How does inflation affect pensions?

We explain how inflation can impact the state pension, defined benefit pensions and defined contribution pensions.

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By

Ceri Stanaway

Updated

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The government sets an annual inflation target of 2%, which is intended to help keep the economy stable. However, national and global events can sometimes play havoc with this figure. For most of 2022, inflation has considerably exceeded the government target. Factors playing into this include the coronavirus pandemic and the war in Ukraine. Both of these have affected the supply – and therefore the cost – of goods and services. Inflation plays an important part in the value of our pensions, before and after we start drawing them. Here’s how inflation can affect state and private pensions.

What is inflation?

Inflation is the rate at which the cost of buying goods and services rises over time. It affects how much “stuff” you can buy with the same amount of money.

Let’s say that on a given date, a loaf of bread cost £1. You can hand over your shiny pound coin (or, these days, usually tap a card or mobile). The retailer will give you the loaf in return.

Roll on another year, and bread inflation over the previous year has been 5%. A pound coin is still only worth a pound, but an identical loaf would now cost £1.05. So you’d have to hand over a 5p coin too.

How is inflation measured?

Official measures of inflation are designed to reflect overall increases (or, less commonly, decreases) in the cost of living. Every month, the Office of National Statistics (ONS) checks the prices of a “basket” of more than 700 commonly bought goods and services.

The official figure that’s usually used when you read about “inflation” is the Consumer Prices Index (CPI). You may also come across the acronyms “CPIH” and “RPI”.

  • CPI (the Consumer Prices Index) measures the speed at which the prices of everyday goods and services rise or fall. It includes everything from groceries, clothing and energy bills to entertainment, holidays and transport. Importantly, it excludes owner-occupiers’ housing costs.
  • CPIH (the Consumer Prices Index including owner-occupiers’ housing costs) includes everything that’s part of the CPI, plus owner-occupiers’ housing costs. These are the housing services associated with owning, maintaining and living in one’s own home. It doesn’t include the costs of purchasing a house. It also doesn’t specifically include mortgage costs, instead using a measure called “rental equivalence”. This is how much rent the householder would pay for an equivalent property and is regarded as a better measure of inflation.
  • RPI (the Retail Prices Index) is the oldest measure of inflation. It includes mortgage payments and is strongly influenced by house prices and interest rates. It has historically been higher than the CPI (and the CPIH). It’s now rarely referred to as it’s been deemed to be an inadequate reflection of average inflation. However, it remains important from a pension perspective as some pension increases are linked to the RPI. It is likely that the method for calculating the RPI will change at some point to be more in line with how the CPIH is calculated.

Does the state pension rise with inflation?

Potentially, yes. Under a system known as the state pension “triple lock”, the amount of state pension payable rises every April in line with the highest of 1 of 3 measures:

  • The Consumer Price Index (CPI) in the previous September
  • Average earnings
  • 2.5%.

The CPI in September 2022 was 10.1% (higher than the other two measures). So, at the time of writing, from April 2023, the new state pension is planned to increase from £185.15 to a week. The basic state pension is due to increase from £141.85 to a week.

These increases will apply whether you’re already receiving your state pension or not. For more on the link between inflation and the state pension, visit our full guide on the state pension triple lock.

How does inflation affect defined benefit pensions?

Defined benefit pensions (sometimes known as final salary pensions) are a type of workplace pension scheme that pays out a fixed, regular income when you retire. How much you get depends on your salary and how long you worked for a company. You’ll typically get more for the same level of contribution than you would if you bought an annuity with a defined contribution pension.

For this reason alone, defined benefit pensions are well worth having. But they’re becoming increasingly rare outside of the public sector.

Another benefit of defined benefit pensions is that the income you receive (or will eventually receive, if you haven’t retired yet) is usually adjusted annually in line with inflation. Some private sector schemes even use RPI, which – as we’ve explained above – is typically the highest of the 3 official ways of measuring inflation. Public sector schemes (such as the Teachers’ Pension Scheme) switched to CPI some time ago.

So, in theory at least, defined benefit pension income should keep up with the cost of living. There’s a big caveat to this, though, in the form of inflation caps.

The impact of inflation caps

While some defined benefit pensions may not place any restrictions on their inflation-linking, the majority of private sector pensions place a cap on increases. A cap between 3% and 5% is typical. Some schemes may set different levels.

Since 1992, annual inflation has only topped 3% in a handful of years – and even then, typically only by a small amount. This means that, even for pensions where the inflation linking is capped at fairly low levels, scheme members won’t have been short-changed by too much.

Roll on the high-inflation era of 2022, and the picture is potentially less rosy. As of September 2022 (the month which pension providers often use as their benchmark), CPI was 10.1%, while RPI sat at 12.6%, with few experts anticipating a dramatic fall over the next few months.

In periods of such high inflation, defined benefit pension holders with a cap on increases may find that their income no longer keeps up with inflation.

Scheme managers often have the ability to ignore the cap and award discretionary increases. However, there’s no guarantee of this.

How does inflation affect the value of defined contribution pension pots?

Unlike defined benefit pensions, defined contribution pensions don’t guarantee you a certain level of income when you retire. Instead, your contributions are invested into a pension pot. The idea is that investment returns will grow the size of your pot over time, so that – when you start drawing on your pension – you’ve accumulated enough to fund your retirement.

Assuming you contribute enough in the first place (and the question of how much is “enough” is a big question in and of itself), the success of this approach will depend on at least 2 crucial factors:

  1. The returns you receive on your investments. The stock market has been fairly volatile over recent years, thanks to events such as the pandemic, the war in Ukraine and a turbulent political environment in the UK, which has had an inevitable impact on some pension investment returns.
  2. High inflation eroding the value of those returns. Historically, pensions have grown faster than inflation. But, during a period of high inflation, pension investments have to work even harder to even match – let alone outpace – inflation.

Plus, because most people pay into their pension based on a percentage of their salary, then unless their salary rises in line with inflation, the real-terms value of the contributions they make will also be lower.

Should I stop paying into a pension if inflation is high?

If you’re paying into a defined contribution pension during a period of high inflation, it’s important not to panic. If you can possibly afford to, maintain your contributions. The tax breaks on offer still make pensions the best way to save for retirement for most people. Plus, the current period of high inflation is unlikely to last forever, and the time will come (hopefully before too long) when investment returns once again outpace inflation. Pensions are a long game, with any short-term economic wobbles usually balanced out in the long run.

How does inflation affect pension drawdown income?

Inflation doesn’t only affect the eventual value of your pension while you’re making contributions. It can also affect how long the pot you’ve built up will last when you stop contributing and start drawing an income.

One of the options you can choose to receive an income when you retire is known as pension drawdown. With this approach, your pension funds stay invested and you gradually withdraw an income. You can adjust the amount you take as required.

Most people live for decades after they retire, so their pension has to last a long time. One of the potential benefits of income drawdown is that, by keeping the unused part of your pot invested, it has the chance to carry on growing and help your pension last longer.

Even if you plan for this carefully, the best-laid plans can be scuppered by high inflation, even if investment returns stay steady. Let’s say you plan to withdraw an income of £10,000 a year, to top up your state pension income. Even with inflation at 2%, you’d need to increase your withdrawals by this amount each year to keep up with increases in the cost of living.

It doesn’t take a maths genius to work out that in periods of high inflation, you’ll need to make bigger withdrawals in order to keep up with living costs. This means your pension won’t last as long – especially if inflation levels are higher than the potential returns on your investments.

One solution is to make lifestyle sacrifices so that you can avoid having to withdraw ever-larger amounts. Provided high inflation doesn’t last forever, these sacrifices should only be temporary. It could also be a good idea to talk to a professional financial adviser, who may be able to recommend ways to preserve the value of your pension pot.

Does annuity income rise in line with inflation?

Instead of (or alongside) going into pension drawdown with a defined contribution pension pot, you can opt to buy an annuity. An annuity is an insurance product that offers an annual income – either for the rest of your life or for a fixed period – in exchange for a lump sum from your defined contribution pension savings.

With standard, level annuities, the income you receive does not increase in line with inflation. This means that, in periods of high inflation, the real value of that income could take a substantial hit. If you want your annuity income to be protected from rising living costs, you need to opt for an escalating annuity. These pay out a little more each year than the previous year. You can choose for an escalating annuity to rise by a certain percentage or have it rise with inflation.

Be aware, though, that escalating annuities tend to offer lower initial income than level annuities for the same lump sum. This means that it may take some time before you receive more income from an escalating annuity than you would get from a level annuity.

Once you’ve bought a certain type of annuity, you can’t change your mind. Take a look at the pros and cons of annuities, and the different types available, in our full annuities explainer.

Is high inflation bad for pensions?

Zoe Stabler

Finder expert Zoe Stabler answers

How significantly your pension is likely to be affected by inflation depends on the type of pension you have, and how far away you are from retirement. Or, indeed, whether you’re already retired.

In principle, the state pension should be protected from the impact of high inflation because of the triple lock. But this is provided that the triple lock remains in place. If the government decides to ditch the CPI-linked prong of the triple lock, then pensioners that rely on the state pension for most of their income may be particularly vulnerable. This is not least because a proportionately high amount of pensioner income goes on energy bills – which are at a historic high as of late 2022.

Private pensions are potentially vulnerable to the effects of inflation too. While many defined benefit pensions have inflation-linked increases built in, these increases are often capped. And defined contribution pension returns may struggle to keep up with the cost of living during periods of high inflation.

All that said, if you’re still some time away from retirement, there’s probably enough time for things to settle down and for defined contribution pensions to recover. If you’re approaching retirement – or already in pension drawdown – and you’re worried about safeguarding the value of your pension, it could be worth seeking professional financial advice.

Bottom line

When the cost of living is rising at a fast rate and inflation is high, everyone is likely to feel the pinch. Pensions can also suffer if they don’t have inflation-linked increases built in because their real-terms value may be eroded by inflation. But there’s also a risk that if cost-of-living increases are forcing you to prioritise what you spend money on, stopping your pension contributions could seem like an easy sacrifice. Avoid this if you can, or if you feel you have no choice, restart contributions as soon as you are able. Retirement income may seem like a low priority if there are still 20 years or more to go before you retire. But your “golden years” can last for several decades, and building up a decent pot can help make sure you enjoy a quality lifestyle in retirement.

Frequently asked questions

  1. Office for National Statistics
  2. Bank of England
  3. Office for National Statistics: Consumer price indices
  4. Office for National Statistics: Measures of owner occupiers’ housing costs UK
  5. House of Commons Library
  6. MoneyHelper

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