The Impact of Inflation on Pension Calculations: What You Need to Know

Most people think of inflation when prices of essential commodities such as groceries and fuel increase. However, that’s just a short effect because inflation can significantly affect one retirement and how their benefits are calculated. Generally, inflation means your pension savings may not get you much, eventually affecting your retirement plan. 

Let’s define inflation, its relation to pension, and how it impacts pension calculation. 

What exactly is Inflation? 

Inflation refers to the rate at which the price of everyday goods and utilities increases over time. Therefore, the same amount of money now buys less than it did previously. Generally, inflation reduces the buying/purchasing power of a unit of money/currency: it causes money to lose value over time, and prices of commodities increase very quickly. 

For instance, if a packet of milk costs $1 in 2023, there is a high probability that the same packet of milk will cost more than $1, depending on the inflation rate. 

Understanding Inflation and How it Affects Pension 

Recently, the world experienced the highest annual increase in inflation since 1996, which hit 8.75% in 2022. It’s a result of compounding economic issues from the pandemic and rising energy prices to consumer insecurity. Consequently, this effect has also been felt in retiree’s pensions across most parts of the world. 

As outlined above, inflation erodes the value of money, and pensions aren’t immune to inflation. Therefore, high inflation means investments and pensions cannot grow as quickly as anticipated and will struggle to keep up. Subsequently, the value of your pension pot is reduced to a certain percentage. The reduced buying power also affects how retirees will spend their pension income. 

Another aspect is that high inflation can negatively impact an individual’s pension benefits since they’re often based on pre-inflation (outdated) salary figures that don’t match the current market rate. 

How Inflation Impacts Pension Calculations 

Before understanding how inflation impacts pension calculation, let’s briefly look into the common way(s) pension is calculated globally. Most formulas for calculating pension benefits take into account the pensionable salary, years of service, years of contribution to the plan/scheme, final annual salary, etc. An example of a common formula is Month’s pay multiplied (x) years of service divided (/) by the benefit multiplier. In some cases, other factors, such as retirement age and income tax, will be accounted for. 

Inflation is another factor one may brush off, yet it affects how their pension benefits will be calculated. Here are different ways inflation impacts pension calculation:

1. Need for increased contributions

Since inflation tends to erode the value of money (reduces buying power), one may be required to contribute more to their pension plan to stay on track, especially in the long term. Therefore, it means one would have to consider saving more each year to keep up with the inflation rate such that their pension benefits in retirement year may be sufficient. Generally, it’s leveraging the power of compound interest to combat inflation on your pension. 

Another scenario that may lead to the need for increased contributions is when a pension plan/fund struggles to meet its obligations due to inflation. To avoid reduced benefits, members may be required to contribute more. 

2. Cost of Living Adjustments (COLA)

Some pension offers inflation adjustment periodically (it’s often annually). However, these adjustments are not guaranteed and are based on the consumer price index (depending on a country’s CPI) and funds available to support inflation adjustment. Often, COLA equals the CPI rate for that specific period.

Suppose your Pension scheme offers COLA; your monthly pension may increase, thus helping you counter the effects of inflation. On the other hand, if your pension income remains the same, your purchasing power will be eaten away by inflation, requiring you to lower living standards. 

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Final Thought 

While pension schemes are a great way of saving for the future, it is good to consider how inflations will impact retirement and adjust accordingly. Also, inflation may affect how much one contributes to the pension before retirement. In most cases, it requires contributing as much as possible to keep up with inflation and growing your pension pot. Above all, investing in a pension that grows at a faster rate than inflation in the long run is critical.

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