Why deflation is bad news for pensioners

Lower prices might sound like a good thing, but deflation should be a cause for concern if you're retired...

Last month, the Retail Prices Index (RPI) fell to  minus 0.4%. This means that deflation (falling prices) has officially hit. In other words, the price of goods is lower now than it was 12 months ago. This is pretty big news since the last time the RPI struck negative territory was in March 1960.

Now, you could be forgiven for thinking deflation is no bad thing. After all, if prices in general are lower, then surely all our incomes should stretch that little bit further, right?

Why is deflation bad?

But the trouble is, as we explained in this recent video, deflation hampers economic growth. When prices are falling we tend to put off big purchases in the hope of paying even less in the future. This drop in buyer demand tends to force prices lower still.

A deflationary trend is very difficult to curb. As companies profits fall, production slows, leading to job cuts. This leads to even lower consumer spending. And so the downward spiral goes go on...

Index-linked pensions

So, it's pretty clear deflation is bad for the economy, but why it is a particular threat to the financial well-being of pensioners?

Well, for starters some payments from pensions are index-linked which means they move in line with the RPI. The most notable example of an index-linked pension is the Basic State Pension.

Each year the state pension rises by either the RPI or 2.5%, whichever is higher. This is good news. It means your state pension benefits are protected from deflation - you'll always get an annual rise of at least 2.5%.

Just be aware that, because boffins in the Department for Work and Pensions seem to want to make things complicated, the increase in the state pension takes place every April but is based on the change in the RPI over the 12 months to the end of the previous September.

So this April, the full state pension stepped up from £90.70 a week to £95.25 a week for a single person (or from £145.05 a week to £152.30 a week for a couple). This reflects the 5% rise in the RPI which took place over the period from September 2007 to September 2008.

But leading economists expect the RPI to remain in negative territory well into next year. If that happens, the best pensioners can hope for is a rise of 2.5% next April - so 50% less than the rise which was applied this April. In cash terms, this would mean an increase of just £2.40 a week.

Pensioner inflation

Now you could argue if prices continue to fall, a 2.5% increase in the basic state pension next April is perfectly adequate. But that would only be reasonable if we agree that the RPI is an accurate measure of inflation/deflation.

If you're retired, I suspect you would argue your real rate of inflation is far higher than the RPI.

After all, one of the reasons why the RPI has become negative is because it includes housing costs. A string of cuts to the base rate has led to much lower mortgage interest payments for many of us which, in turn, has helped to fuel deflation. But, of course, mortgage costs aren't relevant to most retired people.

Perhaps a more appropriate measure for pensioners is the latest RPIX figure, which excludes mortgage interest payments from the measurements. The RPIX stands at 2.2%, far higher than the RPI at -0.4%.

But the real rate of inflation for pensioners is generally regarded to be even higher than the RPIX, and higher than the average rate of inflation felt by the rest of the population. This is down to the fact that a larger proportion of pensioners' income is normally spent on utility bills and food, where prices have risen considerably.

Indeed, some economists put pensioner inflation closer to 6%. So, a guaranteed rise of 2.5% in the basic state pension next year won't be much comfort should deflation persist.

Index-linked annuities

The state pension is not the only type of pension linked to the RPI. Many pensioners have bought annuities which are also index-linked. (Annuities allow you to convert your pension fund into an monthly income.)

An index-linked annuity is supposed to protect the purchasing power of your income from the effects of inflation as measured by the RPI. But, the trouble is, when the RPI falls, it follows that income from an index-linked annuity will fall too.

This is bad news for any pensioner facing a higher real rate of inflation. And if deflation becomes even more severe, as many predict, the income paid from some index-linked annuities will drop even more.

Light at the end of the tunnel

But there is light at the end of the tunnel for some. A number of annuity providers provide protection against deflation for their index-linked annuity customers.

LV=, for example, has confirmed that its customers won't see a reduction in their retirement income as a result of the latest deflation announcement, arguing living costs aren't falling as quickly for pensioners as the RPI indicates.

I think this fair decision makes a very welcome change. It's just a shame not all annuity companies see things the same way. If you have an index-linked annuity, it's probably a good idea to check whether your provider plans to cut your income so you can re-jig your budget.

But I don't wish to cause any unecessary panic. Remember the drop in the RPI is only 0.4%, so the impact on your monthly income should be pretty minimal. And it may not kick in immediately depending on when you bought your annuity. But, if the RPI falls further, the reduction in your income could become more significant. That said, if you're lucky your provider may have a generous view on deflation like LV=.

On a final note, if you're on the verge of retiring and you haven't yet bought an annuity, read How to buy the right annuity for some useful tips. And for the lowdown on index-linked annuities read this article. Don't forget, once you buy an annuity you'll have to live with your decision for the rest of your life, so it's crucial you choose the right one. Good luck.

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