This article was last updated on 16/10/2024
A rise in inflation happens when the price of goods such as food, transport and living costs, like electricity, rise. Changes to inflation not only impact what you can afford today but also what you can afford in the future.
Imagine you have £1,000 saved under your mattress for five years. If inflation is 2% each year, after five years, the cost of living would be over 10% higher. This means your £1,000 won’t buy as much as it would’ve five years ago. In simple terms, its value decreases over time because of inflation.
Savings like your pension aren’t immune to these changes and if your pension value remains the same, this decreases your purchasing power in the future. Over time, this could mean that your pension savings might not get you as far as you’d hoped.
What is inflation?
Inflation is the rate at which the cost of everyday things like food, transport and electricity increases over time. The rise in prices, often presented as a percentage, means that a unit of money essentially buys less than it did previously.
For example, if you buy a pint of milk for £1 today and inflation jumps to 10%, next year the same pint will cost you £1.10. If inflation sticks at 10%, it’ll cost you £1.21 the year after. In the real world, the inflation rate changes constantly.
While it’s common for the value of goods to rise over time due to inflation, prices can also decrease. This is known as deflation.
What’s the relationship between inflation and interest rates?
In moderation, inflation and interest rates are key to growing the prosperity of a country. The difficulty occurs when one experiences instability and becomes too high or low. The danger of leaving inflation and interest rates untreated is a recession.
High inflation is an economic ‘fever’ where symptoms include:
- a loss of appetite to spend money (due to rising prices); and
- a weakness in currencies.
Central banks (such as the Bank of England) try to provide the financial stability needed for a healthy, growing economy. So when inflation is running high, central banks may prescribe raising interest rates to lower the levels of inflation.
This antidote of raised interest rates doesn’t correct inflation overnight and may have side effects of its own, such as:
- it being more costly for you to borrow money for loans or mortgages; and
- more attractive interest rates for cash savers.
What causes inflation to rise?
Here are three common reasons why a rise in inflation happens.
1. Built-in inflation
Built-in inflation refers to when wages go up because of rising costs. If workers in the UK demand higher wages to cope with increasing prices, businesses may raise their prices to afford these higher wages. This creates a cycle where higher wages lead to higher prices, which then leads to demands for even higher wages.
2. Cost-push effect
The cost-push effect occurs when it costs more to make products. For instance, if the price of fuel rises, it can become more expensive for manufacturers to transport their goods. To cover these higher costs, companies might raise the prices of everyday items, like groceries or electronics.
3. Demand-pull effect
The demand-pull effect happens when people have more money to spend, which increases the demand for items. For example, if the UK economy is doing well and people feel secure in their jobs, they might spend more on things like dining out or holidays. This higher demand can push up prices to match the increased spending.
How inflation affects the value of goods over time
The Office for National Statistics (ONS) recently released data showing that inflation was at 1.7% in the 12 months to September 2024. This is the lowest rate in over three years. In practice, this means that £100 of goods and services last year would now cost £101.70.
The government has tasked the Bank of England to keep inflation at around 2% a year. This target is important because it helps keep price increases manageable, allowing consumers and businesses to plan their finances more effectively.
How the Bank of England keeps inflation under control
To keep track of inflation, the Bank of England uses the Consumer Price Index (CPI). This is like an imaginary basket containing hundreds of goods and services, which have their prices tracked over time.
When inflation goes up, the Bank of England might raise interest rates. This makes loans more expensive, which can lead to less spending and help slow down price increases. On the other hand, if inflation is too low, the Bank of England may lower interest rates to encourage more spending and investment.
In rare situations, the Bank of England could consider a negative interest rate, which means banks would pay to keep their money with the Bank of England. This would encourage banks to lend even more money to their customers.
What to do when inflation rises?
Inflation impacts what you can buy now and in the future. To help keep your money from losing value, you could:
- find a savings account with an interest rate above inflation; and
- invest money into the stock market (through a product like a pension).
Savers
To counter the effects of inflation, you could choose a savings account with an interest rate higher than inflation - if there’s one available. This helps ensure that your money retains more of its value over time.
If you’re worried about being stuck with low rates for a long time, consider short-term products (such as an instant access saving account). This gives you the flexibility to benefit from rising interest rates without tying up your money for too long.
Investors
Historically, the stock market has offered higher returns compared to traditional bank savings accounts. Over the last ten years, global stock markets have grown by an average of 10% each year; which is much higher than the UK’s average inflation rate of roughly 3% a year.
Keep in mind that there’s no guarantee the stock market will keep growing at the same rate - it could also go down in value. Plus, remember to consider any fees you might have to pay when investing, as they can affect how much money you make.
How does inflation affect pensions?
If you’re currently receiving the State Pension, the inflation rate can determine the annual increase in your payments. Under the ‘triple lock’ policy, the State Pension should increase each April by the highest of the following three measurements:
- inflation, as measured by the Consumer Price Index (CPI) in the September before;
- average earnings growth, as measured by the ONS in the September before; or
- 2.5%, as the minimum annual increase.
This annual increase applies to both the basic State Pension (pre-April 2016 retirees) and the new State Pension (post-April 2016 retirees). Back in April 2023, the State Pension increased by 10.1% due to the significant rise in inflation.
Personal and workplace pensions are usually invested in the stock market. While changes in the inflation rate don’t directly change the amount in your personal pension pot, they can affect its value and how much you can buy with it.
Before retirement
As prices rise, the money saved in your pension may not stretch as far when you come to retire. If your pension investments don’t grow at a rate that outpaces inflation, you might find that your purchasing power decreases over time.
If you’re Auto-Enrolled into your employer’s workplace pension, a percentage of your salary will be invested into your pension. This means that as your pay increases over time, so will your pension contributions from you and your employer.
If you make regular contributions to your personal pension, it’s a good idea to consider raising your contributions each year to keep up with inflation. This helps ensure your pension grows enough to match rising costs.
After retirement
When you start taking an income from your pension, inflation can erode the value of your withdrawals. But this could be offset if the investment growth of your pension outpaces the rate inflation.
If you choose to buy an annuity with your pension, inflation may have different effects. An ‘escalating annuity’ increases over time to keep up with inflation, while a ‘fixed annuity’ doesn’t - which means its real value can shrink due to inflation.
Summary
Now’s a great time to start looking at your pension contributions and ensure you’re on track to retire with enough money. If you’re concerned about the impact of inflation on your pension pot, you can use our Inflation Calculator. Alternatively, to see how much your pension could be worth at retirement and how long it could last you, try our Pension Calculator.
Once you turn 50, you’re able to book an appointment with Pension Wise, a government service set up to help people understand what their options are when they retire. The great thing about Pension Wise is the appointments are free and completely impartial. You can read Personal Finance Journalist Faith Archer’s blog, What happens in a Pension Wise appointment, to understand the step-by-step process.
Have a question? Get in touch!
Do you want to know more about your pension plan with PensionBee? You can check out our Plans page to learn how your money is invested in different assets and locations, or log in to your BeeHive to see your specific plan. You can always send comments and questions to our team via engagement@pensionbee.com.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
