At retirement, you’ll probably buy a pension annuity which converts the lump sum from your pension fund into an income. You only get one chance to buy that annuity, and once you buy it, you’re committed for life. Most people buy a ‘level’ annuity, which produces the same income each year.
An annuity which pays a level income might suit you well, but not necessarily. You might need to think carefully about how to make sure inflation does not erode the income you draw from your pension.
The most competitive annuity today will see a pension pot of £100,000 provide you with a level income of around £7,920 a year for men and £7,420 a year for women. Look at these figures:
| Starting pension value in 2008 | Inflation increases by X% each year | Value of pension in real terms after 25 years in 2033 |
|---|---|---|
| £7,920 | 2% | £4,779 |
| £7,920 | 3% | £3,698 |
| £7,920 | 4% | £2,854 |
| £7,920 | 5% | £2,196 |
If inflation increases by 2% each year, your pension would be worth just £4,779 in real terms in 2033. If annual inflation leapt further this year, to 5%, and stayed at that level for the next 25 years, your pension income would reduce even more dramatically from £7,920 to just £2,196 in real terms.
Consider an index-linked annuity. Let’s say you are a man with a £100,000 pension pot. For the first 12 years, you will receive a higher annual income from the level annuity than you would receive from the equivalent index-linked annuity. But then the situation is reversed. You would then start to receive a higher annual income from the index-linked annuity than from the equivalent level annuity. And, the index-linked annuity would prove better value over the long-term. After 25 years, the index-linked annuity would have paid out almost £209,000, while the level annuity (at £7,920) would only provide a total of £198,000 — or £11,000 less — over the same period.
