Level or inflation linked annuity?

At retirement, most people are attracted to a level annuity rather than one linked to the Retail Prices Index (RPI) because the stating income is some 40% higher and it would take over 17 years for the RPI annuity to reach the level annuity. Just because an RPI annuity is very expensive it does not follow that investors should shun them or avoided protecting their pension income from the effects of inflation especially when the spending power of a level annuity is halved in just over 20 years if inflation was to average 3.5%. The average 60 year old may live for another 25 years.

Important issues for Middle Britain

In fact a large part of middle Britain may be making the mistake of buying level annuities because they are basing the decision on short term factors such as the starting income rather than considering long term factors such as their longevity, future income needs and threat of inflation.

Asset backed annuities

One way of hedging against inflation is to consider an asset backed annuity. These include Prudential’s with-profits annuities, MGM’s new Flexible Income Annuity and Lincoln’s i2live annuity. The rationale is that in the longer term, equities will provide an effective hedge against and there the annuity income will increase if investment returns are above a certain level. Clearly these annuities are more risky than level annuities and therefore only suitable for those who can take this risk. Perhaps those facing difficult decisions over their annuity options can learn from the world of investments where the cardinal rule is “don’t put all of your eggs in the same basket. Translated into annuities this might mean investing part in a level annuity for maximum growth, part in an RPI annuity for guaranteed inflation protection and part in an asset backed annuity for future income growth.

This doesn’t have to be complicated because a specialist annuity adviser should be able to arrange a portfolio of annuity options by arranging annuities from different insurance companies. This portfolio might include guaranteed annuities or fixed term annuities as well asset backed annuities.

The governor of the Bank of England might be getting ready to write a letter to the Chancellor of the Exchequer explaining why inflation is soaring ahead, and this should prompt professional advisers to explain to their clients the various ways of protecting their annuity from the future effects of inflation.