Inflation is growing, but are higher prices here to stay? We explore the implications for pension schemes and their members
Inflation is an old foe, now almost forgotten in many countries. But should we be worried again, and what impact could it have on our pensions?
In extreme cases, inflation has been a historical nightmare. Germany faced ruinous hyperinflation just after the First World War as it printed money to pay off war debts and onerous reparations. A loaf of bread that cost 160 marks in 1922 surged to a staggering 200 billion marks the following year. People burnt banknotes to keep warm, their currency worthless.
No one’s suggesting we’ll see a repeat of that phenomenon today in OECD nations, including the UK. However, inflation has been ticking up. US prices rose by 5.3% in August 2021 over August 2020. UK average house prices increased by 8% over the year to July 2021, according to the Office for National Statistics, down from 13.1% in June 2021. That was the highest annual growth rate the UK has seen since November 2004.
The Consumer Prices Index (including owner occupiers’ housing costs) is also an area of concern, rising by 3% in the year to August 2021, up from 2.1% in the 12 months to July. That was six times August 2020’s figure of 0.5%, with the cost of motor fuel, second-hand cars and food all soaring over the course of 2021.
But how real is this inflation figure? Measures rely on consumption baskets of goods and services, and statisticians have not caught up with our pandemic-driven spending changes: less on airfares, coffee/sandwich bars and commuting, more on technology, gadgets and DIY. What’s more, the spending profiles of a Universal Credit claimant and an affluent suburbanite are difficult to average out.
Wall of money
But there are strong headwinds. As the pandemic wanes, a wall of money is waiting to be spent, with British savers putting away £220bn since February 2020. This surplus cash, combined with supply shortages, boosts prices. Indeed, the Bank of England projects that inflation will hit 4% by the end of the year, with pressure coming from the phased ending of reduced VAT in hospitality and hotels on 30 September, when it will go from 5% to 12.5% until 31 March. Also in the pipeline is a massive hike of the Ofgem gas price cap on 1 October, up by £139: this will affect 9 million customers following record gas price increases.
The Bank of England, however, believes inflation is a transitory blip, easing in 2022. Yet worries persist. Indeed, some believe the quantitative easing programme – through which the Bank of England bought bonds worth £895bn as a response to the financial crisis in 2009 – has already caused an asset bubble in property and shares.
The pandemic was an even greater economic shock. Alistair McQueen, head of savings & retirement, Aviva notes that “UK GDP fell by one quarter in the opening months of 2020. In response, the UK government spent an extra £350bn. This is on top of the “UK government spending £850bn a year before the pandemic”.
Indeed, public debt has reached a peacetime high of £2.2tn over the past 18 months – the equivalent of £80,000 for every UK household. One bright spot is that it has never been cheaper to borrow, thanks to low inflation and low interest rates.
But eventually debts must be repaid, or Britain could end up as another Weimar Republic. If the inflation gale still blows next year, interest rates will need to rise.
Managing inflation risk
Most defined benefit pension schemes manage inflation risk by hedging, using a liability-driven investment strategy. Some schemes also use indirect inflation hedging assets such as infrastructure and real estate investments that have some inflation linkage.
“If the current inflation scare becomes more pronounced, there will probably be more demand for portfolio protection in these forms,” forecasts Tappan Datta, head of asset allocation at pension consultants, Aon. “Even commodities might at that stage look appealing again, which pension funds have tended to avoid on account of their relatively poor and very volatile path of returns.”
What about pension savers?
Cash savings are poorly suited to fund retirement. Most accounts pay just 0.1% interest a year, or 10p on £100. According to Moneyfacts, not one standard savings account can outpace today’s inflation rate of 2.1%. Last year 91 deals could beat the then 1% inflation rate.
Ian Burns, principal and actuary at pension consultants Buck, advises workers 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 will likely be higher than inflation over the full course of your career”.
Equities are typically viewed as a natural investment to generate real returns relative to inflation, he says. The dividends provided by equities may also be attractive and could grow in line with inflation, with the dividend yield currently around 3.4% on the FTSE 100.
“Investors need to be willing and able to invest for the long term (10-15 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 to investing a large lump sum.”
Retirees shouldn’t leave too much cash in the bank beyond their needs for two or three years. That’s because inflation can wreak havoc with household budgets, particularly those of private sector workers who rarely have index-linked defined benefit schemes. Anyone lucky enough to have such a pension should usually see it increase 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 nearly 7 million people living off a fixed income in retirement, such as a level annuity, he warns that inflation of 3% will halve spending power in just 20 years.
Tully advises they use “some form of equity investment as part of a balanced portfolio. Using a combination of drawdown and annuity can create the flexibility for people to bank a guaranteed income to pay the bills, while also leaving money invested to pay for life’s little luxuries and help protect against inflation.”
Finally, 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. McQueen warns: “Rising price and wage inflation could add billions of pounds to the cost of the state pension. This has forced the government to step back for one year from its manifesto commitment to maintain the triple lock.”
Be prepared for squalls.