The corroding effect of inflation in retirement

Inflation is like rust on a car. At first, you might not notice it. It starts as a tiny spot, often hidden away. Over time, it slowly spreads, and by the time you see it, the damage is more extensive than you realised. Just like inflation, rust can creep up on you, causing significant issues if not addressed early.

With inflation still above 5%, those on the verge of retiring need to consider ways to protect their post-retirement income against it. While inflation does not reduce the money you’ve saved for retirement, it manifests itself through reduced spending power.  Its impact can seem negligible over the short term, but is profound over the long run, making it crucial to factor inflation into retirement planning.   

Inflation was at the forefront of people’s minds last year when it breached the Reserve Bank’s upper target of 6% several times, leading to large increases in the cost of goods and services across the board.  While inflation has softened somewhat this year, it should never be forgotten when planning for retirement.

The official rate of inflation, the Consumer Price Index or CPI, is based on the average increase in the cost of acquiring a fixed basket of goods and services.  But this doesn’t mean all costs will go up by this amount: some costs, such as medical costs, could increase by significantly more than CPI. 

As a result, depending on the goods and services they consume, different people experience inflation in different ways.  This is particularly true as they get older and need to use more of their monthly budget for healthcare costs.

A simple way to make inflation tangible is to use a loaf of bread.  If it costs R20 in 2024, and inflation is at 5% for the next 30 years, it will cost R86 in 2054. If inflation is 6% for the next 30 years, the same loaf of bread will cost R115.  This also shows the difference that just 1% can make!

Recent results from our ongoing tracking study Just Retirement Insights showed that 84% of respondents want their retirement income to keep pace with inflation each year.  This shows an astute awareness that inflation can ravage the buying power of their retirement income.

One way to ensure this doesn’t happen is to purchase an inflation-linked annuity at retirement, which pays a monthly income adjusted annually to keep pace with CPI. However, an inflation-linked annuity will not necessarily provide enough purchasing power to protect retirees from medical or lifestyle inflation, which means they could suffer a real loss year on year.  Furthermore, these annuities are more costly than others.

Another option is a fixed escalation annuity, which pays retirees a predetermined fixed percentage increase each year.  At the point of purchase, retirees ‘buy’ an income escalation of a choice typically between 1% and 10%.  Currently, many such annuities are being sold with increases of 5% or 6% per year. Retirees need to remember, however, that in this instance they are essentially ‘betting’ that CPI will be around 5% or 6% over the next 30 years, which it may or may not be.

While fixed escalation annuities are often easier to understand and may be the best choice for your financial situation, it is important to be cognisant of the fact that annual inflation may be higher than the level of increases in income chosen in any given year.

While future inflation is difficult to predict accurately, one way to gauge how it will behave going forward is to look at how it has behaved in the past.  SA inflation has been below 5% for only 10 calendar years since 2000. While we know history is not a predictor of the future, securing a fixed income annuity with an annual increase of 5%, for example, may not provide sufficient protection every year in retirement.

Current thinking among investment professionals is that inflation will stay ‘higher for longer’ and not reduce substantially over the near term.  The SA Reserve Bank would like CPI to stabilise at 4.5%, which is the mid-point of its target band, and expects it to end 2024 at 4.9%. What this tells retirees is that opting for a fixed escalation rate of 5% - 6% might offer sufficient protection going forward, but there are no guarantees, particularly over a retirement period that could last 30 years. 

Just SA believes that there is a better way of securing a retirement income that aims to keep pace with inflation, which is why they focus on annuity solutions with increases linked to the investment performance of a range of balanced funds.

But, given that starting incomes for these investment-linked options have been lower than their fixed escalation counterparts, with-profit annuity options have been less popular of late. So in another innovative move to ensure retirees get a better later life, Just SA introduced a feature that gives retirees a much higher starting income now, in exchange for investment performance that is capped at 15% over a six-year period in the future. This means that these investment-linked options – which one would expect to provide better inflation protection over the long term – once again offer attractive starting incomes, with a better chance of beating inflation in the long term.