Annuities And Inflation
When you’re considering buying an annuity it’s important you take the effects of inflation into consideration. Inflation will eat into the future buying power of your annuity income.
Annuity income
If you buy an annuity with a level income throughout, your annuity income will be much higher initially, but it won’t increase, and, over time, inflation will reduce the buying power of your income.
You can protect yourself against the ongoing effects of inflation by choosing an annuity with an increasing income – an escalating annuity. Typically that can be by 3% per year, 5% per year, or by the rate of the Retail Prices Index (RPI) per year. Naturally, RPI varies year on year, and if it hits a negative rate, then your annuity income could go down in that year.
This table illustrates how initial annuity incomes can vary depending on the type of income you choose.
Example: Initial yearly incomes from a £50,000 pension fund for a 65 year old male
| Yearly incomes – £50,000 fund | Income | Difference |
| Type of income selected | Initial income | Reduction in initial income |
| Level income | £3132 | N/A |
| Income increasing by 3% per year | £2268 | £864 |
| Income increasing by RPI per year | £1856 | £1276 |
The annuity rates used are from the FSA’s comparative annuity tables, 27th. October, 2011.
When you select an RPI linked annuity, not only do you get a much lower initial annuity income, you naturally don’t know what the future year on year RPI rates will be.
To protect your annuity income against inflation, selecting an income that increases each year makes sense. However, you do start with a much lower income and it can take many years to catch up. The real benefits are in the later years of your retirement.
