Inflation risk in retirement income
Created On: 28/02/2022
From July 2022, superannuation 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 adverse impacts of an unexpected increase in inflation.
WHAT IS INFLATION?
Inflation generally refers to the rising costs of goods and services over time. It reduces the purchasing power of a retiree’s income if not managed. Retirees need a source of income that adjusts to inflation in order to sustain 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 does not match the built-in expectations.
The impact of inflation over a retiree’s lifestyle can be dramatic, even with modest inflation. Chart 1 below highlights how inflation erodes the real value of income for a retiree. There isn’t much difference in the early years, but the impact compounds over time. Even modest rates of inflation will hamper a retiree’s lifestyle. With inflation of only 2% a year, one-quarter of the value of the nominal income is lost after only 14 years. The risk of higher inflation is stark - 5% a 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 a severe impact on a retiree’s lifestyle. Some reduction in lifestyle might be okay. Research by David Blanchett in the US and the Grattan Institute in Australia have shown that retirees tend to spend less (in real terms) over time. However, the fall in spending is typically less than inflation, which means that nominal spending increases. Even if a decline in living standards is intentional (ie less spending on discretionary items), retirees still need to manage inflation to afford the lifestyle they desire.
MANAGING EXPECTED INFLATION AND RISKS
Protecting against inflation in accumulating savings requires a high enough return to offset the inflation. Some investments, like equities, provide high returns that have compensated for rising prices over time. Others, such as unlisted property get a benefit as property prices often increase in inflationary periods, therefore increasing total returns.
Bond investments are more exposed to inflation because the yield to maturity doesn’t change after purchase unless they are specific CPI-linked bonds. This does not mean that bonds cannot help with managing inflation. Buyers of bonds know about the potential impact of inflation.
So, the price they pay, and the yield they demand, will depend on the inflation rate that they expect in the future. This is central to bond markets and is monitored by the Reserve Bank of Australia (RBA) in monitoring inflation expectations. Chart 2 shows the bond market’s inflation expectations from the RBA back to 1985.
Figure 2: RBA measure of inflation expectations from the bond market
Breakeven inflation, as it is known, is simply the yield on a normal bond, less the associated yield on a matching CPI-linked bond. If inflation were to match breakeven inflation until the maturity of both bonds, then the return on each bond would be the same. Investors lock the breakeven inflation rate into expected returns. If the market expects that inflation will be higher, there will be more demand for CPI-linked bonds as they would provide higher returns.
The market clears by increasing the spread between the bonds and breakeven inflation rises. Similarly, if expected inflation is lower, the market will adjust to reduce the breakeven inflation rate.
As Chart 2 shows, expected inflation has generally been in the 2%-3% target band of the RBA since the mid 1990s, reflecting the policy target that was confirmed at that time. It has fallen below that band in recent years as inflation has surprised on the downside. This manages inflation, but there is an additional challenge to manage inflation risk. What if the inflation rate is not what was expected?
Lower than expected inflation will mean a higher living standard so that isn’t much of a problem, as opposed to the reverse situation. This risk is one of the ‘known unknowns’ - in the language of former US defence secretary Donald Rumsfeld. Everyone knows that there will be inflation, and while we might have an expectation of what it will be, no-one actually knows how it will play out until after the fact. Managing this takes more than just high returns.
After all, they might not be high enough. What retirees need is an investment that benefits from higher inflation, or even better, automatically adjusts through a linkage to the CPI.
MANAGING INFLATION RISKS FOR RETIREES
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 is likely to involve the Age Pension. Many retired fund members will receive at least a partial age pension in retirement. This helps manage inflation risk because it is automatically adjusted for inflation. The full Age Pension actually tracks average wages over time, which typically grow more than inflation (with the exception of recent years).
It is also worth a fund considering what type of spending their members need to protect against inflation. As noted, some discretionary spending drops off at older ages, so inflation on this consumption might be okay with less protection. However, it is important to have some inflation cover for the essential components of a retired member’s lifestyle. Members with only a part Age Pension, or those who receive no Age Pension, could benefit from an investment that explicitly manages this risk, by protecting against higher than expected inflation.
Super funds have been protecting members from inflation by growing their accumulation assets faster than inflation. There will be an additional requirement on super funds to consider inflation risk for their retired members. Like many aspects of retirement, inflation risk is slightly different when generating retirement income, but funds can deliver better (inflation-adjusted) outcomes for their members by using some inflation-linked assets in addition to investments with high expected returns.