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. 

As we have covered recently, Prudential, a leading player in the annuity market, is updating its enhanced annuity proposition with product changes developed to take into account an increased range of conditions that may affect a client’s longevity, including a high body mass index, raised cholesterol or blood pressure.

Prudential state that, depending on the severity of the condition, an annuity rate increase of up to 30pc could be granted to a retirees’ annuity income.

Currently, the enhanced annuity market stands at around 10pc of the overall annuity market and looks set to grow still further in the near future as advisers and clients get to grips with the market. Prudential therefore believe it is a good time to launch this extended enhanced annuity contract.

Enhanced annuity rates are available on both guaranteed annuities and with-profits annuities with quotes being generated within 24 hours. Quotes remain valid for 14 days when applied to a guaranteed annuity and 42 days when applied to a with-profits annuity.

It is worth keeping a watchful eye on this developing market. You might well qualify for enhanced annuity rates yourself. Seek advice and find out.

An excellent article appeared in The Sunday Times, 26th October, and on Times online, about various types of annuity. These made good reading, but it was the case study it gave which was more interesting. The one thing it certainly did do was to highlight the benefits of taking advice.

The article covered the following types of annuity:

TRADITIONAL LIFETIME ANNUITY. This is commonly the most straightforward annuity providing a guaranteed income. It is the one bought most.

ENHANCED ANNUITY. Increased annuity rates apply to those with lifestyle or medical conditions, and to those who smoke regularly.

IMPAIRED LIFE ANNUITY. These are available to those with serious medical conditions and who are likely to live less than five years, as well as those with more common conditions, such as certain types of diabetes, high blood pressure and high cholesterol.

FIXED TERM ANNUITY. The income is paid for a specified term (usually at least five years) after which you receive a guaranteed maturity amount (GMA), also fixed at the outset. This must be used to buy another retirement income plan. (See the example below.) 

INCOME DRAWDOWN. With these contracts you can draw down an income and leave the rest of your fund invested. The income is between nil and 120% of what a traditional annuity would pay. 

WITH PROFITS ANNUITY. These are linked to an insurer’s with-profits fund, and aim to smooth returns by holding back some in good years to pay out in the bad. Income varies with in line with bonuses attaching to the policy. At the outset, you select an anticipated bonus rate of nil to 5%. If it turns out to be higher, your income will rise, and vice versa. Warning: some insurers have been paying as little as 2%.

UNIT-LINKED ANNUITY. No smoothing process and income is directly linked to investment performance. You could opt for a medium or high-risk managed fund or a tracker.

VARIABLE ANNUITIES. Known also as “third way” pensions, aim to give the best of traditional annuities (guaranteed income) and income drawdown (potential investment growth).

PHASED RETIREMENT. Here you spread the annuity purchase over several years, instead of only buying one at the outset.

SECURE A BETTER DEAL. Shop around for that annuity, and be prepared to take advice.

THE EXAMPLE. Mrs. R., a council worker, wants income security, while keeping her options open. She decided to buy a fixed- term annuity when she reached 60 last month. She bought a Living Time annuity with her £117,000 pension pot. The plan will pay out £7,400 a year for five years and then return £108,500 to buy a new pension income plan.

As Mrs. R. said: ‘When it comes to money, it is better to play safe.’

In 2007 premiums in the UK pension annuities market were over £11 billion, and this is expected to continue to grow. However, there is an increasing product choice in the at-retirement market, and this can be a challenge.

Advisers in this market need to have a solid understanding of the options available and how they suit the client’s needs. The exact shape of an annuity is necessary before the best annuity rate is sought.

Longevity warrants consideration. According to figures from the Office of National Statistics, a 65 year old woman will now live for 2.8 years longer than they would have in 1980, and a 65 year old man will now live for four years longer.

There is also the issue of inflation. According to research from HBOS, the rate of pensioner inflation has increased by 36% over the past ten years. Some annuity contracts can help in this regard. These include: with-profits annuities, unit-linked annuities, and flexible annuities.

Many are familiar with the long standing annuity products including conventional, unit-linked, with-profits and flexible annuities, but we now have range of new at-retirement products including income drawdown and variable annuities to consider.

The advantage of income drawdown is that clients can keep their pension fund invested for longer and so have the possibility of increasing potential returns. Potentially useful in today’s economic climate.

In 2008, the Association of British Insurers (ABI) estimated that 66% of people now consider the Open Market Option when choosing their annuity, so at least they are looking for options.

Forecasts suggest that the at-retirement market will grow to £18 billion a year by 2012. It’s safe to conclude that these figures will rise as awareness increases.

The compensation limits for bank accounts and the like is going from £35,000 to £50,000, with £100,000 for joint accounts. This covers deposits with banks and building societies. Separate arrangements are in place if an insurance company, fund manager or financial firm collapses.

You may be let down by a financial adviser, for example, or insurance company, where compensation should be forthcoming. However, it is not always easy to understand which compensation arrangements apply.

Personal pensions and income drawdown plans are treated as insurance contracts, because they would normally include some life insurance. Compensation is paid in full for the first £2,000, then 90 per cent of any remaining balance.

These funds should be safe because they are held in trust. The only risk would be from embezzlement, or some administrative blunder.

Pension annuities, which pay your regular pension (your retirement income), are also insurance policies and are treated as such under the compensation rules.

However, with a with-profits annuity, only guaranteed bonuses already attached to the policy, not discretionary bonuses, will be included.

Where your savings are managed by stockbrokers, financial advisers or other investment managers and something goes awry, you can claim 100 per cent of the first £30,000 lost, then 90 per cent of the next £20,000, giving a maximum protection of £48,000.

There can still be reasons why a firm can collapse owing money. The majority of pay-outs under the investment rules relate to firms of financial advisers who have failed because of the inability to pay claims for mis-selling.