Inflation-proofing pensions is no mean feat

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The writer is an FT contributing editor

Estimating how much people need to save to provide an adequate retirement can be a challenge. An even greater challenge is working out how to invest these savings to protect them against inflation.

Over the past three years — in part prompted by conflict in Ukraine and reopening the economy after Covid — UK consumer prices have risen by a fifth, leaving many pension savers poorer in real terms. I spent more than a decade designing and managing portfolios for large pension and insurance funds that aimed to beat inflation, and then some. There is no simple formula that guarantees success.

One of the reasons why inflation is so corrosive to asset market returns is precisely because central banks are focused on targeting inflation.

They do this by raising short-term interest rates: increasing the cost of finance for businesses and cooling economic growth. Higher short-term rates raise longer-term bond yields, pulling down the price at which long-term cash flows can be purchased — and hence bond prices.

Given that stocks are just claims on uncertain long-term corporate profits, and that the size of these future cash flows will be related to the strength of the economy, inflation and the higher interest rates they bring also tend to be bad for stock prices — at least in the short-run.

To put some numbers to this, in 2022, inflation surged beyond 10 per cent in the UK. This was bad news for UK consumers but, more importantly, for many UK investors.

In the US, inflation peaked at 9 per cent in mid-2022 before falling towards 6 per cent by the end of that year. In response, the US Federal Reserve — the global monetary hegemon — raised rates by 4.25 per cent by the end of that year, helping bonds to shed 16 per cent of their value, and global stocks 9 per cent in sterling terms that year. This was followed by further rises in 2023 to 5.5 per cent to further squeeze inflation, ahead of the Fed rate cut of half a percentage point announced last Wednesday.

Stock returns would have been worse, had the value of sterling not plunged by more than 10 per cent in 2022, boosting the returns of dollar-denominated and other non-sterling assets.

UK large-cap stocks did better, given their heavy weighting in oil companies that made hay during the energy crisis, providing investors a return of just over 6 per cent, although still losing money in real terms.

Those not working in the bond markets would be forgiven for thinking that inflation-linked gilts would have helped investors weather this inflationary storm. These types of bonds, issued mostly by governments, see their coupon and principal payments increase with inflation, preserving the real value of savings.

But this real preservation of capital is true only if investors hold these inflation-linked bonds to maturity. In the short run, these instruments are often loaded with interest rate risk, which can cause their value to plummet when inflation spikes. So, in 2022, rather than bailing out investors, inflation-linked gilts lost them 34 per cent.

Gold, another inflation-hedge favourite, did better, although this may well have been luck. Statistically, the relationship between gold and inflation has been a coin-flip from year-to-year.

So what is to be done? For my part, I invest in a portfolio of global and UK equity exchange traded funds, bonds, and alternatives that I hope will not only protect against inflation over the medium-term, but also deliver real-terms capital growth. But I am close to 50 in age, and so what works for me may not work for all.

Individuals assessing their pension portfolio need to bear in mind their time horizon for investing. Bouts of unexpected inflation can deliver a devastating hit to pension pots in the short term. Since the turn of the century, we have had two major global stock market crashes, each of which wiped out over 40 per cent of capital value. And those are on top of the Covid shock which took a cool quarter off the real value of UK stocks in the first ten months of 2020, although this had recovered by March 2022.

Indeed, global stocks have lagged inflation almost one in every three calendar years this century. And yet investing savings in stocks even at the peak of the dotcom bubble at the turn of the millennium — just ahead of them losing half their real value — now looks smart, as they more than doubled in real terms since then, for those that held on.

And so, while history has favoured the bold who hold everything in stocks, this has only been the case for investors who have been young enough to enjoy the sometimes drawn-out recoveries that have followed market downturns.

The old rule of thumb that you should allocate a percentage of your portfolio to bonds that matches your age has cost older savers dearly in recent years, with bonds taking steep losses. But now, with higher yields, the rule looks close to fair.

Bonds offered little value ahead of the post-pandemic rise in interest rates. While they will not make individual investors rich, yields are high enough to balance the risks of significant losses from investing in stocks. And, with yields where there are, they finally provide a reasonable standalone cushion against real-terms capital erosion from inflation.

For decades, we thought we had seen the last of double-digit inflation. It took truly exceptional global shocks to reawaken them, and I for one do not expect them to repeat anytime soon. But I do feel comforted that a balanced portfolio has a good chance to preserve the real value of my pension savings if I’m wrong.