At the moment, inflation seems to be everywhere. On the news, in the shops, at the petrol station, in our energy bills. If I had a Pound for every time I was asked about inflation by a client, I would… have about £150!
Inflation is a serious concern for your financial plan for retirement. But remember that inflation measures what has happened, rather than what will happen. If inflation has been running at 9% and your retirement plan hasn’t needed to be changed, you should be breathing a sigh of relief – you have coped with more inflation than was assumed in your plan.
The worry is, of course, what if prices continue to rise?
The Problems Inflation Causes
Inflation can affect all of the main elements of your financial position – expenditure, income, assets, and liabilities.
Its impact on your expenditure and income is obvious. Your expenditure will go up as the cost of living rises. There are really two types of expenditure – essential and discretionary. Our personal mixture of the two explains how painful a rise in inflation might feel, particularly if inflation is causing the cost of essential items to rise, as it has been over the last year.
However, inflation does not only affect your expenditure, it also affects some elements your income. Company pensions and the state pension are linked to inflation – although there is usually a delay between your feeling the increase in the cost of living in your pocket and receiving cost of living increases to your pensions. If you have a high level of guaranteed, inflation linked income, you can worry much less about inflation.
The link between inflation and asset prices is less direct, and inflation isn’t the only factor that drives asset prices. The only investment which appears to be immune to inflation is National Savings’ Index Linked Certificates (and these aren’t available any more!). When inflation has risen sharply in the past, it has brought about a fall in the value of most asset types; however, the initial fall in value has been followed by a recovery in the value of some assets, with shares and property often being the assets which benefit the most, after the initial shock.
The absolute value of cash on deposit is unaffected by inflation, but the spending power of your cash savings declines. Interest rates may have risen (instant access accounts are now paying more than 1%), but if inflation stays at its current level, you won’t be able to buy as much with your money in a year’s time as you can today.
Inflation is often said to be good for liabilities; governments have “inflated away” their debts in the past. That’s only the case if our income (or the value of our assets) increases along with inflation. Most of us have seen this in our lifetimes – just think of the amount of your mortgage relative to your earnings when you bought your first house.
A Word of Warning
There really isn’t an obvious solution to the problems that rising inflation presents. However, I can be certain of one thing – some people will tell you that they have the perfect answer to inflation. Sadly, most of them will be scammers, who will be joined by a small band of the incompetent! As usual, some people will use the cost of living crisis to take advantage of human vulnerability. Remember that we are here to help and happy to discuss any “investment opportunity” which you may be presented with.
What is the Answer?
History has shown us that there is a solution to the problems which rising inflation presents. However, the solution isn’t very exciting, even though one part of the solution was described as “the only free lunch” in investing by Nobel Prize laureate, Harry Markowitz. In inflationary times, two ingredients are required in the recipe for investment success -diversification (that’s the free lunch) and patience. In times of rising inflation, our recipe needs the same amount of diversification, but it needs a little more patience.
Diversification means spreading your investments across a variety of assets (e.g. shares, property and cash).
Patience means that we may need to ignore large fluctuations in asset prices, such as those which we have experienced in the last year, and we may need to give our risky assets more time to recover, after they fall in value.
Our financial plans may need to be adjusted to allow us to have more patience. The tweaks which might be required will vary from person to person, and that means that what is right for you is unlikely to be right for anybody else – the recipe for success varies from one person to the next.
If you would like to talk through how rising inflation might affect your financial plan, please feel free to contact us.
Philip Wise | firstname.lastname@example.org
Managing Director and Chartered Financial Planner