Saturday, June 25, 2022

How pension payments are affected by inflation, from final pay to auto-enrollment to the state

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With inflation skyrocketing at nine percent in the 12 months to April, we show how the situation is affecting different types of pension payments

Wage growth is a driver of inflation, and those not in the labor market may find that higher living costs are already weighing on their more stable income. Here we show how inflation affects different types of pension payments.

With inflation soaring by 9 percent in the 12 months to April – the highest level in 40 years – and the Consumer Price Index (CPI), its main metric, expected to rise over 10 percent by the fall, many consumers are feeling the pain higher Cost of living, especially pensioners.

Company final salary schemes provide a fixed retirement income based on your years of service and salary at retirement. Kay Ingram, a licensed financial planner and pension advisor, said those participating in this type of scheme should enjoy some inflation protection through a guaranteed annual income.

Meanwhile, those with public sector pensions will have their pensions increased by the full CPI percentage. Private-sector retirees on a terminal salary scheme benefit from a CPI increase capped at either 5 percent or 2.5 percent, meaning their income will feel the effects of inflation more.

Ms. Ingram urged anyone who is unsure how their pension will match the CPI to ask the administrator or trustee of the pension scheme. “There may be different increases for each length of service.” She added that if your pension system was bailed out by the Pension Protection Fund, annual increases apply only to pensions earned after 1998 and on CPI of up to 2.5 percent per year are limited.

Those receiving a state pension can expect their income to increase each April by the higher of the previous September’s CPI inflation measure, the national average income increase, or 2.5 percent. Ms Ingram said: “Inflation is expected to remain above nine per cent in September due to the second hike in the energy price cap. Job vacancies are outstripping unemployment, which will likely lead to wage increases, so the state pension increase is expected to be more than the 3.1 percent granted
this April.”

The basic state pension, paid to people who reached state pension age before 6 April 2016, increased by £4.25 per week. Meanwhile, the flat-rate state pension, which will also be paid to those over legal retirement age from 6 April 2016, has been increased by £5.55 a week. This is an increase from £179.60 to £185.15 per week.

But Tom Selby, head of pension policy at investment platform AJ Bell, pointed out: “CPI rose 6.2% in February and is expected to rise even more this year, meaning the increase is 3.1% will actually feel like a cut for millions of retirees.” If the pension triple lock had been retained, pensions would have risen by 8.3 percent.

If you pay into a company pension, a higher salary automatically leads to higher contribution payments. Ms Ingram said: “Only workers earning more than £10,000 a year are automatically entitled to an employer’s pension contribution. If a wage increase pushes incomes above that, employer-sponsored pension savings and tax breaks could benefit many part-time and low-income workers.”

As of April 2020, almost eight in ten UK workers were paying into a pension, although the pandemic meant some had frozen their contributions. Someone who is automatically enrolled contributes at least eight percent of qualifying income. Here the employer pays three percent, the employee five percent and one percent tax relief.

Paying more does not guarantee that the pension will outperform inflation. Alice Haine, personal finance analyst at investment platform Bestinvest DIY, explained that while pension money is invested, it has a better chance of beating inflation over time. She said: “Pensions tend to grow faster than inflation: Between 2015 and 2019, pension funds grew an average of 7.4 percent per year – much faster than inflation of 1.53 percent over the same period.

“While we are in this era of much higher inflation, the good news here is that fighting inflation is one of the top considerations for fund managers alongside overall growth. Although of course there is no guarantee that they will be successful.”

Ms Haine is urging younger savers to increase their pension contributions now, either by increasing the amount they pay into their occupational pension or by opening a self-invested personal pension, as it will give their money time to weather the ravages of inflation. Younger investors can afford to take on more risk, she said, meaning they can erase losses along the way.

“The worst mistake investors make is holding too much cash — while three to six months of emergency cash in a high-yield savings account is considered wise to prepare for unexpected expenses, anything beyond that will erode its value.”

It might pay off for you to defer your retirement if you can. Pensions adviser Kay Ingram said those who are eligible for a terminal salary pension but are not yet receiving it could benefit from higher inflation.

“These pensions must be increased each year before they begin by a CPI of up to 5 percent for service prior to 2009 and a CPI of up to 2.5 percent for later years.”

That average increase is across the service, she said. “This means that higher inflation now translates into increases for the years when inflation was lower and so can top up the eventual pension payable. Those contemplating early retirement should pause to think as this could lose the full impact of the applicable inflation boost.”

XPS Pensions Group’s DB:UK Funding Watch research found that with an inflation rate of 10 per cent, delaying early retirement by one year could amount to £400 a year. Charlotte Jones, senior consultant at XPS Pensions Group, said: “As inflation continues to rise, we could see more retirees making the difficult decision of postponing their retirement to boost their future income in this hyper-inflationary environment.

“This could have a positive impact on their retirement income, as the impact of caps on pension increases tends to be greater once pensions are paid. Our calculations show that the impact of the caps could improve the income of the average pensioner by £400 a year if they can afford to defer their pension for a year.”

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