Inflation eating into pension incomes but retirees have annuity choices

Pensioners on fixed incomes are among the biggest victims of inflation, watching their capital being eroded by rising prices as low interest rates ravage their savings.

And with above-target inflation and low interest rates set to be a feature of the economic landscape for at least another year, those nearing the end of their working lives have been urged to factor inflation into their retirement planning.

Level annuities, which pay the same level of income throughout retirement, have historically been the default choice for those converting their pension pot into a regular income. But experts now advise looking more closely at annuities that provide some hedge against inflation.

It is one of those decisions when it would be much easier if we knew how much longer we had to live. But with more people now retired for 20 years or longer, inflation can inflict some serious damage on static pension incomes.

When it comes to conventional annuities, there are three main options. The most popular is a level annuity, where you get the same income from when you retire until you die.

Laith Khalaf, pensions analyst at Hargreaves Lansdown, said: "This is what most retiring investors opt for because it offers the highest starting income. But its buying power is guaranteed to be eroded by inflation."

For example, a 10,000 annual income today will be worth just 5,400 in 25 years' time if inflation runs at a fairly benign 2.5 per cent.

Khalaf added: "Taking a level income isn't necessarily the wrong option; your state pension and any final salary pensions are inflation-linked so you are likely to have some protection already. However, if you do take this option it might be prudent to save some of your income as a buffer against future price rises."

The second option is an annuity linked to the retail prices index (RPI). As the label suggests, these pay an income in line with the prevailing rate of the RPI measure of inflation. The income rate is changed each year but is significantly lower at the start than a level annuity - a factor that puts many people off, despite the inflation-proofing element. The current rate for a 65-year-old man is just 4 per cent at the outset, compared with 6.4 per cent for a level annuity. And RPI would have to consistently run at 4 per cent for a 65-year-old man to break even from an RPI-linked annuity compared to a level annuity by average life expectancy.

More commonly used are annuities that increase each year by a fixed amount. Escalating annuities are usually fixed at 3 per cent per year and start at a higher level than an RPI-linked deal, with the rate for a 65-year-old man currently 4.8 per cent.

Khalaf said: "If RPI runs above 3 per cent your buying power is eroded. However, conversely, if it runs below 3 per cent your buying power increases. A 3 per cent escalating annuity breaks even with a level annuity before average life expectancy for a 65-year-old man."

Which you go for depends on the level of non-pension income you have, your risk appetite and where you think inflation is heading. Most people instantly opt for a level annuity because they want the full income level straight away. But if you want to plan for the future, experts advise taking inflation into consideration.

Graeme Mitchell, managing director at Lowland Financial in Galashiels, said: "If you go for a level annuity and that income is OK for the time being, you won't have to touch your savings or investments. But if you have an index-linked annuity you may need to top up your income with your savings in the short-term, as the starting income is lower.

"An index-linked annuity should be the starting point because it's more likely to give you an income keeping pace with inflation. But of course remember that the income could fall if we experience deflation."

There's nothing stopping you combining the various options by splitting your pension pot between different types of annuity. But whatever you do, make sure you shop around for the best deal on the market, rather than accepting the annuity your pension provider will automatically offer.

Khalaf estimates that by securing the best rate on the market you could boost your income by 40 per cent for life. He said: "Both a level income of 14,000 and a level income of 10,000 will be eroded by inflation, but I know which one I would rather have."

Similarly, enhanced annuities pay a higher income to those who smoke or are in poor health, on the assumption that the payout period will be shorter than average.

But it's not all about conventional annuities. Several new options have been made available in recent years, giving retirees far more flexibility.

Temporary annuities, offered by firms including LV= and Living Time, tend to have terms of between five and 15 years, meaning you are not tied into one income level throughout retirement. There is the danger that annuity rates are lower by the time you need to secure a new one, however.

Further up the risk ladder are variable annuities, combining the guarantee of annuities with potential for investment growth. Again, there are several drawbacks, including the cost and higher risk.

And new rules introduced in April made income drawdown more attractive for some people. Drawdown involves leaving your pension invested and taking money from it in tranches, offering the prospect of continued growth but also the risk of losses.Until April those in drawdown effectively had to buy an annuity by the age of 75, but that is no longer the case under the new flexible drawdown arrangement, available to investors with a guaranteed income of at least 20,000. Investors are taxed at 55 per cent on death, meaning 45 per cent of the fund can be left to children, whereas nothing can be left from a conventional annuity.

Mitchell said: "Drawdown is more attractive than it was, depending on your fund size and other assets and provided you're happy with some investment risk in your future income. But if you have a relatively small fund or your pension is your only source of income, it is very risky."

Again, however, there's nothing stopping investors from mixing and matching an annuity with a drawdown plan. Khalaf said: "You don't have to allocate your entire pension pot to just one of these options, you can spilt it between them and hedge your bets."

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