Inflation is the highest it’s been for decades, and whilst it’s hitting our pockets now and affecting the current cost of living, it also has longer-term impacts on our future wealth, spanning all the way to retirement and beyond. Exactly what future retirees may face and exactly how much they will need in savings to enjoy a comfortable post-retirement existence are top of mind as consumer prices continue inflating like a balloon that refuses to pop. Allspring is a sponsor of the UK’s PLSA Retirement Living Standards (RLS), which seek to answer such questions.
Inflation, inflation, inflation …
How much do we need to fund our lifestyle?
Higher inflation requires a greater level of savings pre-retirement. Due to 2021’s high inflation, the RLS have recently been updated for the first time in two years. Figure 1 shows the latest RLS.
At present, the increases in annual cost appear modest, at 3.9% on average. Notably, though, the minimum RLS has seen an increase that’s almost four times greater than the increase for the comfortable RLS.
Factoring in inflation
UK inflation, as measured by the UK Consumer Prices Index including owner occupiers’ housing costs,* increased 7.9% year over year in May 2022. Whilst this could be a blog article on inflation—will it be transitory or not—perhaps enough has been written about that topic. Instead, let’s look at what markets tell us by looking at the difference in prices between conventional gilts (with a fixed coupon) and index-linked gilts (with a coupon and final redemption linked to inflation). That can give a measure of the market expectation of inflation. This measure is, of course, a balance of demand and supply. It’s the inflation expectation of the marginal buyer and seller. In a way, this is the weighted average of many buyers and sellers, some of whom are perhaps not really making a particularly informed bet on inflation. Instead, they may have to hedge liabilities, like our friends in the defined benefit world. It can also reflect uncertainty over inflation, which may mean it’s a biased reflection of expectations. Regardless of the possible shortcomings of using this measure as a true expectation of inflation, Figure 2 displays what the market tells us about inflation.
The market tells us that inflation is expected to increase and stay high. To the extent the Bank of England is aiming for 2% inflation, the market is saying we can’t get there for quite some time.
Using these measures as inflation forecasts, in Figure 3 we’ve project the minimum, moderate and comfortable living standards.
Over the next two decades, the cost of living is expected to more than double. If this holds true, the minimum standard would rise from £10,900 to £27,700 and the moderate would increase from £20,800 to £41,400. From a pension perspective, this may not spell doom as long as the state pension along with private pension contributions and investments maintain the same level of growth and can keep pace. But is that possible? This question can’t be definitively answered unless we know how much money is needed at the point of retirement.
With the cost of living increasing rapidly, how much money will the average individual need to have accumulated at the point of retirement? This isn’t an easy question to answer and, in fact, according to the Pensions and Lifetime Savings Association, 77% of savers don’t know how much they’ll need at retirement. How much money you might need depends on several factors, including:
- The level of your state pension
- Your personal spending rate and living standard aspirations
- Your life expectancy
- How you plan to invest money during retirement
- Your risk tolerance regarding the possibility of outliving your savings
Assuming the state pension increases with inflation, we show in Figure 4 the potential pot size required at retirement for various RLS and investment strategies.
The lowest-risk investment option, the annuity, requires the largest pot size. Whilst investing in equities in retirement requires the lowest pot size, it also requires retirees to stomach the volatility of equities throughout retirement.
Factoring in further risks
Figure 4 doesn’t account for the two key retirement risks: longevity and investment risk. To paint a more complete picture, in Figure 5 we’ve introduced these risks via a key risk measure, the “risk of running out”, which is the probability of outliving one’s pension pot.
Figure 5 illustrates the impact of inflation. The purple line shows the nominal potential values of each of the portfolios, and the blue line shows how much retirees likely would have left after inflation is considered.
Whilst equities are seen as potentially providing the highest returns, they also result in the highest risk of running out. This is because equities have the highest investment risk of the four options. If equity markets sell off just as retirees invested in equities are withdrawing money from their pots, the losses in their pots can be locked in—a situation that can be difficult to recover from. On the flip side, annuities perhaps provide a higher level of income certainty than may be required.
For many savers, either the low risk or the drawdown portfolio may provide the best tradeoff. It’s also possible that some combination of these two portfolios—or even an approach that factors in elements of the other two portfolios—could be constructed to provide a customised, reasonable balance. In other words, the right answer doesn’t have to be either/or. Instead, it could be a mix of “all of the above” that’s specific to a person’s needs, resources and preferences.
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*The UK Consumer Prices Index including owner occupiers’ housing costs (CPIH) is a measure of inflation published monthly by the Office for National Statistics. It measures the change in the cost of a representative sample of retail goods and services. You cannot invest directly in an index.