Inflation risk in retirement income

From July 2022, pension funds will be required to have a retirement income strategy that, among other things, manages inflation risk for retired members. There are two aspects to this. One involves a strategy to manage expected inflation and the other is to manage the negative impacts of an unexpected increase in inflation.

WHAT IS INFLATION?

Inflation generally refers to the rising cost of goods and services over time. It reduces the purchasing power of a retiree’s income if left unmanaged. Retirees need a source of income that adjusts for inflation to maintain a stable lifestyle throughout retirement. Inflation risk arises because the level and impact of future inflation is unknown. Inflation expectations can be factored into a retirement income strategy, but there needs to be a plan for what happens if inflation doesn’t match built-in expectations.

The impact on the lifestyle of a retiree

The impact of inflation on a retiree’s lifestyle can be dramatic, even with modest inflation. Chart 1 below shows how inflation erodes the real value of a retiree’s income. There isn’t much difference in the first few years, but the impact gets worse over time. Even modest inflation rates will hamper a retiree’s lifestyle. With inflation of only 2% per year, a quarter of the value of nominal income is lost after just 14 years. The risk of higher inflation is significant – 5% per year would halve the value of payments over the same period.

Figure 1: The impact of different inflation rates on $40,000 of retirement income per year

The erosion of value can have serious repercussions on a retiree’s lifestyle. Some reduction in lifestyle might be acceptable. Research by David Blanchett in the US and the Grattan Institute in Australia has shown that retirees tend to spend less (in real terms) over time. However, the decline in spending is usually less than inflation, which means that nominal spending increases. Even if a lower standard of living is intentional (i.e. less spending on discretionary items), retirees still have to manage inflation to afford the lifestyle they desire.

MANAGEMENT OF INFLATION AND EXPECTED RISKS

Hedging against inflation by accumulating savings requires a sufficiently high return to offset inflation. Some investments, like stocks, offer high returns that have compensated for rising prices over time. Others, such as unlisted properties, benefit from the fact that property prices often rise during times of inflation, thereby increasing total returns.

Bond investments are more exposed to inflation because the yield to maturity does not change after purchase, unless they are specific bonds indexed to the CPI. That doesn’t mean bonds can’t help manage inflation. Bond buyers know the potential impact of inflation.

So the price they pay and the return they demand will depend on the rate of inflation they expect in the future. This is at the heart of the bond markets and is monitored by the Reserve Bank of Australia (RBA) as part of monitoring inflation expectations. Chart 2 shows bond market inflation expectations from the RBA up to 1985.

Figure 2: RBA measure of bond market inflation expectations

Break-even inflation, as it is called, is simply the yield of a normal bond minus the associated yield of a matched CPI-linked bond. If inflation were to be break-even inflation through the maturity of both bonds, then each bond’s yield would be the same. Investors lock in the breakeven inflation rate in expected returns. If the market expects inflation to be higher, there will be more demand for CPI-linked bonds as they will offer higher yields.

The market clears by increasing the spread between the bonds and the inflation breakeven increases. Similarly, if expected inflation is lower, the market will adjust to reduce the breakeven inflation rate.

As shown in Chart 2, expected inflation has generally been within the RBA’s 2% to 3% target range since the mid-1990s, reflecting the policy objective that was confirmed at the time. It has fallen below this band in recent years as inflation surprised on the downside. This manages inflation, but there is an additional challenge in managing inflation risk. What happens if the inflation rate is not the expected one?

Lower than expected inflation will result in a higher standard of living, so it’s not really a problem, unlike the reverse situation. This risk is one of the “known unknowns” – in the parlance of former US Secretary of Defense Donald Rumsfeld. Everyone knows there will be inflation, and while we can expect it to be, no one really knows how it will play out until it happens. Managing this requires more than high yields.

After all, they might not be high enough. What retirees need is an investment that benefits from higher inflation, or better yet, that adjusts automatically through a link to the CPI.

MANAGING INFLATION RISKS FOR PENSIONERS

The Retirement Income Covenant will require super funds to have a retirement income strategy that considers and manages inflation risks. The first part of this strategy will probably concern the Age Pension. Many retired members of the fund will receive at least a partial retirement age pension. This helps manage inflation risk as it is automatically adjusted for inflation. Full retirement actually follows average wages over time, which generally increase more than inflation (with the exception of the last few years).

It is also worth having a fund considering the type of expenses its members need to protect against inflation. As noted, some discretionary spending declines at older ages, so inflation on this consumption might be acceptable with less protection. However, it is important to have some inflation coverage for the essential components of a retired member’s lifestyle. Members who receive only a partial old-age pension, or those who do not receive an old-age pension, could benefit from an investment that explicitly manages this risk, protecting against higher-than-expected inflation.

The super funds have protected their members from inflation by growing their accumulation assets faster than inflation. There will be an additional requirement for super funds to consider inflation risk for their retired members. Like many aspects of retirement, the risk of inflation is slightly different when generating retirement income, but funds can deliver better (inflation-adjusted) results to their members by using certain index-linked assets. on inflation in addition to investments with high expected returns.

Aaron Minney is Head of Retirement Research at Challenger Life.

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