Whether you’re saving for retirement or have already started taking an income from your pension using drawdown, rising living costs can eat into the value of your pot and your spending power.
Inflation rose to 2.3% in the 12 months to October, up from 1.7% in September. Read more in our article Inflation jumps to 2.3%.
Higher inflation is bad news for pension savers, as the steeper it is, the more it erodes the value of your retirement savings. Here we explain the impact of inflation on your pension, and what, if anything, you can do about it.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
Saving towards retirement and inflation
If you’re saving into a pension, chances are it’s a defined contribution pension, or money purchase pension, where your contributions (and from your employer, if it’s a workplace scheme) are invested in the stock market and other assets such as gilts, property and cash.
The amount you end up with at retirement is based on the contributions made, and investment performance. The hope is that, over decades, you’ll benefit from investment growth that averages more than inflation over the same time period. However, there will be good and bad years depending on how your investments perform and the wider economic climate, and it’s particularly challenging when inflation is high.
The majority of pension savings are invested in stocks and shares, which over long-term periods tend to provide better returns than cash savings. Most workplace schemes are ‘‘lifestyled’, which means as you approach retirement, your exposure to the stock market is reduced and your retirement savings are moved into less risky assets. Shares can potentially protect pension savers from inflation as the companies you invest in may be able to increase their prices in response to higher costs, for example, to grow at the same rate or higher than inflation. But this isn’t always the case, and inflation is a major challenge for some investments such as bonds that produce a fixed income.
Whether or not your pension keeps up with inflation depends on the current rate and how your investments perform. If inflation soared again to the levels we saw last year, for example, your pension would have to grow by more than this amount simply to keep up with the cost of living. However, high inflation periods are thankfully usually relatively short term.
For example, let’s say that your pension is currently worth £150,000 and you plan to retire in 10 years’ time, and inflation averages 2% a year. If your pension grows by 4% per year and you continue to pay in 8% of earnings, then it’ll be worth around £203,282 in ten years. But if inflation rises to 4% a year for ten years and your investment growth is 2%, then your pot would be worth £140,626 in today’s money in ten years’ time.
If your pension grew by an average of 5% a year and inflation was 4% a year, then it’d be worth £185,526 in today’s money, and you’d be able to buy more with your money than you could have with your original investment ten years ago.
State Pension and inflation
The State Pension often forms the bedrock of people’s retirement income and is guaranteed to rise through something called the ‘triple lock’ guarantee. This essentially means that each year, the government commits to increase the State Pension by the highest of September’s inflation figure, earnings growth, or 2.5%. You can find out more about this in our guide What is the pension triple lock?
This means that next year, the State Pension is set to rise by 4.1% (in line with earnings numbers). So those who reached retirement age on or after 6 April 2016, should receive £230.30 a week in the new 2025/26 tax year and people that retired before 6 April 2016 who receive the basic State Pension should get £176.45, up from £169.50 a week, although the amount you’ll personally get is based on your National Insurance Contribution record.
Alice Haine, Personal Finance Analyst at Bestinvest by Evelyn Partners, the online investment platform, said: “While the sizeable boost may appear generous for pensioners, Labour’s pledge to ditch the winter fuel payment for all but the poorest retirees will certainly dull some of the cheer. Losing out on a winter fuel payment of up to £300 will make it even harder for pensioners to maintain their spending power, particularly for those still struggling with the fallout from the cost-of-living crisis.
“Add in frozen tax thresholds, with the full new state pension gaining ground on the standard personal allowance of £12,570 and pensioners are edging closer to the point at which their state pension income becomes liable for tax. Retirees already receiving a higher state pension may already be paying tax on the benefit, while those receiving a private pension income will see more of that swallowed up by tax.”
Defined Benefit Pensions
If you’re due to receive, or you’re already getting an income in retirement from a defined benefit (final salary pension scheme) this will be a guaranteed amount based on your final salary and the number of years you’ve belonged to the scheme. Defined benefit pensions are becoming increasingly rare, and are usually extremely valuable, as they provide a ‘gold-plated’ income in retirement. Find out more about this type of pension in our guide What is a defined benefit pension?
In theory, if you’re receiving income from a defined benefit pension scheme, you don’t need to worry about inflation because the amount you receive will increase alongside the rising cost of living. However, the promise to increase your pension in line with inflation may be capped up to a certain limit if you are taking benefits from a private sector defined benefit scheme, which is usually about 5%. With inflation now much lower than this you should find your defined benefit pension keeps up with living costs. Public sector defined benefit pensions usually rise alongside inflation, and are not subject to a cap. Find out more in our article How do public sector pensions work?
Your choices at retirement and inflation
If you have a defined contribution pension (which the majority of people do), you’ll be free to do as you wish with your retirement savings. This leaves various options, including pension drawdown and buying an annuity, and whether or not your retirement income increases in line with inflation will depend on which you choose, and how you manage your pension. Read more in our article Your pension options at retirement.
Pension drawdown
Pension drawdown, also known as flexible drawdown or flexi-access drawdown, enables you to leave your pension savings invested once you retire, and draw an income from them when needed. You can also take a 25% tax-free cash lump sum from your pot if you wish, or take this out over several years in retirement. Find out more in our articles What is pension drawdown and how does it work? And Should I take my tax-free pension cash at age 55?
You can decide how and when you take an income from your drawdown pension. Meanwhile, you’ll keep the remainder of your pot invested, and the hope is that future investment growth will beat the rate of inflation. This is why even when you retire it’s a good idea to keep a portion of your pension invested to give your retirement pot the chance to carry on growing in value.
However, your money needs to last for decades in retirement, and therefore it’s important to carefully consider how much you withdraw, particularly when the cost of living is rising and you may need to take out more than before. The main risk is that you end up taking too much money from your pension pot too soon, and if your investments don’t perform well, you could run out of money. Find out more about the risks in our article Should I use my pension to boost my income?
For example, according to investment provider AJ Bell, someone with a £100,000 pension who needs an income of £5,000 a year in addition to their State Pension would run out of money after 37 years before inflation is factored in, and with a return on their investments of 4% after fees. However, if inflation averaged 5% during their retirement, the same pot would run out 19 years earlier with withdrawals increased by 5% to meet the rising cost of living. When inflation is running high, the number of years the same retirement pot would last can be dramatically reduced.
This makes it particularly important to make careful use of the flexibility of pensions these days, and only take what you need from your pot to ensure your savings will last for the rest of your retirement. That’s where the skill of a professional adviser can prove particularly valuable, as they can work on preserving the value of your retirement pot.
Annuities
If you use some or all of your pension to buy an annuity, or income for life, then depending on the type of annuity you choose, inflation may or may not have an impact on your income. There are various different types of annuity. For example, you may choose an ‘escalating annuity’, which means that the amount of income you receive will increase over time to keep up with inflation. Beware, though, that the amount you receive at the start will be lower with this type of annuity as it’s expected to increase over time.
If you buy a ‘fixed annuity’, the amount you receive will not change over time, and you’re likely to receive a higher starting income. However, once you’ve bought an annuity with your pension fund, you cannot change your mind. Some retirees, for example, buy an annuity with a chunk of their pension to ensure they have some guaranteed income to cover basic bills in retirement, for example, while leaving the remainder invested. You can read more about annuities in our article Annuities explained.
Helen Morrissey, head of retirement analysis, Hargreaves Lansdown, said: “For those looking to secure a guaranteed income through an annuity, the good news is that rates are riding high. The latest data from HL’s annuity search engine shows a 65-year-old with a £100,000 pension can get up to £7,499 per year from a single life level annuity. This is just a whisper away from the highs experienced after the mini-Budget, but it’s worth saying this income will not rise over time and its purchasing power will be eaten away.
“Inflation-linked annuities can be bought, but starting incomes are much lower – one that escalates in line with RPI would have a starting income of up to £4,806 per year. Periods of high inflation would see this rise, but it would still take several years for the income to catch up with what you would have received from a level product and the reality is you may not live that long.”
Holding cash in retirement
It’s important to keep some cash savings aside for emergencies, and generally experts recommend holding around one to three years’ worth of living expenses in an easy access account. Currently, the returns you’ll receive from interest paid on market-leading cash accounts will keep up with inflation, but there are no guarantees that this will remain the case. Even if it doesn’t, it’s still important to have a cash buffer in place for those unforeseen expenses which crop up from time to time.
Ed Monk, Associate Director at Fidelity International, said: “Inflation-beating interest on cash will no doubt have likely tempted some investors to move money from investments into savings accounts.
“That appeal is eroded by higher inflation, even if cash interest is likely to exceed inflation for a while longer. Meanwhile, there are signs that cuts to interest rates – including cash interest – may not be as rapid as recently expected. In that context, it may be time to rebalance your allocation of cash versus investments.”
What can you do to beat inflation in retirement?
It’s more important than ever to find all the ways you might be able to increase your retirement income. For example, you might be entitled to Pension Credit, which is a means-tested benefit for pensioners on a low income that tops your income up to a certain level (£218.15 per week for single pensioners in the 2024/25 tax year, and £332.95 for a couple). Claiming Pension Credit may also give you access to other benefits, such as help with council tax or heating costs, so it’s important to find out if you qualify for this as it’s still a hugely underclaimed benefit. Find out more in our article Pension Credit explained and What’s in store for your pension in the new tax year?
You can receive free guidance from the age of 50 and above from the Government’s Pension Wise service on your choices at retirement. Call them on 0800 138 3944 to book a free appointment, or you can book through their website.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
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