As the COVID-19 vaccination programs are gathering pace, we are beginning to see the world cautiously returning back to a level of normality. However, the reopening of the economy also raises the possibility that, after many years of very low or negative levels, inflation might soon start rising.
What is inflation?
Simply put, inflation is the rate at which the prices of goods and services in an economy increase over time. It can also be thought as the reduction in the value of money, as consumers are able to purchase less than they previously could with the same amount of money. For example, a rate of 4% of inflation per year would mean that to buy a cup of coffee which today costs €2.00, you will be paying €3.60 in 15 years (1.8 times more) and a staggering €6.50 in 30 years (3.25 times more).
Why is inflation expected to rise?
There are a few reasons to explain this rise in inflation expectations.
Stronger demand for goods and services
As more people are vaccinated and economies begin to reopen, we expect to see a stronger demand for goods and services from consumers who were unable to spend during the extended periods of lockdown and have instead built up their savings. Unemployment is also expected to fall as economic activity increases and businesses recommence their operations, further boosting spending and pushing inflation higher.
Reopening of closed sectors
A strong and sudden increase in demand may emerge from sectors that were forced to completely shut down due to the pandemic, such as the hospitality industry, which could lead to higher prices, as it may take some time for supply to go back to normal capacity.
Growth in money supply
Another driver of higher inflation is the extraordinary expansion of money supply into the economies due to the record levels of government and central bank stimulus in the wake of the pandemic. Growth in money supply typically leads to a rise in inflation as the money makes its way into the economy and leads to an increase in economic activity.
How does inflation impact your pension savings?
The impact of inflation may seem small in the short term, but over longer periods it can drastically erode the purchasing power of savings and investments. This is especially true of cash. The following chart shows how much €20,000 would be worth over the course of 20 years under different inflation rates if it does not earn any interest. After 20 years with a consistent inflation at 2%, €20,000 would only be able to buy €13,352 worth of the things that it could have originally bought. With inflation at 4%, €20,000 would shrink to €8,840 and with inflation at 6%, its purchasing power would be just €5,802.
Even when money is earning some interest or growing at a fixed rate, if inflation is higher than the interest rate, the money’s purchasing power will diminish over time. As a result, portfolios with high levels of cash and fixed income are particularly vulnerable to rising inflation, especially given how expensive these assets already are.
How can you protect your pension savings against inflation?
In order to maintain the purchasing power of your pension savings and potentially see it grow over the long run, you need to ensure that the rate of return on your savings is greater than inflation. It is important that you consider your investment horizon and you regularly monitor the performance of your pension portfolio. For longer time horizons, cash will typically fail to beat the rate of inflation and you may need to consider alternative strategies to ensure that your savings are offsetting inflation over the long run, as long as these are also consistent with your risk profile.
While you cannot completely avoid the effects of inflation, a sound investment strategy as part of your financial plan can guard your savings and investments against inflation and help maintain your purchasing power and standard of living in retirement.