The problem: how do you secure an acceptable income now with your pension whilst combating the effects of inflation in years to come?

Example Annuity income figures

Level: £5,691 from Legal & General

RPI Linked: £3,040 from Aviva

Figures based on a male aged 65, joint life with a female aged 62. Fund of £100,000 (non protected rights). Joint life basis with a 50% spouse’s pension and a 10 year guarantee.

One way to combat the effects of inflation is to add RPI (Retail Prices Index) index linking to your Lifetime Annuity. The table to the right shows that adding in RPI linking can reduce the starting level of income by nearly 50%.

This demonstrates the dilemma: how do you get an income sufficient for your needs in the early stages of retirement but maintain the buying power of that income over time.

We thought we would take a look at a once popular retirement income option, the With Profits Annuity, to see if it might hold answer.

“First things first, what is a With Profits Annuity?”

The money invested in a With Profits Annuity is unsurprisingly invested in the With Profits fund of your chosen provider; you will therefore share in the gain, in the form of bonuses or indeed the losses of the fund.

This is the main difference to a Lifetime Annuity where there is no investment risk and your income is guaranteed.

When a With Profits Annuity is set up, an assumption is made by you, often with help from your adviser, as to what future bonuses might be. This future growth assumption has a direct impact on the initial level of starting income and also future rises.

At the end of each year a bonus rate is declared and the income for the following year is calculated. If the bonus paid is above the anticipated growth rate your income for the following year will rise, but if the bonus is below the anticipated rate your income will fall.

With Profits Annuities have the normal Annuity options, for example you can include a spouse’s pension, guarantee periods and payment frequencies to suit your needs. Some providers will also take into account any health or lifestyles issues you have to improve the starting level of income.

“Why would I consider a With Profits Annuity?”

Most people would like an income which has the potential to rise in order to offset the effects of inflation. But the vast majority of people approaching retirement find the cost of inflation linked Annuities too expensive.

The rationale behind a With Profits Annuity is that Annuities are long term investments and so should be invested in long term assets, such as equities, with the aim to provide a hedge against inflation.

Providing the additional risks associated with a With Profits Annuity are understood and accepted, you may benefit from a rising income, if bonuses are above those anticipated at outset.

The ideal scenario is to opt for as low an anticipated bonus rate as possible to give the required level of income now, with the hope that bonuses are higher than anticipated leading to a rising income.

“How have they performed in the past? Have they done their job?”

Let’s go back to the example we looked at earlier, the income figures were:

Level Annuity: £5,691
RPI linked Annuity: £3,040

In an ideal world a With Profit Annuity would provide a similar level of starting income to the level Lifetime Annuity without anticipating unrealistic bonus rates.

We took a look at the Prudential’s Income Choices contract and discovered that to get a starting income broadly the same as the level quote shown above, an Anticipated Bonus Rate of 4.5% would be needed. In fact the Prudential Annuity gave a slightly higher income of £5,723 per year.

The next logical question of course is what have the bonuses been?

The answer depends on when a policy was taken out, however the following tables summaries the bonuses over the past three years on the Prudential’s Income Choices plan:

Effective date Policy anniversary: 2009/10 tax year Policy anniversary: 2010/11 tax year Policy anniversary: 2011 / 12 tax year
09/03/09 to 05/04/09 7.1% 8.5% 9.0%
06/04/09 to 05/04/10 n/a 7.1% 7.1%
06/04/10 to 05/05/2011 n/a n/a 6.5%

(Source: The Prudential)

Indeed given that the maximum rate which you can assume on the Prudential plan is 6% the bonuses have been sufficient since the launch of the contract to ensure that no investor has seen a reduction in their income.

It should of course be pointed out at this point that past performance is not necessarily a guide to the future and if the bonus rates fall below the anticipated rate income will fall.

“What if bonus rates are regularly below what I anticipated?”

A number of With Profit Annuities offer a floor or guarantee below which your income cannot fall.

The Prudential Income Choices plan guarantees that your income will never fall below a certain level. The floor is set at the same level as the income which would be payable if you assume a 1% bonus rate. In this example therefore the floor would be £3,437 per year; which is still above the income paid by the RPI linked Lifetime Annuity.

This floor increases by 50% of any rise in the Annuity payments. For example if the Annuity income rose by £120 in a single year then the floor would rise by 50%.

“So what sort of person is a With Profits Annuity right for?”

There are a number of different types of investor who a With Profit Annuity might be the right choice for, some examples:

  • If you are looking for potential growth to help combat the effects of inflation, but feel that the starting level of income on an RPI linked Annuity is too low
  • If you are not comfortable with the investment risk associated with a Unit Linked Annuity or an Income Drawdown plan, but do not feel the time is right to commit to a Lifetime Annuity
  • If you want to have some flexibility in your future level of income

“There must be downsides, what are the disadvantages?”

  • Your income is dependent to a large degree on the bonuses paid by the With Profit fund of the provider you choose
  • If the bonuses are lower than you have anticipated at outset, your income level will fall
  • You carry the investment risk, this is not the case with a Lifetime Annuity
  • A With Profit Annuity is a more complex plan than a Lifetime Annuity and generally requires ongoing advice which may incur additional costs or fees
  • If you decide to buy a Lifetime Annuity at a later date you may be unable to shop around for the best income. For example if you invest in a Prudential Income Choices plan you will only be able to buy a Lifetime Annuity from them

“So is a With Profits Annuity the answer?”

Let’s look at the initial problem again: how do you provide an acceptable income now whilst combating the effects of inflation in years to come?

One possible answer is clearly an RPI linked Lifetime Annuity, however we have shown the significant effect on the starting level of income that the RPI linking has. Nevertheless it does provide a guaranteed level of income, with no investment risk, which is something many people are looking for.

If however you are prepared to accept the additional risk associated with a With Profits Annuity then if bonus rates are sufficient it may go some way to solving the issue of income now with the potential for increases to help combat the effects of inflation.

If you would like to discuss With Profit Annuities or indeed any other retirement income option in more detail then do not hesitate to contact one of our team of independent advisers on 0115 933 8433 or email info@investmentsense.co.uk