What is inflation?
Inflation is the rate at which the cost of everyday things like food, transport and electricity increase over time.
Let’s take an average loaf of bread as an example:
- If it cost £1 a year ago but £1.02 today, the inflation rate was 2%.
- If it cost £1 a year ago but £1.05 today, the inflation rate was 5%.
In the real world, the inflation rate changes constantly. And while the value of goods generally rises due to inflation, they can also fall when there’s deflation (as happened in 2009).
Inflation can happen when there’s more demand for something, or the product or service becomes more expensive to produce. And if a lot of products and services were to rise in price at the same time, your cost of living would increase as a result.
The Bank of England keeps a close eye on inflation using something called the Consumer Price Index (CPI). This is an imaginary basket containing hundreds of goods and services, which have their prices tracked over time.
If they notice the price of these items growing too quickly (a sign of inflation), they might increase interest rates to encourage people to spend less and save more. Conversely, they might decrease interest rates to encourage people to spend. The government encourages them to keep inflation at around 2% per year.
How inflation erodes your money
Inflation doesn’t just impact what you can afford today, but also what you could afford in the future.
Let’s pretend you hid £1,000 in cash under the mattress and left it there for five years. And let’s say the rate of inflation was 2% per year over that time. After five years, the cost of living would be about 10% higher than today. So your £1,000 wouldn’t be able to buy as much as it would have done five years ago. In other words, it’s value had been eroded.
However, there are ways to potentially protect your money from being eroded:
- Finding a savings account with an interest rate above inflation
- Investing your money in the stock market and hoping it grows faster than inflation
As of July 2020, the UK’s inflation rate was 1.1%. Unfortunately, we couldn’t find any high-street banks offering instant-access savings accounts that could beat this figure. We did find several fixed-rate savings accounts offering 1.2%, but you’d need to lock your money away for a year and hope that inflation didn’t increase within that time.
Bear in mind that there’s no guarantee the stock market will continue to grow - it could even fall. And you’ll also need to factor in the cost of investment fees.
Your pension and inflation
Pensions are a great way of saving for the future. Not only is your money invested with the aim of growing over time, but your employer and the government will also pay into it for you.
But pensions aren’t immune from the effects of inflation; both when you’re saving for retirement, and while you’re drawing down in retirement.
The money you pay into your pension is invested - most often in the stock market - so that it grows over a long period of time. Pensions usually grow faster than inflation; between 2015 and 2019, pension funds grew by an average of 7.4% per year - much higher than the average 1.53% inflation over the same period.
Still, every year the value of your pension is eroded by inflation; if it grew in value by 4% but inflation was 2% then your pension will have grown in ‘real-terms’ by just 2%.
For example, let’s imagine that:
- your pension is currently worth £100,000
- you plan on retiring in 10 years time
- inflation averages 2% per year for the next 10 years
If your pension grew an average of 2% per year then it’d be worth £122,000 monetarily, but you’d be no better off in real-terms because the price of everything would have increased by 2% (that’s inflation at work). Your £122,000 would be able to buy the same as your £100,000 could have done 10 years ago.
If your pension grew an average of 4% per year then it’d be worth £148,000 monetarily, and you’d be much better off in real-terms. Your £148,000 would be able to buy much more than your £100,000 could have done 10 years ago.
If your pension grew less than 2% per year then you’d be worse-off in real-terms because the cost of items would have outpaced the growth of your pension.
We haven’t included ongoing contributions in the above examples, but the effect on the money you pay in would be the same.
Once you retire, you’ll want your pension to support you for as long as possible. How inflation impacts it will depend on what you choose to do with your retirement savings.
If you leave your pension invested and make regular drawdowns, inflation will continue to erode your pension. However, this could be offset if the growth of your investments outpaces inflation.
If you use your pension to buy an annuity, inflation may or may not have any impact on your annuity income. An ‘escalating annuity’ increases over time to keep up with inflation, but a ‘fixed annuity’ will be eroded by inflation over time.
The importance of growing your pension pot
As we’ve seen, inflation has the power to erode the value of your money over time. This is particularly true if you leave your money under the mattress, or even pay it into a low-interest savings account.
One way of protecting yourself against inflation is to invest your money in a pension, which tends to grow at a faster rate than inflation over time.
Pensions have other benefits too, helping to offset the effects of inflation:
- Your employer will pay into it for you
- The government will boost your contributions with tax relief
- You’ll benefit from the effects of compound interest
If you’re looking to prepare for retirement by combining your old pensions into one easy-to-manage online plan, consider PensionBee - a leading online pension provider.
The information in this article should not be regarded as financial advice.