Ideally, you’ll spend decades contributing towards your retirement savings. This investment, like any other, needs to be protected from the effects of inflation.
We have a look at what inflation is, and we consider how it can impact both your retirement savings and your retirement annuity.
Tip: A tax-free investment could be a useful addition to your retirement portfolio.
What is inflation?
To illustrate inflation, Pathutshedzo Mabogo, acting joint chief investment officer at Eskom Pension and Provident Fund, suggests thinking back to a time when you could fill up your petrol tank for R500.
Today, it will cost you a lot more for the same amount of petrol, and Mabogo explains that this is what inflation is – the rate at which the prices of goods and services increase.
“While inflation does not reduce the money you have saved, it does reduce what you can buy with it. As the cost of living increases, you will be able to buy less with the money you have,” says Mabogo.
By incorporating inflation in your investment planning, you will protect your money from losing its potency.
The impact of inflation on retirement savings
Chris Eddy, head of investments at 10X Investments, says that retirement plans will typically make assumptions about future investment returns and future expenses, specifically:
- What the retirement liability (or the savings goal) will be, and
- the monthly savings required to achieve this goal.
This calculation, which is known as the retirement liability calculation, will depend on the income you need during retirement, and your current lifestyle, which is based on your current income.
“Future inflation is unknown, but it’s expected to affect both your future income and expense growth, so your income at retirement and your retirement goal will grow roughly equally with inflation,” says Eddy.
He adds that, since future inflation is unknown, nominal investment returns are also unknown. But he explains that there are strong historical trends that can make a reasonable prediction in this regard.
“With this in mind, it becomes possible to model a retirement plan that ignores future inflation, by stripping it out of future income, future expenses, and future returns,” says Eddy.
What does inflation do to your retirement annuity?
After spending a good portion of your life’s savings towards your retirement, you will finally hit the right age to settle down and enjoy the rewards.
In order to avoid disappointment, says Meeta Gosai, head of income solutions at Momentum Corporate, it’s essential to understand the impact of inflation on your annuity income.
“This is the regular income you receive during retirement, which is paid from the two-thirds of your retirement savings that you spent on an annuity,” says Gosai.
He sets out an example of a fixed annuity to demonstrate. His example pays a retirement income of R10,000 per month.
“Since the annuity amount is fixed and guaranteed, the income of R10,000 per month remains permanently unchanged,” says Gosai.
He explains that if the annual inflation rate is 4.5%, which is the mid-point of the South African inflation target range, then a basket of goods that was priced at R10,000 last year will now cost you R10,450.
“This shows how inflation reduces the purchasing power of money, because more money is needed – an extra R450 – to buy the same items,” says Gosai.
He warns that the risk of inflation “eating up” the purchasing power of your retirement income becomes greater over longer periods of time.
“Using the same example, over 10 years the cost of the same basket of goods will increase from R10,000 to R15,530 – an increase of 55%,” says Gosai.
“If you receive a fixed annuity of R10,000 per month, you will find that the level of income does not move in line with the cost of goods and, over time, your monthly income buys a lot less than it could buy 10 years ago.”
To avoid this situation, Gosai suggests considering one of the following alternatives:
- Guaranteed inflation-linked annuity: If you opt for this annuity, your retirement income will increase in line with inflation. In our example, the monthly annuity will increase to R10,450 after one year and to R15,530 after ten years, so you will be able to buy the same goods and maintain the same standard of living.
- With-Profit Annuity: The annuity increases target a percentage of inflation, but the increase will depend on the performance of the underlying investment portfolio. Increases may be more or less than inflation in a given year, but decreases will not be enacted. This cheaper alternative to a guaranteed inflation-linked annuity reduces the effects of inflation that are felt with a fixed-guaranteed annuity.
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