Despite government assurances that it’s a temporary blip, inflation is trending upwards. What are the implications for pension schemes and their members?
Originally published in The Sunday Times, written by Stephanie Hawthorne.
Inflation is an old foe, now almost forgotten in many countries. But should we be worried that it seems to be making a comeback in the UK?
In extreme cases, inflation has proved a nightmare. Germany, for instance, faced ruinous hyperinflation after the first world war, as it printed money to fund its onerous reparation payments. A loaf of bread that would have cost 160 marks in 1922 was priced at 200bn marks the following year. Destitute citizens ended up burning their worthless banknotes to keep warm.
No one is suggesting that any member state of the Organisation for Economic Co-operation and Development will suffer a similar fate today. Yet inflation has been ticking up. For instance, the average UK house price increased by 13.1% in the year to June 2021 to £266,000, according to the Office for National Statistics. That was the highest 12-month growth rate the market had seen since November 2004.
The consumer prices index (including owner-occupiers’ housing costs) is also an area of concern, given that it rose by 3% in the year to August 2021, with the costs of food, fuel and second-hand cars all soaring. For context, that figure was six times August 2020’s increase of 0.5%.
But how representative are these numbers? Inflation measures rely on consumption baskets of goods and services, while the statisticians have yet to catch up with pandemic-driven changes to our spending habits – for instance, less on travel and eating out; more on tech and home improvements. What’s more, the spending profiles of an affluent suburbanite and a universal credit claimant are hard to average out.
Nonetheless, strong inflationary factors do exist. As the Covid crisis diminishes, a large amount of cash is waiting to be splashed, given that British savers have put away £220bn since February 2020. All of this surplus money, combined with supply shortages, will push up retail prices.Indeed, the Bank of England projects that inflation will hit 4% by the end of this year, with other upward pressures including the phased ending of reduced VAT in the hospitality industry from the end of September, when it will rise from 5% to 12.5% until the end of March. Also in the pipeline is a £139 increase in Ofgem’s cap on the price of gas in October, which will affect about 9 million customers.
The Bank believes that inflation will ease next year, yet worries persist. Some economists think that the quantitative easing programme – through which the Bank bought bonds worth £895bn as a response to the global financial crisis of 2008-09 – has already caused an asset price bubble in property and shares.
The pandemic has been an even greater economic shock, notes Alistair McQueen, head of savings and retirement at Aviva. He points out that the UK’s GDP “fell by one-quarter in the opening months of 2020. In response, the government spent an extra £350bn.”
In fact, public debt has reached a peacetime high of £2.2tn over the past 18 months – the equivalent of £80,000 for every household. One bright spot is that it has never been cheaper to borrow, thanks to historically low interest rates. But debts will eventually have to be repaid, or the UK could end up as another Weimar Republic. If inflation is still a concern next year, interest rates will need to rise.
Most defined-benefit pension schemes manage inflation risk by hedging, using a liability-driven investment strategy. Some schemes also focus on indirect inflation hedging assets such as infrastructure and real-estate investments. “If the current inflation scare becomes more pronounced, there will probably be more demand for portfolio protection in these forms,” predicts Tappan Datta, head of asset allocation at Aon. “Even commodities might look appealing again. Pension funds have tended to avoid these in recent years on account of their relatively poor and very volatile path of returns.”Cash savings are poorly suited to fund retirement. Most accounts pay a mere 0.1% interest a year, or 10p on £100. According to Moneyfacts, not one standard savings account available today can outpace the rate of inflation. Last year, 91 deals could beat the then inflation rate of 1%.
Ian Burns, principal and actuary at pensions consultancy Buck, advises retirement savers to “contribute a percentage of salary rather than a fixed amount or a one off contribution when combating inflation in pension fund savings. Your pension contributions will then increase in line with salary growth, which is likely to be higher than inflation over the full course of your career.”
Equities are typically seen as the natural investment to generate real returns relative to inflation, he adds. The dividends provided by equities may also be attractive and could increase in line with inflation. The FTSE 100’s dividend yield is currently about 3.4%, for instance.
“Investors need to be willing and able to invest for the long term – 10 to 15 years or more – and also need to be cognisant of market pricing at the point of investment,” Burns says. “Investing a regular amount every month is very different from investing a large lump sum.”
Retirees shouldn’t leave too much cash in the bank beyond their needs for two or three years, he advises. That’s because inflation can erode household budgets, particularly those of private- sector workers, who are rarely on index-linked defined benefit schemes. Anyone lucky enough to have such a pension should usually see it rise each year, broadly in line with inflation.
For the rest, “inflation is the moth that eats away at your savings and income”, says Andrew Tully, technical director at Canada Life. For the 7 million people on a fixed income in retirement, he warns that an inflation rate of 3% will cut their spending power in half in two decades.
Tully advises they use “some form of equity investment as part of a balanced portfolio. Using a combination of annuity and drawdown can give people the flexibility to bank a guaranteed income to pay the bills, while also leaving money invested to pay for life’s little luxuries and help to protect against inflation.”
Lastly, one bulwark against inflation is the state pension, the bedrock of people’s retirement income. This increases by ‘the triple lock’ – the highest of inflation, earnings and 2.5% – and at least keeps pace with inflation. But there are no guarantees. “Rising price and wage inflation could add billions of pounds to the cost of the state pension,” McQueen warns. “This has forced the government to step back for one year from its manifesto commitment to maintain the triple lock.”
Be prepared to feel the squeeze.