Example
Take a 70-year-old with a £200,000 pension pot in drawdown who last year took a flexible income of £10,000 from their fund. They ideally want to maintain their standard of living throughout retirement.
If inflation runs at 2% on average and they increase withdrawals at this rate each year, their fund could run out around their 93rd birthday.
However, if inflation runs at 5% on average and they increase withdrawals at this rate each year, their fund could run out 88th birthday – a full 5 years earlier.
b) Annuity
“For those taking an annuity income, the impact of inflation will depend on whether or not they chose to bake inflation protection into the terms of their contract.
“Anyone who bought an inflation-protected ‘escalating’ annuity is probably pretty pleased with the decision right now – particularly as a few years ago the idea of price rises pushing towards double digits would have been fanciful at best.
“On the other side of the coin, people in receipt of level ‘non-escalating’ annuities will be feeling the pinch in a big way, as rising prices eat away at their spending power.
“Official figures suggest that over 41,000 non-escalating annuities were sold in 2020 versus around 7,000 escalating annuities. Given around 6.1 million annuities were in force in 2019, it’s fair to say millions of people will face a severe annuity income hit in 2022 as inflation rockets.”
Example
Take a retiree who is paid a level annuity worth £10,000 a year. If inflation runs at 2% a year, after 5 years the real value of this income will have dropped to £9,039.
However, if inflation runs at 5% a year, their spending power will plummet to £7,738.
To put it another way, 2% annual inflation erodes their spending power by under 10% over 5 years – whereas 5% inflation slashes their spending power by over 22%.
c) Defined benefit (DB)
“Those lucky enough to have built up generous DB entitlements are likely to have at least some inflation protection built in, although the extent of this will vary depending on their scheme rules.
“It’s worth checking the terms of your contract as even inflation increases capped at 5% could mean a real term cut in your spending power over the short-term.
“The Pension Protection Fund (PPF) is responsible for paying out DB pensions where the sponsoring employer has gone bust.
“The inflation protection you might receive varies depending on the period of time during which you built up the benefits.
“In most cases payments relating to pensionable service from 6 April 1997 will rise in line with inflation each year, but subject to a cap of 2.5% a year. At current inflation rates that means PPF members will be experiencing real terms cuts in their benefits.”
d) State pension
“Finally, your state pension should have gold-plated protection in the form of the triple-lock – a manifesto commitment to increase the payment in line with the highest of average earnings, inflation or 2.5%.
“However, a combination of the decision to scrap the earnings link for 2022/23 and the use of September’s 3.1% inflation figure to uprate this year means that, in reality, millions of pensioners will see their state pension spending power reduced over the next 12 months.
“It’s worth noting that only the basic and flat-rate state pension usually benefit from the triple-lock.
“Other elements of the old state pension and pension credit are just linked to inflation, with the September 2021 rate again used.”
