Don’t be quick to rule out a rising income in retirement

September 28th, 2013

Lifetime annuities have always been a popular choice for retirees seeking a guaranteed source of income for life but according to a recent ABI report, 43% of people don’t take any financial advice before buying an annuity and the vast majority choose a level income that will not increase in payment. 

However, whilst a non-escalating annuity will pay the highest level of income initially, because the income will never increase the effect of inflation could seriously erode its buying power over time. The value of money has almost halved in the last 20 years and even if the Government’s target inflation rate of 2% is met, the buying power of a level annuity bought today could easily be less than half of what it was at outset if someone enjoys a long retirement.

If we also consider that retirees spend a greater proportion of their income on things that tend to increase in price at a faster rate than inflation (for example, energy bills and food prices have both increased well beyond Consumer Price Index rates in recent years) the benefits of choosing an increasing annuity is something that needs to be given serious consideration.
To help illustrate the point, if you are a 65 year old in good health with a fund value of £500,000, you could buy a single life annuity of around £30,000 pa that won’t increase compared to a starting income of about £18,000 that would increase every year in line with inflation. Whilst, on the face of it then, the much higher level annuity may look more attractive, it is not inconceivable that this income might need to be paid for at least 30 years and even if you don’t live for another 30 years you could still ‘make a profit’ depending on what the actual rate of inflation is. For instance, if inflation was 4% every year it would take 15 years for an initial annual income of £18,000 to overtake a non-increasing income of £30,000 pa and a total of just over 25 years for the cumulative amount of income received to outstrip the non-increasing annuity.

In our experience, the vast majority of people who choose a level income when purchasing an annuity do so because they like the idea of having more to spend earlier in their retirement when they are likely to be more active but also because they are put off by the amount of time it will take to be ‘in pocket.’ When looking at the time it will take to be ‘in pocket’ though many people underestimate their life expectancy – and the wealthier you are, statistics suggest the longer you are likely to live.

Whilst, however, the risks of inflation in retirement can often be underestimated and what might seem a good level of income on the first day of your retirement could look quite paltry 20 years later, a level income may be the right answer if you have a shorter life expectancy and/or other assets to call on when inflation starts to bite. And, if you do have a medical condition or lifestyle that is likely to result in a shorter life expectancy an enhanced or impaired life annuity may be available to boost your income even more.

The main problem though is that many individuals will consider their position today and not think much further ahead – and even those that do consider the future often underestimate their life expectancy. For example, the average life expectancy of a 65 year old is currently about 20 years but many retirees may fail to fully consider that because this is an average this will include a high proportion of less affluent people with health problems who, statistics suggest, will not survive anywhere near 20 years.

Statistics show that individuals with substantial pension pots are far more likely to live well beyond the ‘average’ and if you are a couple planning your retirement there is also an increased likelihood that at least one of you will live a long time. Either way though, where health issues are not present at the time of planning, it would probably be sensible to consider a cautious approach and assume that you (and/or your spouse) will live well into your 90s at least.

Once you take a potentially longer life into account, choosing a lower starting income that will rise each year may look quite appealing. Even if you think a higher starting income that will never increase would be preferable, you should still look to have a fallback position when inflation inevitably starts to eat into the buying power of that income. There is also no reason of course why you couldn’t choose to buy a level annuity with some of your fund and an escalating one with the balance.

In summary though, how best to take your retirement benefits is probably one of the biggest decisions that you will make in your life and it is important to be aware that annuities are only one of the options you can consider. Making a decision without first taking advice from a professional could lead to the wrong outcome, and if an annuity has been purchased it is vital to remember that this is not something that can be changed at a later date.