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28th October, 2022
These days, it’s hard to escape the effects of inflation. It’s almost always front-page news and we’re feeling it constantly in real terms. Today’s figures are ones we haven’t witnessed in Ireland since the 1980s with 8.7% inflation recorded in August 2022. It’s natural to focus on the short-term impact of inflation as we feel it every day in our trips to the supermarket or paying household bills. However, it’s important to look further ahead, especially when it comes to your pension. For many people, outside of the family home, their pension is likely to be their largest asset.
If you were to retire today with a pension fund of €1m, you would receive a lump sum of €250,000 and the balance of €750,000 would transfer to an Approved Retirement Fund which, subject to investment returns and an annual withdrawal rate of 4%, would provide you with an income of €30,000 per annum in retirement.
Suppose you were to start saving today with the objective of reaching that same €1m fund in 20 years. If inflation was 2.2%, that same €1m fund in 20 years’ time would feel like €650,000 in today’s terms or €19,500 in income in retirement.
However, if inflation was to persist at 4% per annum for the next 20 years, in real terms your €1m fund would be more than halved with the income in retirement reduced to just €13,500. This is the real impact inflation has on your pension. It erodes the purchasing power of your money, which may well make your retirement plans unachievable.
With an asset as significant as your pension, oversights now could result in missing out in decades of compounding. This will have a significantly negative impact on the value of your pension fund at retirement.
The biggest contributors to the value of your pension fund will be your contribution rate, investment strategy and the charges that apply to your pension fund.
Let’s look at how you can influence each of these:
While you will need to set aside enough cash to meet your short-term needs, contributing any excess cash to your pension is the most efficient way to save for the future and should remain a priority. This is due to the tax reliefs on contributions and tax-free investment growth that apply to the investments made within the pension fund.
Tax relief is granted on personal contributions at your marginal rate as outlined in Figure 1 below. Ultimately for higher rate taxpayers for every €100 you contribute to a pension you receive €40 back in tax relief. –
Figure 1: Maximum personal contributions allowable for tax relief
Simply, contributing regularly to your pension, however, isn’t enough. The crucial part is to get your contributions to work for you, by investing in a suitable investment strategy in line with your risk tolerance and time horizon.
The biggest losers in an inflationary environment are deposit holders – with deposit rates being negligible, they see the purchasing power of their cash fall as it’s not generating a return while prices rise. Investing these contributions in equities, property and other real assets can protect your pension from inflation and generate real returns over a sustained period of time.
While 2022 has been a turbulent time for the investment markets, investing today when asset prices are lower could provide greater returns in the future. Given pensions savings are typically a long-term investment, time is on your side to weather any short term volatility in the markets. Due to the tax relief on contributions, the initial investment is already 40% ahead.
Figure 2 shows the impact of doing nothing, investing personally, and investing your surplus cash in a pension.
Figure 2: Value of €28,750 in 20 years’ time, under three investment strategies:
Growth rate on investments of 5%, and a discount (inflation) rate of 2.2%.
Fund exit tax of 41% applies to personal investment accounts and is deducted annually.
For pension scenario tax relief of €11,500 is invested in a personal investment account
Charges will have a significant impact on the final value of your pension fund throughout its lifetime. The headline rate is generally quoted as the annual management fee, but what about the other associated charges, and in some case avoidable charges, that could apply to your pension such as allocation rates, commissions, custody charges, bid/offer spreads, exit penalties and fund manager charges? It’s important to have a clear understanding of all these charges, how they impact your pension fund and whether they provide value for money.
While inflation is at levels that haven’t been seen in a generation, it is expected to come down to more manageable levels in the near term. As this new inflationary environment is going to be with us into the future, it’s really important to take control of the situation. Carrying out regular reviews of your overall goals and financial position with your financial adviser will safeguard against unnecessary leakages and help make your retirement plans a reality.
Contact Davy at email@example.com or request a call at davy.ie/ how-do-i-protect-my-pension-against-inflation.html
WARNING: These figures are estimates only. They are not a reliable guide to the future performance of your investment
Warning: The information in this article does not purport to be financial advice and does not consider the investment objectives, knowledge and experience or financial situation of any particular person. You should seek advice in the context of your own personal circumstances prior to making any financial or investment decision from your own adviser. There are risks associated with putting a financial life plan in place. There is no guarantee that by having a financial life plan in place, you will meet your objective. The tax information contained in this article is based on Davy’s current understanding of the tax legislation in Ireland and the Revenue interpretation thereof. It is provided by way of general guidance only and is neither exhaustive nor definitive and is subject to change without notice. It is not a substitute for professional advice. You should consult your tax adviser about the rules that apply in your individual circumstances