How to protect your retirement savings from inflation

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

While prices certainly aren’t rising as fast as they were in recent years, with inflation reaching a 41-year high of 11.1% in October 2022, they haven’t fallen either, and households across the UK have been forced to adjust to higher costs.

This can be a particular worry for those in or approaching retirement as it means they will have to stretch their pension further than anticipated.

According to previous research by Unbiased, over half (54%) of people aged 50 and over feared they wouldn’t have enough income to survive financially when they stopped working due to higher costs.

Knowing how to use your pension funds to draw an income for life isn’t easy. The decisions facing those either in retirement or quickly approaching it are tough, as 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.

Adding to the confusion is that we don't know what will happen to inflation in the future.

However, there are steps you can take to protect your pot from inflation.

Here, we outline three of them.

1. Consider an annuity

The combination of increased pension flexibility (following the introduction of pension freedoms in 2015) and rock-bottom interest rates throughout the pandemic has meant that annuities have, until recently, fallen out of favour with retirees.

More flexible income drawdown has instead become the preferred option.

However, following rising interest rates since December 2021, annuities have enjoyed something of a comeback.

Annuities provide a fixed, guaranteed income for life or a specific period, which can offer the peace of mind that you won’t run out of money.

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

Another is the terms you choose at the outset are fixed for the rest of your life or fixed period, so you can't change them. However, this could be positive if the certainty of future income is important to you.

It is possible to buy inflation-linked annuities, where payments rise each year in line with rising costs. However, the catch is that your payments would start considerably lower than they would be had you opted for a level annuity that doesn’t rise.

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

If you smoke or have health problems, you may qualify for an enhanced annuity (also known as an ‘impaired life annuity’). These pay a higher rate to people who are likely to have a reduced life expectancy.

2. 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 investments 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.

It could mean you need to reduce the income you take, or, in a worst-case scenario, you could run out of money.

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 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 an individual savings account (ISA), it might be worth pausing pension withdrawals and drawing from these instead if inflation is high.

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

Every year, you can sell £3,000 of assets without paying any CGT, which is the annual exemption. As transfers between spouses and civil partners are tax-free, married couples can sell £6,000 in shares between them every year without paying a penny in CGT.

Additionally, you can receive £500 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 of income tax.

Get expert financial advice 

While the strategies outlined above can be effective in protecting your retirement income against inflation, making the wrong decisions can jeopardise the longevity of your retirement pot.

It’s crucial to personalise your strategy, as everyone's retirement income needs are unique.

Whether you choose the security of an annuity, the flexibility of a bucket strategy, or the tax benefits of alternative income sources, taking proactive steps and staying informed can help you navigate the economic landscape and enjoy a more secure financial future.

This is where expert advice can make a difference.

Let Unbiased match you with a financial adviser for expert financial advice tailored to your unique retirement needs, ensuring your income strategy is both effective and sustainable in the face of inflation.