Inflation linked Annuities: the case for and against

Posted on October 25th, 2011 | Categories - Annuities

Inflation has been front page news recently as figures have shown it has risen to the highest level in a generation. It is also generally accepted that the inflation rate suffered by older generations is higher than both published measures.

So, case closed, an Inflation Linked Annuity must be bought every time? Well, maybe not.

Given the headlines that the latest inflation figures made we thought we’d take a look at the case for and against Inflation Linked Annuities.

The case for

Erosion of income The effects of inflation can be startling and there is no doubt that it erodes a level or fixed income. Just compare the costs of an average shopping basket containing the following items:

1 loaf of bread
250g butter
12 eggs
1 pint of milk
1kg sugar
100g coffee

In November 1988 this shopping basket would have cost £4.11, by November 2010 the price has risen to £8.89, an increase of 116% in 22 years (Source: Office for National Statistics).

If you are a pensioner buying that basket of goods with a level or fixed income, you need to find the extra money from somewhere. You could spend your savings, you could change your shopping habits and buy the economy range, or you could cut out spending on other goods and services, but something has to change, unless of course you had an income which kept pace with inflation.

From the age of 65 a man statistically speaking has another 22 years to live; a woman has 24 years. If inflation was to average 2.5% over the remaining lifetime the buying power of a £10,000 annual income would reduce to £5,729 for a man and £5,446 for a woman.

These figures all confirm the damaging effects that even a relatively low level of inflation can have.

Current levels of inflation The levels of inflation we are currently experiencing are the highest for a generation, combined with low interest rates and falling Annuity rates they make for a ‘perfect storm’ for pensioners.

In an ideal world, and putting aside the disadvantages of an Inflation Linked Annuity for a moment, you would inflation proof all of your income.

It is worth remembering though that a proportion of your retirement income may already be inflation proofed.

The state pension often makes up a large proportion of pensioners income, it is guaranteed to rise in line with the higher of earnings, inflation (measured by CPI not RPI) and 2.5%. Many people also have a proportion of their retirement income made up from final salary pension schemes. These again have an element of inflation proofing built into the annual income.

Low interest rates on savings & stockmarket volatility Many retirees have in the past accepted a Level Annuity, believing that the interest from their savings or an income from their investments would help make up the shortfall when the income from their Annuity started to be eroded by price rises.

However, in recent years interest rates have plunged to levels which are generally not keeping pace with inflation and volatile stockmarkets have reduced the returns to investors.

An Inflation Linked Annuity would have meant that income might not have been needed from savings or investments, which were having their own troubles.

The case against

Inflation may fall Despite the current high levels of inflation many experts, including the Bank of England, believe that as we move into 2012 and 2013 inflation will start to fall back to more normal levels. Indeed in a recent speech the governor of the Bank of England, Mervyn King, said that domestic inflation was almost zero.

Other economists have gone further suggesting that we could be in for prolonged period of Japanese style deflation.

Of course the rise in inflation over the past couple of years could just be a spike in a much longer period of generally low inflation. Even if this is the case a relatively short period of high inflation could erode incomes by 15 – 20%, which will never be made up, unless of course prices fall.

Lower starting income The biggest argument against an Inflation Linked Annuity is traditionally the much lower starting level of income compared to a Level Annuity, this is demonstrated by the following figures which are based on a purchase price of £100,000:

Male aged 65 Female aged 65
Level Annuity £5,610.12 per year £5,646.96 per year
RPI Linked Annuity £3,249.24 per year £3,370.68 per year
Difference £2,360.88 per year £2,276.28 per year

The figures assume a joint life Annuity, with the male being three years older than the female, a 50% spouse’s pension, 10 year guarantee and income paid monthly in arrears. Source, the Investment Sense Pension Annuity Calculator.

In our experience most people prefer to have the higher level of starting income, believing a larger income is more important to them in the early years of retirement when they are still fit and active, compared to the later years when they may have less need for income.

Of course inflation will erode the buying power of the level income.

Breakeven point Taking the figures from the table above, when would the income given by the RPI Linked Annuity rise above the Level Annuity?

Male aged 65 Female aged 65
2% inflation More than 25 years More than 25 years
4% inflation 15 years 15 years
6% inflation 11 years 10 years

Of course this is not the breakeven point which only occurs when the cumulative income from the RPI Linked Annuity is above the Level Annuity. On average the breakeven point is eight years later.

The choice therefore between a Level and RPI Linked Annuity is as much to do with your retirement age and life expectancy as it is predictions for inflation. The longer you live the more you are likely to benefit from an RPI Linked Annuity.

The verdict for inflation linked annuitiesThe verdict

Perhaps unsurprisingly it’s a hung jury. The case hangs on three main areas:

1. Future levels of inflation

2. Your life expectancy and retirement age

3. Whether or not you have other sources of income which are inflation proofed

Trying to predict inflation is hard, even impossible. History tells us that we are likely to experience inflation rather than deflation in years to come, but we live in such unpredictable economic times who knows what level of inflation we can expect in the future?

The longer you live and the earlier you retire the more time inflation will have to erode your income, making an inflation linked income more valuable. Do your own calculations, make assumptions for inflation and life expectancy and see what your  own personal breakeven point is between an Level and RPI Linked Annuity.

Finally, consider other sources of income. The state pension, or a final salary scheme, both of which will be inflation proofed to some degree may make up a large proportion of your income, it may therefore be less important to buy an RPI Linked Annuity.

Of course all the talk about inflation linking and RPI Linked Annuities counts for nothing if you cannot afford to live on the income it gives you now and you may have no choice but to opt for a level Annuity.

Making the decision which Annuity to choose is never an easy one, our team of Independent Financial Advisers is here to help though. Working with you they can help you to make the right decision for your own individual circumstances, they can be contacted on 0115 933 8433, or by emailing info@investmentsense.co.uk