In recent months, the rate of inflation in the UK has risen significantly. According to data from the Office for National Statistics, the Consumer Price Index (CPI) rose to 5.1% in the year to November 2021.
This news is somewhat worrying, as this is more than double the Bank of England’s annual target of 2%. While some inflation can be beneficial for the economy at large, too much can have a damaging impact on people’s finances in a variety of ways.
Read on to find out three of the biggest ways that inflation could affect your finances.
1. It reduces the buying power of your cash holdings
One of the most notable ways that inflation can impact your finances is that it reduces the buying power of your money over time. This can be a problem if you want to keep a portion of your wealth in cash.
If you want to see the impact of inflation over time, the Bank of England’s inflation calculator can be a useful tool.
For example, £10,000 worth of goods and services back in 1990 would have cost you £23,244 in 2020. This is because there was an average annual rate of inflation of 2.9% throughout the period.
Even if inflation consistently remained at the Bank of England’s annual target of 2%, your cash would still lose one-third of its buying power after only 20 years.
It can often be a good idea to keep a portion of your wealth in cash, as an emergency fund can act as a useful buffer if you experience a financial disruption. However, holding too much of your money in this way can leave it exposed to the corrosive effects of inflation.
2. It can reduce your real returns when investing
Another way that inflation can affect your wealth is that it reduces the real returns of your investments. This means that they need to work harder in order to grow your wealth in the long term.
Essentially, this is because while your investments may seem to show good growth, a high rate of inflation means that their true value may not be increasing by as much as you think. Furthermore, there is also the risk of your investment losing value in real terms.
Due to this, you may need to reassess your investing strategy. Exposing your wealth to more risk can lead to greater returns, though it’s important to be aware that it also increases the chance of short-term volatility.
If you want to meet your financial goals, it’s important to make sure that your investments are working hard for you. That’s why seeking professional advice from a financial planner can be beneficial if you’re concerned about the impact of inflation on your wealth, as they can help you to assess your risk tolerance.
3. It could affect your pension wealth
When it comes to building wealth for your retirement, it’s important to be aware of the Lifetime Allowance (LTA). As you may know, this is the maximum amount that you can save into your pension tax-efficiently.
In his March 2021 budget, chancellor Rishi Sunak announced that the LTA would not rise in line with inflation. Instead, this important allowance will remain frozen at £1,073,100 until at least 2026.
But, while the LTA remains frozen, it’s likely that you’ll see your earnings – and so your pension contributions – rise over the next few years, at least in line with inflation.
So, as inflation pushes up your earnings and pension contributions while the LTA remains frozen, it’s much more likely that you’ll be affected by the threshold. This is especially true when you consider that the value of your fund is also determined by tax relief and any investment returns you receive.
As a high earner, this puts you at risk of having to pay more tax on your savings when you come to draw your pension benefits, ultimately reducing how much you have to live on in retirement.
Working with a financial planner can help, as they can help you to avoid reaching the LTA. This may involve:
- Reducing pension contributions
- Withdrawing your excess pension as income, rather than as a lump sum
- Applying for Lifetime Allowance protection where applicable.
A financial planner can work with you to put a plan in place to minimise your tax liability, giving you greater peace of mind that you’ll have enough wealth in retirement. This can help you to rest assured that you’re on track to achieve the retirement you deserve.
Get in touch
If you’re worried about how inflation could impact your progress towards your financial goals, get in touch. Email firstname.lastname@example.org or call 01204 300010 to find out more about how we could help you.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Your pension income could also be affected the interest rates at the time you take your benefits. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.
This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.