Retirement planning – the danger of inflation

This article was first published in Cardiff University’s alumni magazine, Cardiff Connect.

When I was at university, inflation was a fact of life – indeed inflation accounting was a significant part of my degree. In the 35 years since, inflation ceased to be a major concern, perhaps largely driven by Chinese industrialisation and less dependence on oil. Now there are concerns that inflation may be making a comeback, perhaps due to the interruption to supply lines from Covid, high demand as lockdown eases, money supply creation over the last decade or so and the economic disruption caused by Brexit.

Inflation has the most impact on the long-term decisions taken by businesses, individuals and governments. For individuals, the most significant financial decisions we have to make are in respect of our retirement plans.

During the Twentieth Century, the retirement schemes were principally employer final salary schemes and a state pension based on national insurance contributions. However, changes in working patterns and increased life expectancy led to a major reduction in membership of final salary pension schemes as well as a delay in receiving the state pension – especially for women. This has put the onus more onto the individual to have to invest for their own retirement principally through money purchase pension schemes, other investments (e.g. ISAs) or buy to let properties. As a result, the inflation risk now rests with the individual.

The key is to plan ahead, and that needs to take account of increasing inflation expectations.

The popularity of pension schemes has also been impacted by tax changes. An approved pension scheme is tax favoured and this boosts the investment return. Over the last five years or so, the lifetime limit on the fund and a tapering of the annual allowance mean that contributing to an approved pension fund is not a viable option for very high earners.

Options for retirement saving outside of an approved pension scheme include investing in stocks and shares or buying property to rent. Stocks and shares can be purchased incrementally over time whilst property purchases are more lumpy with mortgage finance being used to leverage up. Typically, such debt finance is interest only, and so relies upon growth in the value of the property to build up a retirement “pot”.

For those saving for retirement through stocks and shares, the focus initially is on growth orientated shares changing to a balance between income and growth and ultimately to be income orientated in retirement. In considering the impact of inflation, over the last few months the market value of growth stocks has fallen as expectations for inflation have increased, whilst inflation has historically undermined fixed income stocks.

Property assets are more problematic as a source of retirement income because it is more difficult to get a portfolio spread. If you only own a single property then a void period is much worse than a dividend reduction on a portfolio shareholding. A further problem is that if capital repayments are not made on the debt then there won’t be sufficient net rental income to provide an income in retirement. Inflation can appear more beneficial to property portfolios as the mortgage debt is a fixed liability so as the property value goes up then the debt falls as a proportion of the value. However, since the desire is to provide an income in retirement then the key issue is whether the rental income is able to increase with inflation and that relies upon the financial position of the tenant.

The key is to plan ahead, and that needs to take account of increasing inflation expectations.

For more information and advice on retirement planning, visit FC Financial Planning.