Why you should factor in above-average inflation when planning your clients' retirement spending.
Inflation is an important part of clients’ understanding of their retirement journey. When clients are focused on building up their pension pot to ensure a comfortable retirement, they might easily lose sight of how inflation can shrink the value of the pension’s assets that they have worked so hard to accumulate.
As they approach retirement, clients need to know that they have enough assets in place, but also that their assets are growing in value at a rate that is higher than the rate of inflation. This task is made more difficult in today’s low interest rate environment. Although UK inflation is currently low, it should be remembered that this will not last forever (even with Brexit), and this will start to erode the value of pension savings and income.
Inflation can be volatile and unpredictable, posing a constant threat to a client’s purchasing power, and so ranks as a key concern among pre-retirees and retirees. Even with low levels of inflation, retirees run the risk of earning negative real returns from traditional income sources, for example government bonds and interest from building societies, which are now paying historically low yields. Thus when inflation does eventually increase, it becomes especially important for retirees to have investments that can make up for inflation’s negative effect on investment returns, purchasing power and the longevity of a portfolio.
Another challenge that retirees face is their greater exposure to sectors of the economy that are more affected by inflation. For example, retirees’ personal inflation rate may be higher due to rapidly rising healthcare costs or higher heating bills. Compared to those in early retirement, the average retiree spends almost twice as much on healthcare and other sectors that have always suffered most from inflation, and less on transportation, education and other categories with low historical inflation.
The top chart below shows the differences in spending by age and category for those individuals who are 65-74 and 75+. For example, spending on housing increases for those aged 75+, whereas spending on recreational activities decreases.
The bottom graph on the slide shows the inflationary pressures on each of these categories. Inflation has the most impact on housing, transport, food and health, and the least on clothing.
Another factor for investors to consider is the tendency among risk-averse clients to overweight conservative assets that have barely kept pace with inflation. But, with rising life expectancies, many retirement-age investors have plenty of time to consider pursuing the inflation-beating potential of stocks.
Of course, stock market investments contain much higher risks and, as with most investment strategies, it is important that the portfolio should have a broadly diversified, risk-controlled approach, investing in a range of assets that tend to perform well under different market conditions. Individual asset classes respond differently to rising and falling inflation. Together, they may offer more protection and consistency than any one asset alone. Inflation-sensitive assets to consider for managing inflation include commodities, inflation-linked bonds, real estate and equities related to natural resources and infrastructure.
This all highlights the importance of factoring in above-average inflation when planning a client’s spending during retirement. It is worth noting with clients that well-rounded retirement portfolios include a meaningful allocation to inflation protection strategies with the potential to deliver long-term real returns.