Since January 1987, the price of a carton of eggs in the UK has more than doubled. A kilogram of bananas will now cost you around five times as much as it did back then, and a kilo of beef rump steak will cost 12 times more than it did 34 years ago.
All these price rises are thanks to inflation. In simple terms, inflation is the rate at which prices rise. You may never notice inflation, or perhaps you’ll only notice the price of your favourite cereal increase ever-so-slightly, but it is always something to be aware of.
Inflation may seem negligible year-on-year, but it can really affect you in the long term.
Let’s say that, in 1987, you kept a small lockbox hidden somewhere safe, and inside you stored £1,000 in cash. If you opened that lockbox now, the purchasing power of the cash inside would be far less than it was it when you locked it away. You could have bought 12 times the amount of rump steak in 1987 than you can now!
In all seriousness, however, inflation can be important when you consider the amount of protection you have, such as critical illness cover or life insurance.
Index-linking your insurance policy creates a protective buffer from inflation, allowing the value of your payout to rise alongside the cost of living.
If you don’t index-link your insurance, you could leave your family less than they need to maintain their lifestyle. Read on to find out why and what you can do to prevent this.
The inflation rate is a measure of the average price rise of goods in the UK
Though the inflation rate represents an average price rise, different products and services can rise at different rates. This is reflected with the above example of the price changes of eggs, bananas, and rump steak over the past 34 years.
The higher the inflation rate, the higher that prices are rising. The higher the prices rise, the less purchasing power your money has. If your wage doesn’t rise alongside inflation, then the purchasing power of your salary will decrease over time, as will your standard of living.
The inflation rate in June 2021 was 2.5%, which means products and services cost an average of 2.5% more than they did in June 2020. This is the highest rate of inflation since August 2018.
The graph above from the Office for National Statistics shows the average price of a kilogram of bananas since 1971. Inflation isn’t a straight line, so products and prices do not increase by the same amount each year. As you can see, the price of bananas has fluctuated dramatically.
But what does the price fluctuation of bananas have to do with your life insurance?
Your insurance payout could be significantly affected by inflation
Life insurance and critical illness cover are designed to provide financial support should the worst happen. Life insurance will provide for your loved ones should you pass away, and critical illness cover (along with other income protection policies) will provide for you if you need to take an extended break from work for health reasons.
There are numerous things to consider when it comes to taking out protection, but one of the key questions to ask is “is it index-linked?”
If you don’t index-link your protection, the sum assured will not rise in value alongside inflation. In real terms, the overall value of your payout will be less years later. The payout your family could receive from your insurance policy may not be sufficient in 10- or 20-years’ time, for example.
Imagine you had taken out a life insurance policy in 1995 for £100,000, and you passed away 25 years later, in 2020. That £100,000 in 1995 may have been exactly what your family needed to continue with their way of life, replacing your salary going forward and covering any extra payments after your death.
However, with the Bank of England showing an average of 2.7% inflation a year since 1995, you’d have needed £196,600 in 2020 to have the same purchasing power as £100,000 in 1995. In simple terms, it would have cost you £196,600 to buy the same amount of goods that £100,000 would have bought in 1995. That’s almost twice as much.
Given this, your family may therefore need close to £200,000 to maintain the same standard of living in 2020. While your £100,000 policy might have been appropriate in 1995, it would likely have left your family short in 2020. This is why index-linking is vital.
Index-linking helps guarantee that you or your family get the payout they deserve
Index-linking your protection acts as a layer of armour to protect you and your family from inflation. It ensures that the value of your protection rises year-on-year to keep pace with the cost of living.
Most life insurance, critical illness cover, and income protection providers will offer an indexation option. This typically means that your premium and the amount of cover rises each year in line with inflation.
There are three official ways to measure inflation, and the amount that your plan increases by will usually be tied to one of them.
- Retail Prices Index (RPI)
- Consumer Price Index (CPI) or Consumer Price Index including Housing (CPIH)
- Average Earnings Index.
Index-linking ensures that your protection policies don’t lose their value over time, no matter how much the cost of living rises. You can rest easy, knowing you or your family will always get the payout they need to maintain their standard of living.
It should be noted that index-linking cannot typically be added later and must usually be included when you take out your protection. Conversely, you can often decide to stop index-linking your cover at a later date.
You and your family deserve to know that your finances are secure
Ensuring that your family can continue their way of life without any worries once you’re gone is the focus of indexation. It can also help you to relax in the case of serious illness, knowing you will have sufficient funds to keep you going should you need to stop working.
Insurance is there as a backup just in case the worst were to happen. Making sure the value of your protection rises in line with living costs can help to ensure your loved ones are always adequately protected.
Get in touch
If you would like to discuss your protection requirements, please email firstname.lastname@example.org or call us on 01904 655 330.