Here we look at the issues retirees face when tackling the impact of inflation on their pension annuity income. First, these Individuals have to strike a balance between competing factors when converting a pension into an annuity income stream. One hot topic is inflation. Inflation of just 4% will halve the value of a level annuity income in less than 17 years, a shorter period than the average retirement.
The problem is that there are so many factors: annuity rates, investment returns, an individual retiree’s future health or life expectancy, as well as the likely effect of inflation.
Taking care of Inflation is also clearly not top priority for the majority of retirees. In 2006, 87% of the 350,000 pension annuity contracts sold paid a level income for life, just 6% included escalation, with the remainder made up of impaired annuities, enhanced annuities and investment-linked contracts.
The cost of inflation-proofing is one stumbling block. A 65-year-old, non-smoking man investing a £100,000 pension pot in a single-life pension annuity guaranteed for 10 years could receive a level income of £7,692 a year from the best paying lifetime annuity provider. This is a significant £3,012 a year more than the retail price index (RPI)-linked equivalent (£4,680) starting annuity income.
An option is fixed escalation, either through a conventional lifetime annuity that pays out for life, or a fixed-rate annuity that pays a secure income for a fixed period, then matures, allowing the retiree to rethink their financial strategy according to circumstances. The 65-year-old man above could receive a starting income of £5,664 from the ‘best buy’ lifetime annuity which, rising at a fixed 3% a year, would exceed the level annuity annual income in year 12 and the overall income by year 21.
There are other options for wealthier and more financially sophisticated retirees. We have income drawdown or with-profits annuities which effectively keep funds invested in a range of assets. The hope is that positive investment performance will outweigh any negative effects from inflation.
The conclusion to this is that hedging pension income fully or even partly against inflation either means higher costs or risks, and possibly a combination of the two. Wealthier people may be alright with this, but the majority might not.
The majority of annuity purchasers still fail to exercise their open market option to shop around for the best annuity rates for their circumstances. They also lock into ‘healthy lives’ annuity rates, just at a time when the chances of succumbing to ill health are starting to increase. Even though retirement is getting longer, we are actually spending a greater proportion of those years in poor health.
If you do buy a conventional annuity you lose any income flexibility compared to unsecured pension products like income drawdown or fixed term annuities that allow you to tailor your income to meet your changing needs and state of health over the years.
If inflation falls and annuity rates start to fall back, those retirees who wait could be faced with the prospect of a lower retirement income. But, waiting before committing to an annuity could mean a potential benefit from being able to respond to changing individual circumstances – for example, through becoming eligible for higher impaired annuity rates, future product innovation, legislative changes, or being able to extend death benefits for longer.
