The Menace Of Inflation On Your Pension

Here we explain simply what inflation is and how you can work out the effect it will have on your future pension income needs.

This is the second part in a three-part series that will help you to work out what size pension pot you need to retire comfortably, and how much you need to save to get there.The Four-Step Guide To A Comfortable Retirement: Part TwoIn part one, I showed you one way to estimate how much income you'll need when you retire.I did this using 'today's prices'. That's a curious phrase which I think I should explain. It simply means the price we pay for goods today. If you were to retire today, you'd need an income that covered all your expenses in today's prices.However, most of us aren't retiring today. We're retiring in ten, twenty, or thirty years, perhaps. That's why we have to take into account inflation, which is the rate at which prices of the goods we buy rise. Tomorrow's prices are likely to be higher than today's, so when you retire you'll need a higher income.If you recall, I estimated that I would need £15,000 in today's prices, but as time goes by inflation will devalue that figure. In 40 years, £15,000 will buy much less.So, adjusting for inflation, here's what I might need in future to buy the same as I can with £15,000 today:£15,000 plus inflation at 2.5% or 3%When?2.5%3%In ten years' time£19,000£20,000In 20 years£25,000£27,000In 30 years£31,000£36,000In 40 years£40,000£49,000You'll see from the table that if I was to retire in 40 years I'd need more like £40,000 to £50,000. This is based on inflation going up by 2.5% or 3% per year on average. The real figure may be higher or lower. Sadly, we can't know what it'll be till we get there, but these figures are as good a guess as any.Now it's your turn!Your first step is to use my earlier article to estimate what retirement income you'll need in today's prices. Then you need to add on inflation. To do that:1. Go to this page.2. Click on 'Calculator 1'.3. Fill in the fields as follows:FieldDescriptionHow much will youinvest each month?Leave blankFor how many years?Type in how long till you retireIs there an initial lump sum?Type your required pensionincome in today's pricesWhat is your expectedrate of return?Type 2.5You may have guessed that this calculator was originally designed for investors. However, it has many applications -- like this one!4. Press calculate. The figure shown is your estimated annual income requirement for when you retire.It would be sensible to get an estimate based on other rates of inflation, such as 3%. To do this, change your entry in the last field.What now?The answers you get should be insightful about the huge impact of inflation on your retirement income. The next step is to work out how large a retirement pot you need to save in order to fund this income.You've been reading part two!Go back to part oneGo forward to part three