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. 

A leading enhanced annuity provider, LV=, has added new lifestyle and medical conditions to its product offering. In addition to those already accepted, customers who have a combination of milder medical conditions, such as high blood pressure and high cholesterol, and disclose them at the time of the application, may now be eligible for an enhanced annuity rate and an increased retirement income.

Those applicants suffering from two or more milder medical or lifestyle conditions may also be able to qualify for enhanced annuity rates offering up to 7.5% more retirement income than a standard annuity. The new qualifying medical and lifestyle conditions include high blood pressure, being overweight, high cholesterol, smoking cigars, and smoking less than 10 cigarettes each day.

LV= hope the improvements to their enhanced annuity will encourage more people to apply to them and potentially receive a higher income in retirement, especially as the many conditions that people may think are trivial and won’t enable them to qualify for an improved annuity, such as high blood pressure, may in fact open the door to enhanced annuity terms.

Applicants therefore need to be completely open about their circumstances when in discussion with their adviser, as even relatively minor conditions could increase the annuity income they receive in retirement for the rest of their life.

Enhanced annuity provider, Just Retirement, has a cloudy future as a backer wants out. Their shares, in line with those of other insurers, have seen big drops, with price falls of 78% in the past 12 months and 54% in the past 3 months. After a bad last quarter growth prospects are unlikely to improve over the next year.

Invesco, its third largest external investor, has bought an additional 58,805 shares in the company at 62.14p. Analysts Panmure Gordon changed their recommendation on Just Retirement from hold to buy following the announcement. Lazard Asset Management sold a total of 51,265 shares, with 35,000 going at 69p and 16,265 at 67.87p.

One bidder could be private equity group Cinven, which bought Just Retirement’s smaller rival Partnership Assurance in June for £160 million. Sources at Partnership say its board has rejected any idea that Cinven would bid for its rival.

Panmure Gordon said that some of the larger UK life assurance companies, including Legal and General, Aviva and Prudential could also be interested in bidding for Just Retirement, given their interest in developing enhanced annuities.

A leading provider in the enhanced annuity arena, MGM Advantage, is  lining up a ‘third way’ product for next year. It is planning to launch a ‘third-way’ unit linked product in 2009 as part of a drive for innovation in the ever growing pension annuities space.

Their sales director Aston Goodey, previously of Prudential, said the plan would be aimed at people aged between 50 and 75, and would be linked to a pension annuity rather than an income drawdown contract. The idea is that it would be asset backed, offer some income protection and possibly some sort of capital protection. Definitely still on the drawing board ! He even likened the product to with-profits annuities.

Interestingly, they are keen to avoid any associations of the product with variable annuitiy contracts, which have so far received a pretty much lukewarm reception in the UK at-retirement market. MGM Advantage claim the market is ‘crying out’ for innovation.

So, the end result is that they are likely to launch a new annuity based contract, with flexibility, but they don’t want it badged as a variable annuity. Interesting dilemma.

Scenario: individual being retired by his company on ill health grounds. He is aged 59 and has a company pension and also a private pension. What might be the position if retirement income is taken based on ill health? Might he lose out financially?  

The Pensions Advisory Service say on this matter: If he qualifies for a pension from his employer’s scheme based on ill- health then he should not lose out on the amount of pension he gets.
If the employer’s scheme is a salary- related scheme, the rules often provide for an increase to the pension (the retirement income) for someone suffering from ill health, compared to someone choosing to retire early in normal health. However, there could be special terms in the scheme’s rules.

If his pension scheme is not salary- related (and this goes for the personal pension he has too), he should make sure that his medical condition is taken into account when a pension annuity is purchased.

Some annuity providers may be able to offer him better terms (and therefore a higher annuity income) because of the ill health – and this is often called an enhanced annuity or an impaired- life annuity. He might therefore get the best annuity rates via this route, but, as always would be wise to seek advice.