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How to handle inflation in retirement

Don't overdraw from your investments to cover price rises
How to handle inflation in retirement
  • Increasing withdrawals from your portfolio to compensate for higher inflation can shrink the capital value faster
  • Draw from a cash reserve to make up the shortfall
  • Ensure your portfolio has enough assets that can outpace inflation

If you are retired, and have good pension provision and/or assets of a substantial value, you may not be overly concerned about recent increases in food and fuel prices. But high and rising inflation's impact on pension incomes, not to mention on assets such as shares and funds, means it’s important to try to limit the potential damage this can do to your retirement pot.

If you are drawing down a set amount each month from investments, rising prices might mean that this is no longer sufficient. On the other hand, increasing the amount you take each month, if this withdrawal is not derived from natural income such as dividends and bond coupons, will eat further into the capital value of your assets. With the current market volatility, increasing withdrawals is a particularly risky strategy because your investments' capital value is already likely to have fallen; selling additional chunks will shrink their value further. That increases the risk of running out of capital before the end of your life. Shrinking your capital base also means that you have fewer shares and units to pay out dividends. 

As the table below shows, taking money from your portfolio when it has fallen in value is particularly detrimental earlier on in your retirement (also see 'How to handle your portfolio in extreme situations', IC 11 March 2022).

 

 

How withdrawals and the sequence of returns can impact a portfolio's value
  Portfolio 1 Portfolio 2 
YearWithdrawalAnnual returnsAnnual portfolio value Annual returnsAnnual portfolio value 
0  £100,000 £100,000
1£5,00030%£125,000-20%£75,000
2£5,00020%£145,000-15%£58,750
3£5,0005%£147,2505%£56,688
4£5,000-15%£120,16320%£63,025
5£5,000-20%£91,13030%£76,933
Cumulative return 11% 11% 
Source: Quilter Investors

 

This is particularly the case with withdrawals that are proportionately larger, points out Tim Erlam, wealth adviser at Brewin Dolphin: if, for example, you have been withdrawing 5 to 6 per cent a year and are thinking of upping this to 7 to 8 per cent. However, an increase from 1 per cent to 2 per cent would be less of a problem – this is a generality, though, and the impact of increased withdrawal rates should always be considered on a long-term basis.

If your portfolio has done particularly well in the past few years and growth rates have outstripped your withdrawal rates, you may now be in a better position to take out a little more in a sustainable manner.

If you are not taking the income from your investments at all, you could start to draw it instead to cover some or all of your living costs. “Adopting a natural income strategy where you withdraw no more than the yield generated by your investments is a good way of making sure your pension remains robust over the long term,” says Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown. “These returns will fluctuate over time, but you can use cash [savings] to supplement your income as and when needed. This should help you ride out any investment volatility and make sure your pension remains robust in the face of rising inflation.”

In retirement, advisers suggest having cash equivalent to one to three years’ of basic expenses, held in an easy-to-access account. But holding this cash in a low-interest account presents its own problems at a time of high inflation. Weighing up these competing pressures requires careful consideration. 

As a longer-term strategy, Andrew Marker, head of retail pensions at Vanguard UK, suggests adjusting the percentage of income you draw each year based on how well your portfolio performs, within an inflation-adjusted floor and ceiling.

“As an example, inflation is 2 per cent, your starting portfolio is £800,000, your withdrawal rate is 5 per cent, and you have a performance ceiling of plus 5 per cent and floor of minus 2.5 per cent,” he says. “If [in this scenario] in the first full year of retirement the value of your £800,000 portfolio rises by 20 per cent, the ceiling would mean that your income in year two would rise by only 5 per cent plus inflation to about £42,800.

"If, however, the value of your portfolio fell by 20 per cent, the floor would mean that your income dropped by only 2.5 per cent in inflation-adjusted terms, to around £39,800." Stowing away gains for future use means the good years effectively fund the bad and ensure a reasonably consistent level of income. 

 

Tax

If you take money other than your tax-free cash entitlement from a pension, it is subject to tax at your marginal rate. So Erlam suggests taking it from accounts from which withdrawals do not incur tax, such as individual savings accounts (Isas).

Sean McCann, chartered financial planner at NFU Mutual, suggests that if you have used up your own tax-free allowances and “you’re married or in a civil partnership, move investments or cash holdings between you to make full use of both your personal allowances of £12,570 tax-free income, dividend allowances of £2,000 and personal savings allowances [for interest earned on cash and bonds] of £1,000 for basic-rate taxpayers or £500 for higher-rate taxpayers. If selling shares or funds, use both your capital gains tax (CGT) annual exemptions and consider splitting sales across tax years.”

If you sell investments held outside tax-efficient wrappers, profits should only be up to the value that can be offset against your annual CGT allowance of £12,300 – or £24,600 for a couple. You can also offset gains against losses from current or previous tax years, if you reported them to HM Revenue & Customs within four years from the end of the tax year in which you made the disposal.

 

Asset allocation

The amount you should hold in each asset class depends on several factors including the size of your portfolio, how much you need to take from it each year and how long you need it to last.

But as a very general example, if you are newly retired you could consider an allocation of around 60 per cent to equities. The remaining amount could be invested in areas including alternative assets such as infrastructure and absolute return funds, and some bond funds. See also How much should you allocate to alternative investments? (IC, 10 December 2021).

One strategy is to have different pots of money for the short, medium and long term, allocated accordingly. Money needed in the next three years could be in cash. Money needed in five to 10 years could be invested in a moderately cautious way, so equally split between bonds and equities, or allocated to equities, bonds and asset-backed investments such as property. Money not needed for 10 years or more could be focused on equities. But don’t take more risk than you need to meet your objectives.

Also consider the cost of investing. If you have funds with high charges or high platform fees this eats further into the value of your assets and makes it harder for them to outpace inflation. Reducing the charges you pay can help to mitigate the impact.