How Inflation Drastically Affects Pensions and Investments
The cost of what seems like everything is rising rapidly. Since January, consumer prices have increased by a whopping 7.8%. The cost of housing, electricity, gas and fuel has risen by 3.7%, alcohol and tobacco by 2%, clothing by 1.7%, and restaurants and hotels by 1.1%. It’s fair to say that most of us are feeling the wrath of inflation on a daily basis. That’s the short-term effect of inflation. But what about the long-term consequences?
In this blog, we’re breaking down everything you need to know about inflation, particularly when it comes to pensions and investments.
What is inflation?
Inflation relates to the decrease in the purchasing power of money over a period of time. In short, what your money will get you more today than it will in 2, 5, 10, or 20 years’ time. Prices for goods and services will inevitably change over time. Some will go up, while others will decrease.
There’s no set annual inflation rate that individuals can expect because many factors can have a drastic effect on the cost of goods and services. What’s been happening this year is a perfect example of this – the reopening of the economy following the pandemic, supply chain issues, and Russia’s invasion of Ukraine have all contributed to the skyrocketing costs we are dealing with now.
There are three main types of inflation –
Demand-pull inflation: This is a textbook example of supply and demand. Inflation occurs when the demand for goods or services is higher than the supply that is available.
Cost-push Inflation: This type of inflation relates to an increase in the cost to produce goods or services (for example, building materials and labour).
Built-in Inflation: This is a cycle that occurs because of the anticipation of inflation. When prices rise, wages also somewhat rise so that people can afford the cost of living.
How does inflation affect investments?
Over time, the value of your savings will inevitably go down because the cost of products and services have gone up. Just how much inflation affects investments really depends on the type of investment itself.
Let’s take an example. If you are looking at corporate investments where a business has a deposit account with its bank, the highest rate on a fixed five year deposit is currently 0.1% AER. If there is a lump sum of €50,000 in the account, it’s not going to gain much interest over time. However, if annual inflation is 2%, that €50,000 will be worth €41,071 in ten years.
If you’ve invested in stocks, some level of protection might be on offer depending on the company you’ve invested in. Bonds, on the other hand can be particularly vulnerable to inflation as payments are based on fixed, rather than variable rates.
Investing in real estate and precious metals (e.g. gold) can often do well in spite of inflation as the value of the commodities tends to rise over time.
How does inflation affect pensions?
Similiar to investments, the way in which pensions are affected by inflation varies based on the type of pension that’s at play.
Defined Benefit pensions
A defined benefit pension is unique in that the amount of money that will be in your fund at retirement will automatically be in line with inflation. However, defined benefit pensions are in decline and if you were once a member of this type of scheme, chances are that you will be offered an enhanced transfer value to move your fund out of it. To get a better understanding of ETVs and defined benefit pensions, read this post.
Defined Contribution pensions
It’s vital to keep inflation in mind if you are a member of a defined contribution scheme. This is because the value of your pension fund needs to grow at a rate that keeps up with inflation. Otherwise, the fund isn’t sustainable over time. An annuity, which is an investment that promises a fixed series of payments to you in retirement can often be a good way to protect your pension against heavy inflation.
What can you do to counteract the cost of inflation?
While inflation is always going to be something that we will all have to deal with, the good news is that action can be taken to ensure that it doesn’t heavily affect the value of your investment or pension.
Firstly, it’s wise to speak to a qualified financial advisor to ensure that the type of investment or pension you have has ample opportunity for growth over time. In the example we used of a business using a deposit account for excess funds, it would be much more fruitful to invest in a corporate bond. Financial advisors will let you know what all of your options are, without allegiance or bias to any particular provider. From there you can decide what works best with your own financial and retirement goals, and make any necessary changes. For instance, if you have multiple pension pots from previous employers, your pension fund could have a better opportunity for growth if you set up a Private Retirement Bond. This way, all funds are under one roof and you’ll have more control in terms of how they are invested. Tactics such as increasing your pension contributions over time will also counteract rising inflation.
A long term investment strategy should have inflation expectations built into it. Talk to the team at Elevate today to discuss your own financial goals and put a solid plan in place for your future.