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How to protect your retirement savings from inflation

Here we outline three ways to protect your retirement income and savings from high inflation.

How to protect your retirement savings from inflation

Everyone is being affected by high inflation right now, but those of you in retirement might be feeling it particularly hard.

The same can be said for anyone approaching retirement. We conducted research earlier this year and found that more than half (54%) of people aged 50 and over fear they won’t have enough income to survive financially when they stop working due to the rising cost of living.

Knowing how to use your pension funds to draw an income for life isn’t easy.

With inflation currently at 3.9%, the decisions facing those either in retirement or quickly approaching it are even tougher – you have a tricky balance to strike.

If you don’t draw enough income, you may not be able to meet today’s costs. Conversely, drawing too much increases the risk of running out of money down the line.

Although inflation won't stay high forever, things could get worse before they get better. The good news is there are steps you can take to protect your retirement income. Here we outline three of them.

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1. Consider an annuity

Annuities, which are where you trade some or all your retirement pot for a guaranteed income, have fallen out of favour in recent years.

This is due to a couple of factors. The first is that pension freedoms - introduced in 2016 - allow you to draw from your retirement funds as and when you please.

Otherwise known as income drawdown, this has become the preferred choice for retirees.

Over the last few years, annuities were also out of favour as a combination of increasing life expectancy and low interest rates (at the time) resulted in tumbling gilt yields and pushed annuity rates downwards.

An annuity provides a fixed, guaranteed income for life, which can offer some much-treasured security when prices are rising fast. And the level of income you can receive has jumped sharply recently.

Since December 2021, interest rates have marched upward, rising from 0.1% to 5.25%. Annuity rates have followed suit.

One of the main drawbacks of annuities is that they typically do not provide any lump sum death benefits. In most cases, your annuity dies with you.

Another is that the terms you chose at the outset are fixed for the rest of your life - you can't change them. But this could be a positive if the certainty of future income is important to you.

To offer protection from future inflation, it's worth considering an inflation-linked annuity.

This is where the annuity payments increase each year in line with rising costs.

The downside of opting for an inflation-linked annuity over a level one is that your starting payments will be significantly lower. However, with a level annuity, your income will be vulnerable to future price rises, so it's crucial to choose carefully.

It’s equally important to shop around – some providers will pay you more income than others.

A further consideration is an enhanced or impaired life annuity, which takes into account your health and lifestyle choices.

If your life expectancy is shorter than average, you may be offered a higher income. In some cases, you can get up to 40% more.

  1. Adopt a bucket strategy

Spreading your money across different asset types – such as cash, shares and bonds - is a great way of reducing the amount of risk you take. It can also be an effective way of protecting your retirement pot from inflation.

For those of you using income drawdown for some or all of your funds, one way of achieving diversification is by using a bucket strategy.

With this approach, you divvy up your pot into a few segments determined by when you plan to draw income from them. Three ‘buckets’ is a useful rule of thumb, but you can choose more to suit your personal retirement goals.

For each segment, you designate an investment timeframe. For instance:

  • Bucket one: first three years
  • Bucket two: years three to 10
  • Bucket three: Over 10 years

The first bucket aims to cover any immediate and short-term needs, and so will typically be invested in cash.

While growth potential is low, and it will likely suffer at the hands of inflation, you have the peace of mind that it will not be affected if stock markets were to fall.

As you have no plans to dip into bucket two for at least three years, you can afford to invest in assets which offer a better chance of beating inflation such as government and corporate bonds, and also stocks and shares. 

Bucket three has the longest investment time horizon, meaning you can afford to take the greatest risk. As such, stocks, shares and property tend to be preferred for this segment.

Maintenance is an important factor here. You should frequently review whether the buckets are meeting your short-and-long-term retirement goals.

As pension funds are exempt from capital gains tax (CGT) you can move money between buckets without HMRC taking a chunk. 

The idea behind this strategy is to avoid drawing income from poorly performing assets.

Selling shares when stock markets are low can turn paper losses into real ones, while also affecting how quickly your retirement portfolio grows once markets rebound. In the worst-case scenario, you could deplete funds too soon.

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3. Turn to tax-free income investments

Pensions offer several tax benefits, but tax-free income isn’t one of them.

Any income you draw from your pensions will be taxed at your marginal rate. For annual income of between £12,571 and £50,270, you’ll pay 20% with anything above taxed at either 40% or 45%.

Paying tax can be painful, particularly during periods of high inflation when every penny counts.

If you have investments outside your pensions that provide tax-free income, such as individual saving accounts (ISA), it might be worth pausing pension withdrawals and drawing from these instead, at least until inflation stabilises.

Even if you have stocks and shares held outside of an ISA, there are some tax advantages available to you.

Every year you can sell £6,000 of assets without paying any CGT. This is called the annual exemption. As everyone gets one, married couples can sell £12,000 in shares every year without paying a penny in CGT.

Furthermore, you can receive £1,000 in dividends every year without paying any income tax.

There can be additional benefits from drawing money outside your pension from a tax perspective.

If you were to die before the age of 75, any money in your pension can be passed to your beneficiaries free from tax. Funds in your ISA or wider investment portfolio, however, would potentially give rise to an inheritance tax charge.

Need some help?

While the strategies outlined above can prove effective, making the wrong decisions can harm the chances of your pot lasting the distance. In addition, as everyone's retirement income needs are unique, it's important to make sure your strategy is personalised.

This is where expert advice can make a difference.

A regulated financial adviser can review your current retirement provision against your goals, and recommend a personalised strategy to help you achieve them.

Click below to match with a retirement expert today.

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About the author
Craig Rickman is senior content writer at unbiased.co.uk. He has been writing about personal finance and wealth management since 2016, including four years as a journalist at the Financial Times Group. Prior to this, Craig spent eight years working as a regulated financial adviser. He holds the CII level 4 Diploma in Financial Planning.