Inflation Can Ruin Your Retirement

The biggest danger to all financial planning is the effect of inflation - or rather the effect of not taking inflation seriously. It is easy to get complacent, after all the Government talk about their 2% target and we always seem to be fairly close to that figure. The reality however is very different.

Retail price inflation as measured by the Retail Price Index (RPI) has been about 4% - 4.5% for some time now (March 2008). The RPI is described on the Government website http://www.statistics.gov.uk/STATBASE/ssdataset.asp?vlnk=7485 as "It measures the average change, from month to month, in the prices of the goods and services purchased by most households in the United Kingdom." and so it is reasonable to use RPI figures when planning your finances. So what is the effect of inflation? Let me give you an example. I have seen the following quoted;

"If I have £500,000 saved at retirement, an investment return of 5% will give me £25,000 a year which is sufficient for my needs, and when I die I will leave the £500,000 to my kids."

Now this looks fine at first glance. But if inflation is running at just 4% a year and the first year's income is then increased by 4% and then each year thereafter, the whole £500,000 will have been used up after just 23 years. Every penny - gone! Retire at age 60 on this basis and at age 83 you have NOTHING LEFT.

The example above is based on just 4% inflation. Just imagine what the effect would be if inflation was higher and it most likely will be for you once you retire.

The RPI is based on a basket of goods including food, gas, electricity, council tax, petrol, flat screen televisions, digital cameras, MP3 players and satellite navigation etc, a wide range of goods. Some of these items are increasing by more than the average rate of inflation and some goods are actually falling in price. This mix brings us to an average rate of about 4%-4.5%. When you retire, much of your income will be spent on those necessities which nowadays are increasing by more than the RPI figure and less of your income on digital cameras, plasma televisions etc which are bringing down the RPI average.  Just imagine how quickly the £500,000 in the example above would disappear if inflation was higher than 4%.

There is a handy calculator on the Government site at http://www.statistics.gov.uk/StatBase/Product.asp?vlnk=14762 which enables you to calculate your own personal inflation rate and I urge you to test it for yourself. One retired client of mine came back to me with a figure of 8%.

One last tip. Use the number 72 to see the effect of inflation. Divide 72 by an assumed rate of inflation and the answer is the number of years over which a sum will gradually halve in value. For example, with an assumed rate of 4%, a sum will halve in value over 18 years. At 7.2% inflation, it will take just 10 years. So if you start out with a level pension of £24,000 a year and experience 7.2% inflation, after ten years it will be worth only £12,000 and ten years after that, only £6,000 a year. With many of us expected to live well into our eighties, it doesn't bear thinking about. 

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