Inflation impacts retirees in two ways. Firstly, it increases the future costs of goods and services. Secondly, it erodes the value of the assets set aside to meet these costs.
In recent years, inflation has been relatively benign, but it wasn’t always so. In the second half of the last century it averaged 6%. Even low rates of inflation can have a substantial impact over time. For example, at just 3% inflation the value of money more than halves over 25 years.
Even low levels of inflation can erode purchasing power
Source: Figures calculated based on hypothetical inflation rates of inflation of 2%, 3% and 4% to show the effects of inflation over time. Actual inflation may be higher or lower than the rate shown here.
So what are the practical implications of inflation for retirees? Let’s look at some of the issues:
- Patterns of expenditure. Over time, health issues make it difficult to socialise so expenditure declines. That means a level income may be a natural hedge against inflation. Nursing home costs potentially undermine this strategy, but the majority of people won't end up in expensive care homes.
- Health and lifestyle. Clients with a serious illness or poor lifestyle that is expected to significantly shorten their life expectancy may choose to ignore inflation.
- Hyperbolic discounting. Whether your clients are choosing a maximum withdrawal rate or buying a guaranteed income, allowing for inflation means less income today. Behavioural economics tells us that people value a £ today more than a £ tomorrow.
- State pension and defined benefit schemes. Many people will have an income from a defined benefits scheme and a state pension. Usually, these both have some protection against inflation. This means it might not be necessary to protect other income.