The hidden dangers of inflation and how it can deflate the money in your pocket

The hidden dangers of inflation and how it can deflate the money in your pocket

Learn about the dangers of inflation and how it can deflate the money in your pocket

The long-term effects of inflation can cause crippling financial pain in the course of your lifetime, but particularly at the point of retirement if you fail to plan.

Today, you will need £1,718 to buy the equivalent goods you may have bought for £1,000 in 1999. The purchasing value of your investments, ISAs and pensions are therefore, essentially being eroded.

The situation was dramatically worse between the decades of 1980 and 2000 with £2,547 then being required to be able to buy what £1,000 bought back in 1980. That reveals an average inflation rate of 4.79%.

This blog explains why you need to invest intelligently and ultimately, not simply relying on cash deposits for ‘inflation-proofing’.

Ignoring the effect of inflation means you will not feel, or be, as wealthy or as confident as you could be in your financial future. Maintaining a standard of living is critical for all of us, but according to an article from the BBC, a significant percentage of people actually underestimate the future cost of being able to afford and provide the essentials, at different points in their lives.

Although it is difficult to identify the impact of inflation, for example, in your monthly outgoings, it is inevitable that the price of your lifestyle will increase. This increase in prices can be damaging if, for some reason, you stop working and have to resort to living off your life savings.

Cash isn’t king

There are two 30-year saving/investing periods in the whole of your lifetime, and these periods have been rounded for convenience – your unique situation may be different.

From the ages of 30 to 60, the time when you should essentially be working, saving and accumulating. Then the second period falls between the ages of 60-90, when you are likely to be spending or gifting.

Putting your life savings in a bank account may appeal to your sense of self-preservation when you retire. You may once have invested in the stock market and thus accepted shifting valuations as the price of doing business, ultimately perceiving it as a business transaction.

In your ‘prime time’, it seems sensible for you to avoid the markets and play it safe and yet if you adopt this approach, your lifestyle may erode as inflation washes your savings into the proverbial sea.

In recent years, the U.K. has experienced fairly modest inflation compared with its international counterparts, but the picture has not always been as serene. The chart below depicts the inflation rate over the last 70 years (RPI).

This is not to say double-digit inflation figures are just around the corner, but it is safe to say that it is likely that during your retirement timeline, the inflation rate will certainly fluctuate upwards. A few years of inflation also adds up over time; the power of compounding interest is pivotal and so being aware of this concept and essentially being pro-active now can indeed help to preserve your lifestyle moving into retirement.

When working, you will likely experience an anticipated annual pay rise, this could be something in the order of inflation plus a per cent or two more. If you saw no change at all in your pay packet, you knew you were not standing still, but in fact, you were regressing. Now, once you have stopped working, in retirement, your investment portfolio offers you the opportunity to keep up with and beat inflation.

The example below helps us to visualise this.

Chris and Kate were both in their early 60s and considering retirement. They owned their home, which was unencumbered (mortgage free), had no debt and no financial dependents (though they did spoil their two children).

They sold their business for £1 million and were fortunate enough to have the choice of consulting in some capacity or stopping work altogether. They both expected to receive the full state pension of £8,700, which would increase each year.

They had a comfortable lifestyle and were looking forward to being able to travel more, have dinners with friends, as well as spending more time with their children. Chris and Kate formulated a family budget of approximately £57,000, which increased with inflation.

For Chris and Kate to be able to support their lifestyle, they would need to be able to withdraw £40,000 after-tax (inflation-adjusted) from the £1 million sale of their business.

Data from the Office of National Statistics and Historical Asset Class performance determined whether Chris and Kate would still be able to support their lifestyle if they stopped working.

They had the option of ‘playing it safe’ and could choose to keep their cash invested and assuming their income continued to increase with inflation, it was calculated that they had a 25% chance of being able to sufficiently support their lifestyle before their funds ran out. Considering these odds, the outcome did not look promising; in fact, it could be the case that either of them may have to take on some additional work well into their retirement, to be able to sustain their current lifestyle.

If Chris and Kate were to accept some investment highs and lows, they would be able to negate the risk of inflation diminishing their lifestyle. One option for them could be to invest 40% of their savings in global stock markets, with a further 60% in global bonds and fixed interest. This combination plan would give them a 90% chance of supporting their lifestyle over the coming years.

Place yourself in Chris & Kate’s situation; if you are hoping to be able to adequately support a comfortable lifestyle once you reach retirement, then you need to consider your investment options carefully, investing intelligently may be able to offer you the best chance at enjoying those years that you have worked so hard to reach. You do not want inflation to ruin this time, so get investing wisely and look forward to enjoying your new lifestyle.

If you would like to discuss your current or future plans for retirement and explore the options available to you contact Capital today.

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