at the best of times for anyone with investment-based pension pots to work out whether they are in a position to retire; and it’s made much harder when inflation is roaring and markets are depressed.

High inflation, such as the UK is likely to experience for the coming months, is bad news for retirees, as it reduces the buying power of their current income at a time when it’s already likely to be significantly lower than during their working life. Volatile markets, meanwhile, put a big fat question mark over the worth of investments, and therefore what kind of lifestyle they might fund in future.

• Learn more: SIPP Portfolio Ideas | How SIPPs Work | Transfer a SIPP

So, what are your options if you’re either planning to stop work or already retired and keen to protect your pension’s real value?

• Dividend investing: three tips for a comfortable retirement income
• Five ways to maximise your pension income

1) Budget for inflation

The best way to understand your position is to work out your essential and ‘lifestyle’ expenditure, building in the potential impact of inflation, and compare it with existing or likely retirement income.

Fiona Tait, technical director at Intelligent Pensions, advises: “Your post-retirement income must be sufficient to cover the former, allowing for inflation; ideally it will also cover the latter, but this is where some hard decisions need to be made. If there isn’t enough money available from your savings, it may be necessary to give up some of your non-essential activities. Failing that, you could be facing having to work longer, either full- or part-time.”

2) Delay retirement

As Tait says, working out a budget can help determine whether you’re actually in a comfortable position to stop working at this point. If not, continuing to work has two advantages. Not only does it mean your pension can continue to grow untouched, but it also enables you – and hopefully your employer too – to keep contributing tax-free cash to your fund.

If you’re at state pension age, deferring the state pension has the additional benefit of permanently boosting your weekly income when you do eventually come to take it.

Each nine-week period of deferral boosts your pension value by 1%; a year’s deferral means you’ll get an extra 5.8% of pension. On a full state pension that currently amounts to an extra £10.42 a week or around £558 a year of inflation-linked income for life.

• FIRE movement exposed: is it really possible to retire at 40?
• Think before dipping into your pension

3) Shun cash, favour equities

As already mentioned, when prices are rising fast, cash rapidly loses real value. To put that into perspective, if you keep £10,000 in cash and inflation stays at 9% for two years, by the end of that time it will be worth less than £8,500 in terms of what you can buy with it.

It’s therefore even more important than before to avoid simply cashing in your pensions and leaving them in a bank account when you come to retire. Even the best-paying savings accounts won’t remotely protect the value of your money, although you will, of course, need some cash for everyday expenses.

In contrast, over the long term, equities can provide decent protection against rising prices, because companies make goods and services that can (to a greater or lesser extent) pass on rising costs in the form of price increases for customers. That means they can continue to generate the earnings they need to pay shareholder dividends and attract new shareholder interest.

“As you reach retirement, consider keeping money invested in the stock market for as long as possible,” suggests Ian Browne, pensions expert at Quilter. “This is a higher-risk option – but with ‘safer’ asset classes (cash, bonds) offering little to no income, it may be sensible to keep the money invested and rely on a cash buffer to cover your daily outgoings.”

The safest investment option is a balanced approach, spreading your pension fund across a broad range of asset classes including property, ‘alternatives’ such as infrastructure, bonds and commodities, as well as shares. A multi-asset fund could provide a simple one-stop shop solution, but this is one time when independent financial advice could make a great deal of sense.

4) Beware ‘pound cost ravaging’

One big danger for retirees using a pension drawdown account is that they continue to draw the same level of income when markets are falling and their fund is losing value. If you withdraw a fixed sum, then it will make a much bigger hole in the fund, in percentage terms, when the market is dropping than it would in a rising or steady one. It will also require investment units to be sold at a time when they’re worth less anyway.

Such ‘pound cost ravaging’ early on in retirement can make it very difficult for your fund to get back on track to support your retirement plans, and high inflation only serves to compound the problem.

If you can defer retirement or avoid drawing any income when markets are volatile, that’s ideal. If you do need to take cash out, you could aim to take only natural income from dividends or interest, so that no units have to be sold.

5) Utilise other income sources

The best way to protect the value of an invested pension in an inflationary, volatile economic environment is to invest it in assets including equities, and then to leave it alone as far as possible during that time.

So, one option is to make timely use of other assets more likely to be impacted by inflation – savings in cash ISAs or other savings accounts, for instance. Other sources of wealth such as rental income or an inheritance could also be drawn on to tide you through periods of high inflation and volatility.

6) Think about annuities

If you’re really keen to have a secure, relatively inflation-proof retirement income, there’s only one way to achieve that, says Tait, and that is to use your pension fund to buy an inflation-linked annuity.

“Unfortunately, these annuities are hard to find, and the promise of future increases means that the initial income on offer will be much lower than for a flat-rate annuity, particularly for younger retirees.”

To put that into context, take a 65-year-old with a £300,000 pension pot. According to the moneyhelper.org tool, if she opts to buy a level (unchanging) annuity, the current best rates (as at 19 July) will provide her with an annual income of around £18,370 for life.

If she chooses a product with a built-in uplift of 2% each year, her starting annual income will be around £14,500. If she takes the fully RPI-linked annuity, she will receive just over £10,000 in the first year, but it will retain that real purchasing power.

Annuities become increasingly attractive as you get older and possibly develop medical conditions, because both reduce life expectancy and therefore bolster the rate you’ll receive. If our retiree waits until she reaches 75 and then chooses a level annuity, it will pay her almost £25,600 a year.

But remember, you cannot bequeath these products to the next generation; and as Ian Browne points out: “Once you buy an annuity, there’s no going back: they can’t be redeemed or sold.”

7) Remember tax relief

Inflation eats away at purchasing power. Tax wrappers, including pensions and ISAs, help to preserve it by keeping your money safe from the taxman. It’s another reason why cashing in your pension and simply putting the cash into a savings account is potentially a very bad idea.

That’s particularly the case as savings interest rates rise and the amount generated by your account creeps upwards, because while your personal savings allowance ensures the first £1,000 of interest earned is tax-free, beyond that you may have to pay tax on it.

• Pension tax relief: the secret weapon to combat inflation
• Shares to protect against persistently high inflation

8) Minimise fees

Similarly, if you pay the lowest costs in platform fees for your pension or drawdown account, then you have more pension value left to spend or leave invested. Flat-fee accounts make eminent sense if you have £50,000-plus, or even less, in your pension, because they don’t rise with the growing value of your accounts in the same way that percentage fees do (even if the percentage reduces for larger value accounts).

Over several decades and for larger sums, the differential can be well into five figures – especially for SIPPs, which come with additional custody and administration fees.

Comparison site comparetheplatform.com shows that over 20 years, a 60-year-old with a £400,000 pension and making three trades a year would pay just over £7,000 with interactive investor's flat fees, compared with almost £27,000 with Bestinvest or almost £40,000 with Hargreaves Lansdown, which both use a percentage fee scheme.