When you factor in inflation you will need to save much more than you might think.
Not long ago, the biggest fear of central bankers across major economies was deflation. Policy after policy has been introduced to ward off this risk. More recently we have seen inflation pick up, particularly in the UK where sterling’s depreciation has translated into higher prices of imported goods. Whether this continues or, as the Bank of England (BoE) expects, we fall back to levels nearer the targeted 2% remains to be seen. Understandably, fears remain that unprecedented levels of monetary easing around the globe will eventually give rise to a sustained period of higher inflation.
There are sound arguments for and against the likelihood of long term inflation, but if the past 60 years in the UK is any indication, virtually every year will see broad increases in prices. In fact, there has been only one year since its start in 1958 when the Retail Price Index has been negative.
For this reason, it is essential to factor in inflation when planning for the future.
The impact on pensions
Take for example a 45-year-old with a current pension pot of £220,000, contributing £1,000 gross per month. Research by Netwealth suggests that if they are invested in a moderate risk portfolio generating average annual returns of 4.1% after fees, they would be able to draw an uninflated income of £4,000 per month from age 65 to age 95, a healthy £48,000 gross income per year.
However, if we see inflation in line with the BoE’s target of 2%, this £4,000 a month would buy the equivalent of £2,692 of goods by retirement and only £1,516 by age 95. To counteract the effects of inflation on the original £4,000, withdrawals would need to start at £5,944 at age 65, increasing to £10,555 at 95. The challenge is that, in order to achieve this without changing contributions, the current pot would need to be worth more than £550,000, an increase of £230,000 compared to today’s value.
With final salary pensions now few and far between, increasingly we all need to take more responsibility for saving for retirement
Make the most of long-term investing
Whilst it is unlikely that someone suddenly has access to £230,000 to add to their retirement pot, they do have 20 more years before retirement. They could take more risk in the hope of greater returns, increase their regular contributions, or a combination of both. If they wanted to increase their contributions to help make up the shortfall, the monthly amount would need to be a pretty substantial £3,000 – at which point it may be that reality bites and instead they have to reconsider their expectations for the type of retirement they will have.
With final salary pensions now few and far between, increasingly we all need to take more responsibility for saving for retirement. In an environment with potentially low inflation-adjusted investment returns, the stark reality is that we need to address this much earlier and will probably need to save considerably more than we might think.
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