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NIESR - inflation could hit 4% - HL comment

Ahead of the Bank of England’s Quarterly Inflation Report out tomorrow, the National Institute for Economic and Social Research (NIESR) has predicted that inflation could hit 4% in the near term, in large part due to the weaker pound.

  • Impact of inflation on pensions
  • Options for savers

"Increasing inflation is the wolf at the door for retired investors, but perversely it could be good news for final salary pension schemes.

It is essential to protect your income in retirement from inflation as it can halve the value of your income over the duration of a typical retirement. The state pension increases automatically as it uses the triple-lock to ensure pensioners always get the best increases which match or exceed the rate of inflation. For your private pensions, one option is to buy an index-linked annuity but they don't come cheap. A 65 year old with £100,000 could buy a level income of £4,781 but if they wanted their income RPI linked, the starting rate would drop to just £2,840.

An alternative strategy is to use drawdown invested in equities and equity income funds and to draw the natural yield (just the dividends and interest). This can produce a starting income of around 3.5% or £3,500 from a £100,000 pension pot and back-testing shows that such a strategy would have increased an investor's income to around 3 times its starting amount over the past 27 years.

You can also mix and match your retirement income plans, by using a combination of annuities and drawdown, which works well to secure a base level of income to meet your essential needs, with variable income above.

For final salary schemes, rising inflation is likely to lead to falling bond prices and rising yields. Whilst this may lead to some capital losses on pension scheme bond portfolios, it will also lead to shrinking liabilities because these are valued by reference to bond yields. The overall effect is likely to be to bring down the record deficits we have seen in recent months."

Danny Cox, Chartered Financial Planner, Hargreaves Lansdown:

"The bad news for savers just gets worse, as declining interest returns cannot match the rate at which prices are set to rise. Savers face the continuing vicious circle of eating into their capital or taking a leap up the rungs of the risk ladder in search for inflation beating returns.

The only cash product guaranteed to beat the rate of rising prices are NS&I Index-linked Savings Certificates. New issues are as rare as hen’s teeth, but if you already hold them you can roll them over at maturity for another term."

Options for savers

Stick with it

You need some cash as an emergency fund and to meet short term bills. Six months’ worth of expenditure is a good starting point, hold more if you are retired. Use cash ISAs to shelter your savings from tax. The tax savings of ISAs are cumulative and rates will rise at some stage. You can shelter £15,240 in an ISA in this tax year and for most people this is very sensible, blue chip planning.

Review regularly

Savers should regularly check the rates of interest they receive on their savings accounts and cash ISAs – it can be easy to miss a notification of rate a cut – and transfer to a higher paying account to improve their returns.

Go long

Higher rates are usually available for those who are happy to lock some of their money away for a fixed term. When choosing a fixed term savers should consider the prospect of interest rate rises. A 4 or 5 year fixed rate bond may look like a better deal now, but could look poor as and when rates do rise. And if you encash you’ll pay penalties on the interest already received, so don’t lock away money you will need access to.

Invest in search of better returns

Investors can transfer Cash ISAs into a Stocks & Shares ISA in search of improved returns. This is a riskier option than cash but worth considering by those who are happy to accept the ups and downs of the markets for the potential of longer term gains. Equity income yields around 3.5% – 4% at the moment and over the longer term should also provide capital growth, thereby providing a rising income.

Lend in search of better returns

Peer to Peer (P2P) providers match lenders and borrowers to provide investors with attractive interest rate returns as an alternative to traditional gilt, corporate bond and fixed interest investments. P2P is an investment, not a cash alternative, so is only for those who are happy to accept risk to their capital and interest. From April this year the new Innovative Finance ISA allows investors access to P2P products within a new, third way ISA. A good “rule of thumb” is to work on the basis that the higher the interest rate you are offered, the more risk you are taking on. There are many different providers so make sure you do your homework and understand what you are signing up for and the risks.


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