Escalation: Inflation Protection
There are different annuities to suit different needs. The main types are:
- increasing; and
- investment linked
A level annuity, sometimes called a ‘standard’ annuity, pays the same income each year for the rest of your life. The main drawback with a level annuity is that what you can buy with the income falls as prices rise through inflation. For example, suppose at the start of your income groceries cost £50 a week. If inflation averages 3% a year for 10 years, their cost would rise to £67 per week. If you could still only afford £50 then you would have to buy fewer groceries. That is the effect of inflation.
Level annuities pay a higher starting income – compared to increasing annuities. Think carefully about the effect of inflation. Could you really cope with having no increases at all in your annuity income during your retirement, which could last 30-40 years?
Example of a level annuity
Harry retires at 55 and, typically, has a good chance of living 25 years or more. After taking his tax-free lump sum he has a fund of £40,000 to buy his annuity. He chooses a level annuity. This pays him around £2,800 per annum (£235 per month or £54 per week)
If inflation averages 3% a year, the buying power of Harry’s pension would fall dramatically as retirement progresses. After 10 years his £2,800 annual pension would only buy the same as £2,000. After 20 years it would fall to £1,500, and after 30 years would be £1,100. If inflation averages more than 3% a year then the buying power of Harry’s pension will fall even further and faster.
To protect your income from rising prices, you can choose an annuity that is designed to increase each year. There are two main choices:
- escalating annuities – your income is guaranteed to increase at a fixed rate each year, commonly 3% or 5%.
- RPI-linked annuities – your income is adjusted each year to reflect changes in the Retail Prices Index (RPI) – the main measure of inflation used by the government. So, if inflation is 3% one year, then your income goes up 3%. If inflation is 10% next year then your income goes up by 10%. However, your income is not guaranteed to increase each year – if the RPI did not rise, nor would your income. If the RPI fell, so would your income.
With an increasing annuity, the starting income is a lot lower than you would get from a level annuity. For example, for a man aged 65, the starting income from a 5% escalating annuity might be two-thirds or less of the amount from a level annuity. It could take more than 10 years for the escalating income to catch up, and nearly 20 years before the total that you would have received from the escalating annuity exceeded the total from a level annuity.
Example of RPI-linked annuity
Hannah retires at age 60. After taking a tax-free lump sum, her remaining pension fund is £35,000. She chooses an RPI-linked annuity. The pension starts at £1,750 a year (£146 a month, or £34 a week). After 10 years, inflation has averaged 2% a year. Her annual pension has increased to £2,133 a year. This means that she can still afford to buy the same as she did with £1,750 10 years ago. Over the next 10 years, inflation averages 10% a year. Hannah’s pension increases to £5,533 to maintain its original buying power of 20 years earlier (i.e.£1,750 a year).
Level or increasing?
You need to weigh up whether you think you will live long enough to benefit from the protection against inflation offered by an increasing annuity. Your income requirements may reduce as you become less active in older life – a level annuity may work well for you in a low inflation economy, which we are experiencing just now, but should inflation dramatically increase you may find the purchasing power of your annuity sliding too quickly.