Don't Let Inflation Destroy Your Pension

Here's how to ensure your pension is fully protected from the effects of inflation.

David Kuo pessimistically forecasts people retiring in 2012 will be worse off than they were in 1980. Although he reckons the basic state pension will rise from £87.30 to £106 per week for a single person, this will still be less generous than pensioners enjoyed in 1980 when the state pension was linked to average earnings.

He also predicts, on average, a 65 year-old man retiring in 2012 will be forced to live on less than £8,000 a year during his twilight years and that includes income from his state pension and personal pension combined.

Thankfully, many of you retiring today will enjoy a decent level of income from your final salary pension schemes. Under this type of pension, benefits are guaranteed at the outset and linked to a proportion of your salary on leaving employment. But many of us retiring in the future won't be so fortunate.

The value of your pension can be adversely affected by numerous factors but one often overlooked threat is the long-term impact of inflation (rising prices).

Protecting Your Pension Fund

If you have already been won over by pensions and are happily squirreling money away, don't let your careful retirement planning be destroyed by inflation. Let's say, you're investing £100 each month and you intend to retire in 35 years' time. While that's all well and good, if you don't step up your contributions in line with inflation you may find that your pension fund turns out to be a lot smaller than you expected.

Just to give you a better idea of what I'm getting at: if you invested £100 into your pension each month for 35 years - at an annual growth rate of 7% - you would end up with a fund with a nominal value of £185,651. But taking the effects of inflation into consideration -- at an assumed annual rate of 2.5% --your fund would actually only be valued at £76,535 in real terms. Or putting it another way -- less than half!

But stepping up your contributions each year shouldn't make your pension payments any less affordable because Daviaberage earnings are expected to rise with inflation too. Just make sure you do increase those contributions!

Protecting Your Pension Income

Not only will you need to inflation proof your pension contributions to accumulate a decent pension pot, you should consider protecting your pension income during retirement too.
Most of you will probably use your pension fund to buy an annuity which converts your fund into an income payable for the rest of your life. But without inflation-proofing your income its purchasing power will gradually reduce over time.

Unfortunately, most annuities are sold on a 'level' basis which means the income you receive stays the same. But you can purchase an income which automatically increases annually in-line with the RPI or by a fixed percentage of say, 3% or 5%.

To adequately protect your income it's probably best to match it as closely as you can to the RPIX the Retail Price Index Excluding Mortgage Interest which is more representative of the effects of inflation on the purchasing power of pensioners who are likely to be mortgage-free. RPIX stood at 3.1% in December.

But there's a downside. The income from your annuity will be considerably lower if you go for an increasing income rather than a fixed 'level' income. For example, a male aged 60 with a pension fund of say £100,000 could buy an annuity today which will provide him with an annual level income of around £6,410. But if he chose to buy an annuity which increases by 5% each year this will slash his income to just £3,650 - a reduction of 43%.

That said, if you survive to reach average life expectancy or beyond, I think an increasing income will still provide better value overall.

A Final Word On Inflation

Last year we polled our Fool readers on rates of inflation. An astounding 90% of respondents felt actual inflation is far higher than the Government's figure. Indeed, most readers felt a more realistic rate for inflation is actually closer to 7.4%, suggesting the cost of living is rising at a much faster pace than the Government would have us believe. If this is true then you might want to consider boosting your pension contributions even further if you can.

If you're a novice when it comes to pensions, try reading our Pension For Beginners series first.