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Effect of high inflation on pensions

Effect of high inflation on pensions

Edward Willday – Nov 14, 2022 – 5 mins

Effect of high inflation on pensions

Edward Willday – Nov 14, 2022 – 5 mins

Over the summer, the UK’s inflation rate hit a high of 10.1%. This is over five times greater than the target inflation rate of 2% that the Bank of England aims to keep inflation within. In this article we discuss what inflation is and why rates are so high, plus what this means for your pension. We’ll finish by discussing what’s being done by the Bank of England about the high levels of inflation.

What is inflation?

The Bank of England define inflation as “the term we use to describe rising prices. How quickly prices go up is called the rate of inflation”. The rate of inflation is calculated by the Office of National Statistics each month, by comparing the price of a virtual basket of commonly purchased products – the total price of this basket is known as the Consumer Prices Index. This figure is compared to what it was a year previously – the percentage change is the rate of inflation. A stable rate of inflation is a good sign of a healthy economy, which is why it’s so important to track.

The chart below (Source: Office for National Statistics, on BBC.com) shows the inflation rate over the last decade.

As can be clearly seen, since late 2021 there has been a sharp and continuing rise in the level of inflation.

Why are inflation rates so high?

As previously mentioned, inflation rates rising is due to the cost of the virtual basket increasing. This, in turn, can occur due to supply and demand – when there is higher demand than there is supply, the price increase. Additionally, when the unit cost of a product increases, the final sale price of the product will also increase.

The invasion of Ukraine by Russia led to an increase in food prices – Ukraine is colloquially known as the ‘bread basket of Europe’ due to the amount of grain that comes from the country. With this supply channel stopped, the price has increased. Additionally, oil and gas prices have risen considerably due to the invasion, due to sanctions imposed on Russia – previously, a significant amount of Europe’s oil and gas came from Russia.

On top of this, due to the Covid-19 global pandemic, several supply chain bottlenecks have come about. This is leading to less supply of certain products, also driving the price up.

What this means for your pension?

The impact of high inflation on your pension largely depends on the type of pension you have.

State pension

The amount of state pension received by pensioners in the UK can be impacted by the level of inflation – if there is no increase to state pension in line with inflation, pensioners are worse off – the money they receive does not stretch as far, as prices have increased. To offset the impact of inflation on pensions, the government have instilled a Pension Triple Lock guarantee. This means that the UK state pension is guaranteed to rise by the highest of three factors, with the data taken in November in readiness for an increase the following April in the new tax year:

  • The rate of inflation in the previous September (two months before the data is derived) – so in November 2022 this will be 10.1% – the inflation rate of September 2022
  • Average earnings from May to July
  • A minimum uplift of 2.5%

There is discussion in government at this time about whether to honour the Triple Lock in its truest sense, or whether to use the average earnings figure. This is because it is estimated it will cost an additional £5bn to honour the 10.1% rise. The decision should be announced as part of the new financial statement in mid-November.

Private pension

The money that you have in your pension pots is an investment, so should grow over time. Usually this happens at a faster rate than inflation, but as with any investment, this is not a guarantee. When calculating your private pension growth in real terms, you should deduct the inflation rate from the percentage value of growth.

For example:

  • If your pension pot grows by 2% per year and inflation is at the Bank of England target of 2%, in real terms you are no better off. The money in your pot after 5 years
  • If your pension pot grows by 4% per year and inflation is at 2%, you’d be able to buy more with your pension pot after 5 years than with the same pot of money at the start of the 5 years
  • If your pension pot grows by 1% and inflation is at 2% (so the rate of inflation is higher than the pension growth), you can buy less with your pension pot after 5 years than with the same pot of money at the start of the 5 years. Therefore despite the pension pot having grown, in real terms it has not grown.

What’s being done about the high level of inflation?

As part of their plan to tackle high inflation, the Bank of England are raising the base interest rate – this is currently set at 3%, the highest it’s been since 2008, following a rise of 0.75% which was the biggest single rise since the 1980s. The purpose of this is that it will make people spend less as they will be more inclined to save their money. This will lead to prices rising at a slower rate, and therefore a lower rate of inflation. It is important to note, though – even if the inflation rate is brought down to be more inline with the Bank of England target, it doesn’t mean that prices will come down and that the cost of living will decrease. Lower inflation does not make items cheaper to purchase, it simply means that the price is rising at a slower rate.

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