Spending Review – Millions Face Cut In Value Of Workplace Pensions

As the above, somewhat alarming, headline taken from a BBC article highlights, some detail in Rishi Sunak’s Spending Review, which although at first glance looks like a small change in some small numbers, might actually have a much more significant effect on some people’s lives than the headlines referring to billions and billions of pounds.

Pension changes included in the Spending Review

From 2030, the way increases in final salary pensions are calculated could be changing from one measure of inflation to another, Retail Price Index (RPI) to Consumer Price Index (CPIH).

The difference between the two at the moment is just 0.4% a year which might not seem a lot, however, when extrapolated over a long retirement, can make a big difference as this article on the BBC website shows.

The reason this figure can be surprising is that humans as a whole are really bad at estimating the effect of compounding, this small annual difference when compounded over a number of years can have a significant effect.

Compounding and inflation

While this change may be annoying and seem unfair, for people lucky enough to still have final salary pensions, it is relatively easy to solve. We can use compounding over the same long period of time in our favour. By investing small amounts regularly and investing these in assets that grow faster than inflation, we can easily build funds to mitigate any drop in income that may arise. But you need to take action now, the longer you leave looking at this problem, the harder it becomes to solve.

The negative effect of compounding can actually have a much more serious impact on people without final salary pensions, who may be saving for their long term futures themselves via a money purchase pension plan or any other savings vehicle. These plans do not have any built in protection against inflation. Over time inflation will reduce what your funds can purchase as prices go up. The dual effect of compounding and increased longevity can mean that inflation eats away at your funds slowly over time, sometimes not even noticeably over the short term but making a huge difference on not only how much you have to spend in retirement but also when you can afford to retire. Again, although compounding can create this problem it can also be the solution, allowing us to build funds over time to get the great retirement we want, but you need to take action.