The Impact of Inflation on Pension Returns

Understanding Inflation

Inflation means that the same amount of money buys less over time. Over longer periods, the impact on purchasing power can be considerable. Just as compounding is a powerful driver to grow our capital, inflation operates in a similar way, but in the opposite direction.

Suppose you invest $10,000 for 30 years for a constant annual return of 8%. With no inflation, you would receive $100,627 at the end of the period. That’s 10 times your original investment.

Now suppose inflation was also 8% over the period. What would this mean? Although you would technically have grown your money, its purchasing power would have remained the same as the original $10,000. In other words, your inflation-adjusted growth would be zero.

Even if we take a more realistic figure such as 3%, your effective return on investment would decline from 8% to 4.85%. Meaning that instead of increasing your purchasing power by 10 times, you would only increase it around 4 times.

This is important during retirement, because you are no longer adding to your capital, but withdrawing from it. In other words, the $10,000 is decreasing and the growth rate is being made lower by inflation.

Inflation's Threat to Pension Returns

Many workplace pensions have changed from offering a guaranteed regular payment for life (Final Salary or Defined Benefit scheme) to contributing to a fund that is essentially managed by the employee (Defined Contribution scheme).

However a pension fund is managed, when inflation is high investment returns can suffer. For example, if interest rates increase as a result of higher inflation, existing bond investments will be worth less. And in any case, real portfolio returns will be lower, therefore the amount you have upon retirement will effectively decrease.

Even for those on Defined Benefit schemes, which often adjust payments upwards to reflect the cost of living (Cost of Living Adjustment or COLA), this typically reflects the general level of inflation, as opposed to costs such as healthcare, which tend to increase at a faster rate.

The only way to ensure you are secure in your retirement is to identify the real rate of return you need to achieve your goals, and ensure that your investments counter the effects of inflation.

Strategies to Counter Inflation's Effects

Thankfully, various ways exist to boost returns and counter inflation’s effects. Here are some practical tips.

Diversifying Investments

There are some assets, such as gold or commodities, which are anti-inflationary. Having a variety of assets in your portfolio means that you can lessen or even overcome inflation’s effects.

Inflation-Linked Securities

As the name suggests, these are financial instruments (e.g., inflation-linked bonds) that automatically adjust in value to retain their purchasing power. Typically, the nominal return will be less than comparable securities.

Regular portfolio reviews

In cases where inflation is extreme, or particularly mild, it could make sense to add or remove asset classes to reflect this. This is best achieved through periodic reviews, rather than trying to time the market.

Don’t rely on the government

Government programs are in most cases not designed to entirely replace personal investments or pension schemes. Relying solely on the government could mean that you are unable to maintain your lifestyle post-retirement.

Early Planning and Risk Management

While there are periods of low and even negative inflation, central banks around the world target a certain level of inflation as healthy. In other words, we should always be thinking about investment returns in real terms.

As with everything in investing, the earlier you start, the easier it will be to achieve the results you want. Leaving it too late, on the other hand, will mean that you may need to seek very high returns and take too much risk.

Balancing risk and return and reacting to the often-surprising path of inflation and monetary policy is not easy. We recommend that you don’t carry the burden alone.

Set up a meeting with one of our advisors to discuss your retirement goals and learn more about how we can help you achieve them.