Inflation in Ireland has hit a whopping 6.7% in March, up from 5.6% a month earlier. The central bank are forecasting that inflation will peak at 7.7% p.a. this quarter. With fuel prices spiralling there is plenty of discussion on the short-term effect of inflation, but have you thought of the effect it could have on pension planning?
The loss of purchasing power among pension savers is a massive issue. Although it is very unlikely, should inflation continue at 7.7% p.a. for a period of even three years it will wipe about 25% of the purchasing power of your pension fund. To put that into real terms, a pension client who was hoping to treat themselves to a premium car such as an Audi A4 on retirement (current cost €50,000) will have to settle for Ford Mondeo (current cost €37,000). While that is a whimsical example it does illustrate the major problem that inflation causes. On the more serious side of income in retirement it could mean the difference between having some disposable income to enjoy retirement and struggling to pay the bills every month.
Now that the problem has been identified what mitigation factors can be taken. I would propose that the solution is twofold, firstly growing the pension pot at a rate that will combat inflation and secondly re assessing how income is spent in retirement.
Looking at growing a pension pot there are two factors to consider Costs and Returns. Focussing on costs has never been as important over the last 40 years as it is now. Thankfully the pension and investment industry has come a long way since the time of initial units and large bid offer spreads. That being said costs are still crucial, if you can reduce your investment expenses by 0.50% p.a. that helps to mitigate the cost of rising inflation. However focusing purely on costs can also be detrimental. A number of top international fund managers such as Dimensional, Russell and Vanguard have published studies showing that a good financial advisor can add between 3% and 4.5% to investors investment returns.
Looking at investment returns the more risk that can be taken the better chance an investor has to reduce the effect of inflation. Coupled with this looking at a pension as a lifelong asset instead of a time horizon to retirement and a subsequent time horizon post retirement can allow investors to take on increased risk in the short term. This of course assumes that investors are availing of the ARF option rather than an annuity. The key to getting this mix right is regular pension reviews with a good financial advisor, even if you are in a group DC scheme you can enlist an advisor on a fee basis to ensure that you are choosing the correct investment options in that scheme.
Finally, we need to think about retirement and an individual’s income needs in a new light. The traditional annuity which in theory is inflation linked is no longer the best option for many clients. The annual increase in the annuity is often capped at the lower of the increase in the Consumer Price Index or 3.00% p.a.. Should inflation continue at 7.7% p.a. over the next three years the real value of this annuity will fall by around 12.5%. This reduction in buying power is permanent and will not be offset in future by low inflation due to the cap double factor cap on annual increase.
For pensioners who have chosen an ARF to meet their retirement needs, an alternative way to look at funding retirement is focus on when pensioners typically spend their money. Firstly, plan for funding of long-term care and then focus on the lifestyle spending. Due to better health, mobility and lifestyle in the early years of retirement pensioners will have a certain spending pattern in their 60s. this pattern will reduce in their 70s, and then it reduces again into their 80s. This can allow pension investors to carry out detailed cash flow modelling over four-phases: pre-retirement (age 50 to 60 or 65), the period of early retirement (say age 60 to 70), middle retirement (age 70 to 80), and late retirement (80 and up).
To summarise while high inflation is an issue, taking the time to work out an appropriate investment strategy can help combat its effect.
Author: Eoin Hassett, Independent Trustee Company. For further information, please talk to your Financial Advisor or email email@example.com