Annuities: Is it worth buying an RPI linked Annuity?

Posted on October 22nd, 2012 | Categories - Annuities, Retirement

Despite inflation being on a downward trajectory for most of 2012, many financial experts believe that a combination of higher food and energy prices, plus the effects of Quantitative Easing (QE), could mean that the rate of inflation starts to rise significantly as we move into 2013.

So, given that inflation erodes the buying power of fixed incomes, should would-be retirees be seriously thinking about buying an RPI linked Annuity?

How expensive is RPI linking?

Inflation proofing your income is important; after all, who want’s the buying power of their income to reduce? However, as the tables below show, buying an RPI linked Annuity is hugely expensive, often cutting the starting level of income by around 40%.

This comes on top of significant falls in Annuity rates, of around 20% over the past three years and 7% in the last three months alone

Male:

Level RPI Linked Difference
Single Life £5, 643.63 £3,539.40 £2,103.96
Joint Life £5,105.76 £2,999.88 £2,105.88

 

 

 

 

Female:

Level RPI Linked Difference
Single Life £5,428.44 £3,341.16 £2,087.28
Joint Life £4,959.60 £2,916.48 £2,043.12

 

 

 

 

The tables assumes a standard Annuity is bought with a pension fund of £100,000, that both the man and woman are aged 65 and that the Annuity is arranged with a 10 year guarantee and a 66% spouse’s pension.

Which Annuity gives more income over the longer term?

It’s clear that the starting level of income is significantly lower for an RPI linked Annuity, but with annual rises in the income, when does the RPI linked Annuity give a higher level of income and when is the total amount paid out higher?

The exact dates of course depend on the rate of inflation, which no one can accurately predict, but we can look at some examples.

Cross over point:     Years before RPI linked Annuity equals the level Annuity

Breakeven point:     Number of years before the RPI linked Annuity has paid out an amount equal to the level Annuity

Male:

Cross over point (3% inflation) Breakeven point (3% inflation) Cross over point (5% inflation) Breakeven point (5% inflation)
Single Life 17 years 25 years plus 11 years 19 years
Joint Life 19 years 25 years 12 years 22 years

 

 

 

 

 

 

Female:

Cross over point (3% inflation) Breakeven point (3% inflation) Cross over point (5% inflation) Breakeven point (5% inflation)
Single Life 18 years 25 years plus 11 years 20 years
Joint Life 19 years 25 years plus 12 years 21 years

 

 

 

 

 

 

At a relatively modest 3 % rate of inflation, the cross over point is between 17 and 19 years and the point at which the RPI linked Annuity pays out more than the level Annuity is over 25 years away.

The latest Office for National Statistics (ONS) figures show that a man age 65 can expect to live for a further 17.8 years, for a woman this rises to 20.4 years.

Therefore, for the people with average life expectancy, there is no benefit to buying an RPI linked Annuity if inflation remains at a relatively low level.

However, if inflation were to average 5%, then the cross over point falls to between 11 and 12 years. Importantly, the breakeven point moves closer to the anticipated life expectancy at between 19 and 22 years, which for healthy retirees, who will live longer than the average, could make inflation proofing viable in the long term.

So, RPI linking or not?

Retiring soon? Our advisers can help you make the right decisions

The Investment Sense team of Independent Financial Advisers in Nottingham

Contact our team of advisers today:

0115 933 8433

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Whilst inflation may have fallen over the past year and is now close to the Bank of England’s target, would-be retirees shouldn’t focus too closely on the rate of inflation when they retire, but consider what might happen in years to come.

We will all hopefully be retired for a long time, and despite low inflation today, this may change in the future, especially if world energy and food prices continue to rise and when the full effects of Quantitative Easing are felt.

In our experience the vast majority of retirees opt for a level Annuity, preferring “jam today”. This is usually because they simply cannot afford the 40% reduction in the starting level of income, which comes with an RPI linked Annuity.

Since most people will spend more money in the early years of retirement, there is a certain logic to ‘front loading’ retirement income. Any surplus income could be saved and used at a later date when the level Annuity income is being eroded by inflation

Furthermore, for most retired couples the State Pension will make up a significant proportion of their retirement income, which is guaranteed to rise in line with inflation, earnings, or 2.5%, whichever is higher. The majority of people therefore have some income which will increase year on year.

However, would-be retirees should also remember it is commonly agreed that older generations suffer a rate of inflation higher than the official figures. This is because more of their income is spent on items which are rising in price faster than the average basket of goods. Inflation is therefore actually more of a problem for older generations and the effects need to be carefully considered when Annuity options are being considered.

After all, once an Annuity has been bought, and the decision between level and RPI linked has been taken, no changes can ever be made.

In conclusion

As much as we’d like to give one, there really is no definitive answer, for those people who are healthy and expect to live longer than the average, as much as anyone can tell, then buying an RPI linked Annuity could have significant benefits.

However, for most people, with an average life expectancy, the breakeven point is likely to be so far into the future that the lure of a higher starting income, available now, is likely to prove too tempting.

Our team of Independent Financial Advisers in Nottingham are experienced in developing retirement income strategies for clients the length and breadth of the UK. If you are approaching retirement and would like advice on your options call one of our IFAs today on 0115 933 8433, alternatively enquire online or email info@investmentsense.co.uk