Tips on Protecting Your Pension and Investments from Inflation
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Inflation affects more than just daily expenses; it can significantly impact the purchasing power of your retirement savings. In this article, we explore how you can protect your pension against inflation.
Inflation, a concept dealing with the rise (and fall) of prices in the economy, has been a focal point for investment markets over the past three years, following a decade of relative dormancy. Recent and potentially future higher inflation rates can materially impact your pension.
As of April/May 2024, inflation in Ireland stands at 2.9%, a substantial decrease from its peak of 9.2% in 2022. While the immediate impacts of inflation on daily life are often the focus, it’s equally important to consider its long-term effects on the purchasing power of retirement savings. Proper planning for retirement must account for inflation to ensure that your pension remains sufficient to cover future expenses. Comparing inflation rates of 2% versus 5% over an extended period, as illustrated in the graph, clearly demonstrates its significant impact.
What Does It Mean in Terms of Reducing Purchasing Power?
Purchasing power refers to how much you can afford based on your costs and income, including during retirement. Inflation decreases purchasing power by causing prices to rise across the economy. Essentially, the same amount of money buys fewer goods each year. In 2021 and 2022, inflation surged while wage growth did not keep pace, leaving many worse off in real terms.
In early 2023, over three-quarters of professional firms in Ireland awarded average pay increases of 4%. However, this lagged behind Ireland’s 8.2% inflation rate at the end of 2022. Despite these pay increases, most workers were still worse off due to reduced purchasing power, driven by food and energy price inflation.
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Why is Inflation Now More Topical?
After a sharp decline towards the end of last year, inflation has continued to decrease in early 2024, albeit at a slower pace. Goods disinflation, the primary driver of falling inflation in 2023, has moderated, and energy prices are no longer contributing to disinflationary pressures. The future of inflation largely depends on service components, where price pressures remain high due to robust demand, tight labour markets, and above-trend wage growth.
This decline in inflation is not unique to Ireland; it is also observed in larger markets such as the US and the eurozone. Falling inflation is favourable for central banks, which are either cutting rates or preparing to do so. Despite some persistence in service sector prices, major central banks, including the US Federal Reserve and the European Central Bank (ECB), have indicated that rate cuts are imminent.
From 1995 to 2020, the annual Consumer Price Index (CPI) in the US ranged between 1% and 3%, with minor deviations. In the European Union (EU), average inflation varied mostly between 2% and 3% from 1995 to 2012 and between 0% and 2% since. This trend changed significantly in recent years. During the Covid-19 pandemic, global CPI dropped markedly between January and May 2020 due to collapsing demand and falling oil prices. Since May 2020, however, inflation has surged, marking the fastest post-recession inflation increase in the past 50 years.
By 2021, inflation rates began surpassing target levels. Rising commodity prices and supply chain disruptions were the main triggers. As these factors waned, tight labour markets and wage pressures became the primary drivers. The war in Ukraine, starting in February 2022, and its impact on energy and food markets, greatly accelerated this process. Initially, major central banks considered the price rise ‘transitory’ and were thus slow to respond.
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What Can You Do to Hedge Against Inflation?
Inflation levels can fluctuate due to various factors. Hedging against inflation can be achieved by increasing exposure to risk assets and boosting contributions.
Investors concerned about inflation’s impact on their pension and investment returns should consider their long-term strategy, including their investment horizon and risk tolerance. For many, maintaining a globally diversified portfolio, such as Zurich’s actively managed multi-asset funds, is advisable. Diversification across a broad mix of assets can help navigate inflationary periods. It’s important to note that holding cash may reduce future spending power, especially in today’s high-inflation environment.
As you approach retirement, the value of your pension pot, and consequently your purchasing power for a retirement annuity, may decline. Those who contribute a set percentage of their salary, which increases with inflation, or who increase their contributions, may be better protected against high inflation.
For trusted advice on reviewing and refining your strategy to mitigate the impact of inflation on your pension, contact Alan McCarthy at alan.mccarthy@mbcfinancial.ie.