There are essentially three risks to an individual’s retirement financial plan:
- Longevity – the retired person lives far longer than expected. A 65-year-old may on average expect to live around 20 years. However, there is the possibility of them living until 100 or even older.
- Sustainability – the retirement financial plan being unable to provide the required income for the remainder of the individual’s life. A rule of thumb could be that withdrawals of 3.5% to 4% can be taken from an investment portfolio. However, if the asset mix is not correct, or the sequence of returns fall in the wrong order, the fund portfolio may run out of money sooner than expected. This means that the investment portfolio and rate of withdrawal must be reviewed at regular intervals.
- Inflation – This is the third risk and can be too easily dismissed. Since the turn of the century inflation in the UK has averaged 2.8% per annum. At that rate the cost of living will double every 26 years. In a different era, but during my working lifetime, between 1975 and 1995 annual inflation averaged 7.6%. In that era the cost of living was doubling every 10 years.
A retirement financial plan may have to last 20, 30 or even 40 years. If it has to last 40 years, with an inflation rate of 7.6% per annum, the retiree would in the final years of retirement be facing a cost of living 16 times greater than when they retired.
The above illustrates the inflation risk to retirement. Personal inflation is different for everybody. It depends upon what the individual spends their money on. If the cost of food increases rapidly, but the cost of technology and travel increases less rapidly, the inflation rate for someone who spends the majority of their income on food will be higher than the person who spends more on the latter two.
So, when will high rates of inflation return? Sorry, no one has that crystal ball. What we can do is look at the causes of inflation. Where demand for economic essentials outstrips demand prices will increase. Economic essentials being food, fuel, and labour.
When there is an over-supply of money in the system people can borrow cheaply and feel wealthier. They are therefore willing to pay more for goods and services.
Finally, if markets lose confidence in a country’s economic performance, that country’s currency will decline increasing the prices of the goods it imports. Also, the interest rates the country has to pay to borrow money will increase.
It will not be one event that will trigger higher inflation but a combination with one component feeding into another.
The one thing I have not mentioned is government and central bank policy. At the moment they would wish to avoid stagflation, where the economy is not growing but prices are going down. They are, therefore, welcoming a small amount of inflation.
Longer term, the government has – and is – taking on record amounts of debt.
How would the government react if, in real terms, the value of that debt were to halve over a decade due to high inflation? An average inflation rate of 7.6% per annum could create other problems but a few years at 5% could be seen as helpful.
The temptation must be there, but once the inflation genie is out of the bottle, how do you get control of it again? Economies are very difficult things to manage.
Retirees, therefore, need to build ways to hedge their retirement plans against inflation. An annuity that does not increase may look good in today’s money, but if it is going to account for a large proportion of income in retirement, what will it pay in real terms in 15 years’ time?
Are we at the bottom?
Historically, equity release rates have never been lower. Are we at the bottom? Is the only way now up? If interest rates are going to increase is now the time for a new retiree with insufficient pension savings to look at using equity release first and then buy an annuity in a few years when rates may improve a great deal? Is this another way in which the impact of Covid-19 is changing everything?
It is too easy, based on experiences of the last couple of decades, to feel we will be in a constant low inflation environment. Governments around the world have taken on increasing debt, increasing money in the financial system to keep their economies afloat after the financial crash and as a result of the Covid-19 pandemic. They have been able to borrow at very low interest rates. For how long will this last?
The fear investors have at the back of their minds is that governments become unable to service the debts they have taken on. This will mean that the cost of borrowing money becomes greater.
Overall therefore inflation is going to impact on a retirees’ retirement plan, and the amount of money they have to spend over it – the need to ensure it is robust enough to deal with any inflation level will not go away.
Bob Champion is Chairman of the Air Later Life Academy