How to protect your retirement savings from inflation

We outline three ways to protect your retirement income and savings from high inflation.

While the UK inflation rate was 2.2% in August 2024, those in retirement may still be feeling the impact of the high inflation experienced between September 2022 and March 2023, when it was a 41-year high at 11.1% in October 2022.

The same can be said for anyone approaching retirement.

According to previous research by Unbiased, over half (54%) of people aged 50 and over feared they wouldn’t have enough income to survive financially when they stopped working due to higher costs.

Knowing how to use your pension funds to draw an income for life isn’t easy. The decisions facing those either in retirement or quickly approaching it are tough, as you have a tricky balance to strike.

If you don’t draw enough income, you may not be able to meet today’s costs. Conversely, drawing too much increases the risk of running out of money down the line.

Although inflation has eased, it remains uncertain how it will fluctuate in the future. The good news is there are steps you can take to protect your retirement income.

Here, we outline three of them.

1. Consider an annuity

Annuities, which are where you trade some or all your retirement pot for a guaranteed income, fell out of favour until recently when rates soared, driven by several base rate rises by the Bank of England (BoE).

Since December 2021, interest rates have marched upward, rising from 0.1% to 5% (at the time of writing). Annuity rates have followed suit.

One of the reasons why annuities became less popular was because of pension freedoms, introduced in 2016, which allows you to draw from your retirement funds as and when you please.

Otherwise known as income drawdown, this has become the preferred choice for retirees.

Before the BoE started hiking the base rate, annuities were also out of favour as a combination of increasing life expectancy and low interest rates (at the time) resulted in tumbling gilt yields and pushed annuity rates downwards.

An annuity provides a fixed, guaranteed income for life or a specific period, which can offer some security when prices rise fast. 

One of the main drawbacks of annuities is they typically do not provide any lump sum death benefits. In most cases, your annuity dies with you.

Another is the terms you choose at the outset are fixed for the rest of your life or a fixed period, so you can't change them. However, this could be positive if the certainty of future income is important.

To offer protection from future inflation, it's worth considering an inflation-linked annuity. This is where the annuity payments increase each year in line with rising costs.

The downside of opting for an inflation-linked annuity over a level one is your starting payments will be significantly lower. However, with a level annuity, your income will be vulnerable to future price rises, so it's crucial to choose carefully.

It’s equally important to shop around – some providers will pay you more income than others.

A further consideration is an enhanced or impaired life annuity, which takes into account your health and lifestyle choices. If your life expectancy is shorter than average, you may be offered a higher income. In some cases, you can get up to 40% more.

2. Adopt a bucket strategy

Spreading your money across different asset types, such as cash, shares and bonds, is a great way of reducing the amount of risk you take. It can also be an effective way of protecting your retirement pot from inflation.

For those of you using income drawdown for some or all of your funds, one way of achieving diversification is by using a bucket strategy.

With this approach, you divvy up your pot into a few segments determined by when you plan to draw income from them. Three ‘buckets’ is a useful rule of thumb, but you can choose more to suit your personal retirement goals.

For each segment, you designate an investment timeframe. For instance:

• Bucket one: first three years
• Bucket two: years three to 10
• Bucket three: Over 10 years

The first bucket aims to cover any immediate and short-term needs, and so will typically be invested in cash.

While growth potential is low, and it will likely suffer at the hands of inflation, you have the peace of mind that it will not be affected if stock markets were to fall.

As you have no plans to dip into bucket two for at least three years, you can afford to invest in assets which offer a better chance of beating inflation such as government and corporate bonds, and also stocks and shares. 

Bucket three has the longest investment time horizon, meaning you can afford to take the greatest risk. As such, stocks, shares and property tend to be preferred for this segment.

Maintenance is an important factor here. You should frequently review whether the buckets are meeting your short-and-long-term retirement goals.

As pension funds are exempt from capital gains tax (CGT) you can move money between buckets without HMRC taking a chunk. 

The idea behind this strategy is to avoid drawing income from poorly performing assets.

Selling shares when stock markets are low can turn paper losses into real ones, while also affecting how quickly your retirement portfolio grows once markets rebound.

In the worst-case scenario, you could deplete funds too soon.

3. Turn to tax-free income investments

Pensions offer several tax benefits, but tax-free income isn’t one of them.

Any income you draw from your pensions will be taxed at your marginal rate. For annual income of between £12,571 and £50,270, you’ll pay 20%, with anything above taxed at either 40% or 45%.

Paying tax can be painful, particularly during periods of high inflation when every penny counts.

If you have investments outside your pensions that provide tax-free income, such as an individual savings account (ISA), it might be worth pausing pension withdrawals and drawing from these instead if inflation is high.

Even if you have stocks and shares held outside of an ISA, there are some tax advantages available.

Every year, you can sell £3,000 of assets without paying any CGT, which is the annual exemption. As everyone gets one, married couples can sell £6,000 in shares every year without paying a penny in CGT.

Additionally, you can receive £500 in dividends every year without paying any income tax.

There can be additional benefits from drawing money outside your pension from a tax perspective. If you were to die before the age of 75, any money in your pension can be passed to your beneficiaries free from tax.

Funds in your ISA or wider investment portfolio, however, would potentially give rise to an inheritance tax charge.

Get expert financial advice 

While the strategies outlined above can be effective in protecting your retirement income against inflation, making the wrong decisions can jeopardise the longevity of your retirement pot.

It’s crucial to personalise your strategy, as everyone's retirement income needs are unique.

Whether you choose the security of an annuity, the flexibility of a bucket strategy, or the tax benefits of alternative income sources, taking proactive steps and staying informed can help you navigate the economic landscape and enjoy a more secure financial future.

This is where expert advice can make a difference.

Let Unbiased match you with a financial adviser for expert financial advice tailored to your unique retirement needs, ensuring your income strategy is both effective and sustainable in the face of inflation.