Energy inflation crisis
In recent months it has been hard to miss the topic of inflation, and how it is starting to turn out to be more persistent than initially expected. One key driver that may contribute to a continuation of elevated inflation, is the current crisis that is unfolding in the energy markets. As economies are starting to recover from the pandemic crunch, the surge in demand for energy is outstripping a supply that is slow to respond.
A number of factors are limiting the ability for supply to respond to increased demand. Balance sheets of fossil fuel producers were badly damaged from the sudden demand shock at the onset of the pandemic, and they have yet to recover sufficiently to support a rapid re-expansion of production.1 With the demise of US shale oil production, OPEC and Russia have more influence on global production levels.2 But one particularly topical factor, given the current backdrop of the 2021 UN Climate Change Conference (COP26), is the pressure from shareholders of fossil fuel firms not to increase fossil fuel production. As the long-term energy transition to renewables continues, the current expansion rate of renewable energy capacity is currently unable to make up for this sudden shortfall. Political leaders face a challenging task ahead to ensure this crisis doesn’t lead to a public backlash against the ambitious Net Zero plans that are so crucial to the COP26 goals.
In the UK, this crisis has resulted in 163 of an original 60+4 energy suppliers going bust in recent months. These firms are unlikely to have had sufficient internal risk management to match short-term guaranteed retail prices with a rapid increase in the cost of the wholesale market price for energy. Customers of the failed providers will have automatically been transferred to other more resilient energy providers by the regulator. It is also expected that the big energy firms, and those with appropriate internal risk management, will likely be able to weather this storm. However, for the end customer this situation could be disconcerting nonetheless.
More significantly, though, as short-term energy tariff guarantees approach renewal energy providers will be looking to pass on wholesale energy price increases to their retail customers in the coming months. The graph in Figure 1 illustrates the scale of price increase for natural gas in recent months (from the derivatives market). We note that this is also likely to lead to a significant increase in electricity costs too. As with the demise of coal in the UK, natural gas is the key fossil fuel used to make up residual power generation needs, when wind, solar and nuclear are insufficient. Such increases in prices are likely to have an inequitable impact. This is felt more by those on lower or fixed incomes, including many pensioners.
Figure 1: UK natural gas futures price (per therm)
Considering the average UK retiree
How significant is this for a UK retiree? Those retiring today are likely to support an income from a mix of sources, which may include a final salary scheme, personal savings and the state pension, alongside any defined contribution (DC) pension pots.
Focusing on DC pensions, a median pot size for a UK retiree that purchases an annuity is between £30,000 and £50,000, based upon the most recent Financial Conduct Authority (FCA) market data.5 For those instead going into drawdown the median is slightly higher, at £50,000 to £100,000. Assuming a representative £50,000 pot, the chart in Figure 2 compares a typical level of lifetime income that could be funded, with the average domestic energy bill in the UK.6 For annuities we have taken current quotes from the market, and for lifetime drawdown assumed a sustainable withdrawal rate of 3.5%.
Figure 2: A comparison of typical retirement income from a £50,000 pension pot with an average UK energy bill
A more complete analysis would include other sources of income and expenses. However, with this limited comparison, it is not difficult to imagine that, as the surge in wholesale energy prices filters through to domestic energy bills in the coming months, it is going to have a significant impact on the financial well-being for many in retirement.
One potential solution that retirees may consider is to opt for an annuity linked to the retail price index (RPI). Figure 2 illustrates how costly this is in terms of reduced initial income, compared to a level annuity. Also, energy bills only make up one component of the basket of goods and services that determines the RPI inflation rate. Retirees are likely most concerned about price increases in their core spending, for which heating and lighting the house are fundamental. The basket underlying RPI inflation may not fully represent such core spending needs, and so not fully capture the likely energy price impact on a retiree’s core expenses. RPI may therefore offer a poor hedge to energy price inflation.
Energy self-generation options
Given the current momentum around the need to act upon climate change, a typical retiree is likely to be more engaged in making their own personal contribution towards this. From an investment perspective, the Defined Contribution Investment Forum (DCIF) 2020 report7 indicated that interest in responsible investing and climate-friendly funds was significant among pre-retirees, as it is with Millennial generations. Around two-thirds of pre-retirees (ages 55-65) indicated that responsible investing would lead to more trust in and engagement with their pension funds.
This increased engagement with climate change is also likely to mean many are looking to reduce their own personal carbon footprints. The costs of domestic renewable energy options have fallen considerably in recent years, and can be an attractive way to help achieve this, even with the end of some of the UK government subsidy schemes. Furthermore, such self-generation of electricity means less reliance on paying for electricity from the National Grid, and so less exposure to future wholesale energy prices that drive energy bills. Reducing the need for wholesale energy could be viewed as a more direct way to hedge to a key driver of core expense inflation, in particular a more direct strategy than accessing income benchmarked to RPI.
Some of the domestic renewable energy options include:
- Rooftop solar: Also known as photovoltaics (PV), it capture the sun’s energy and converts it into electricity that can be used to power a home.
- Rooftop solar (with accompanying battery storage): A battery can enable storage of energy produced by rooftop solar, to match with energy usage at times when solar panels are unable to generate electricity.
- Heat pumps: A heat pump captures heat from outside and moves it into your home. It uses electricity to do this, but the heat energy delivered to your home is more than the electrical energy used to power the system. If combined with renewable energy for electricity, it can thus be considered an effective way to reduce your carbon footprint.
Retirement income vs. energy self-generation
Each of these options involves paying an initial cost. But then they are also expected to delivery future energy savings, as the energy generated substitutes a purchase of energy through a “grid-energy” supplier at a tariff that is dependent on the wholesale energy price.
We consider a simple example where a retiree installs a rooftop solar panel system to generate their own electricity (but without an accompanying battery or heat pump), and also assume that they are not reliant on gas for heating. The chart in Figure 3 compares income and savings, based upon the following example:
- A typical UK pension pot of £50,000. This is used to purchase income through a level annuity at current market rates as of 24 October 2021.8
- No solar→ 100% of income is used to purchase a level annuity.
- With solar→ £4,800 of the pension pot is invested in rooftop solar and the remainder into the annuity. Solar costs and initial annual energy savings are taken directly from the Energy Savings Trust,9 assuming a retiree is at home most of the day, living in the South East of England and participates in the Smart Export Guarantee for excess energy.
- Energy price inflation is assumed to be 3.0% per annum (p.a.), which drives an increase in projected saving. No allowance is made for deterioration in solar panel performance between years in this simple example.
Figure 3: A comparison of combined income and energy savings from a level annuity purchase with and without accompanying rooftop solar, at different points in the future, for a £50,000 pension pot
For illustrative purposes only. Data source: Money Advice Service, Energy Savings Trust, Milliman analysis.
A few observations on this comparison:
- Investing in rooftop solar—based upon this specific simple example—makes financial sense from the outset. The combination of projected savings to energy bills from rooftop solar and residual annuity income results in an improvement in disposable income for our example retiree after allowing for energy costs. However, the comparison will clearly differ depending on market annuity pricing and the specific cost of the solar system installation.
- In future years, the savings from the investment in rooftop solar increase with energy price inflation. These savings are essentially an exact offset against the specific risk of rising energy bills—a key component of core expenses. The savings will depend on future inflation. We have assumed a simple 3.0% p.a. But if energy inflation were to spike more significantly in future years, the savings could be greater. Energy self-generation gives peace of mind, by providing some “insulation” from significant increases in energy bills.
- From a tax perspective, rooftop solar could be funded from tax-free lump sums and also deliver energy savings that avoid income tax too.
- A new rooftop solar installation has led to a genuine additional increase in the UK’s renewable energy generation capacity and helped to reduce a retiree’s personal carbon footprint.
In this specific example, both the financial and nonfinancial benefits are clear. However, there are also some downsides and risk to consider. Some key points being:
- There is a clear need to own an appropriate property where rooftop solar installation is feasible.
- There is a clear dependence on the technology being effective. Solar panels are now a fairly basic technology and various standards exist to help certify the technology and its installation. But there is the risk that the specific models installed fail to perform as initially advised or are poorly installed.
- There is also consideration into whether there is intention to stay in the same property throughout retirement. Retirement is typically a time when many consider downsizing a property to release value, although a property sale could also include compensation for the added value from solar panels.
- For those of the average pot size, affordability is a key issue. The costs above may still represent a significant proportion of a tax-free lump sum, for which there may already be other competing demands, such as paying off existing debts.
This simple example hopefully illustrates the point that, on an expected basis, combining a retirement income product with rooftop solar can make financial sense. Furthermore, considering an adverse energy price scenario, such as what is expected to unfold in the coming months, also provides valuable risk management to financial well-being. We have focused just on rooftop solar, as savings from heat-pump solutions are more variable and dependent on specific circumstances—including existing heating system, insulation and glazing—but there are situations where similar arguments could apply. The UK government’s recent announcement on providing grant funding for heat-pump installations may also help make this more financially attractive to some.
If this is in the best financial interest of a retiree, then the natural question is whether pension trustees acting in the best interest of their members should be considering how to make allowance for it. There are clearly challenges in that the benefits are likely to be highly heterogenous. In the case of solar, not all retirees own a suitable rooftop. Potentially the solution lies with retirement income providers. Can there be a standardised, cost-efficient way to incorporate such options and advise on them in income product offerings? Alternatively, is the onus on trustees and providers to highlight these potential benefits, and act as gatekeepers to suitably vetted energy self-generation providers?
Certainly, if answers could be found, then this would provide a valuable benefit to retirees, as well as supporting the nation’s plans to implement Net Zero.
Summary
The current energy crisis is the latest manifestation of climate change and its challenges, becoming real. In planning for retirement, average life expectancies now mean considering climate transition risk and the impact of decarbonisation is a material factor—as regulation is also now ensuring is the case.
Financial well-being in retirement is ultimately a function of both income and expenses. To date, most focus of the post-retirement discussion has been around optimising income from a pension pot. However, potentially we should also be considering a more holistic retirement planning approach, which accounts for potential shocks to regular expenses and how best to manage them too. The current energy crisis is a prime example. Furthermore, it may be best to start evaluating these options preretirement, as once tax-free lump sums are taken and income decisions made, it may be harder to utilise pension savings for this purpose.
Coming up with a default post-retirement income framework is a huge challenge in itself. Factoring in energy self-generation will likely be even more complex, as it is so dependent on specific circumstances. However, energy self-generation to some will make a compelling case, both financially and non-financially, from enabling a tangible impact in reducing personal carbon footprints, to helping in addressing climate change. Potentially we need to start considering how best to incorporate such solutions as part of solving the post-retirement conundrum.
Disclaimers
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