June 3, 2011 5:24 pm

Inflation proof your pension income

Individuals approaching retirement are looking for new ways to “inflation-proof” their pension income, as rising living costs continue to erode real spending power.

With inflation running at twice the Bank of England’s target rate of 2 per cent, millions of retirees on fixed incomes, such as level annuities, are seeing a real decline in their income.

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Advisers say that those approaching retirement must now consider a range of ways to protect their income against rising living costs. Here, we set out some inflation-proof tactics.

RPI-linked annuities

Income from these annuities rises and falls in line with the retail price index (RPI). At 5.2 per cent, RPI is currently higher than the consumer price index, the Bank’s preferred inflation measure, at 4.5 per cent.

However, RPI-linked annuities are rarely sold. In 2009, they made up just 3 per cent of all annuities purchased. Advisers say this is because they can look poor value compared with the starting income from a level annuity.

For example, a 65-year-old man retiring with £40,000 in pension savings could buy a level annuity income of £2,700 a year. If he opted for an RPI-linked annuity, his starting income would be just £1,700.

It would take 11 years of annual increases for the RPI-linked annuity to match the annual income from a level product. But even after this “cross over” point, it would be more than 20 years before the total income from the inflation-linked product beats that of the level annuity, because the RPI pension was less generous in the early years.

“When faced with these figures, the vast majority of clients go for level and take the jam today,” says Katherine Oxenham, financial planning director with Annuity Direct. “The attitude seems to be that they want to enjoy their income as much as possible now and worry about the future when it happens.”

Those looking to buy an RPI-linked annuity can choose between products that rise and fall or have a “floor” so they don’t fall in times of deflation. The timing of the annual inflation increase or decrease differs from provider to provider.

“Aviva uses the RPI figure published the month before the increase is due but does not decrease the income if inflation is negative,” explains Oxenham. “Partnership uses the RPI figure three months before the anniversary and does reserve the right to decrease income during negative inflation, although it didn’t exercise that right two years ago.”

Fixed-rate escalating annuity

Income from these annuities escalates each year, typically at 3 per cent or 5 per cent. They have a higher starting income than a RPI-linked annuity but a lower income than a level annuity. The Money Advice Service, a free service, estimates that it would take about 14 years for a 3 per cent escalating annuity to catch up with a level annuity and it would be 26 years before the total income from the 3 per cent escalating annuity exceeded that paid by the level annuity.

Investment-linked annuities

These annuities are backed by assets such as stocks and shares. With-profits annuities are linked to the performance of an insurance company’s funds, while unit-linked annuities are linked to the funds in which your pension invests. These annuities come with annual charges and investment risk. But advisers suggest that, when bought in combination with a level annuity, they could help protect against inflation.

“One strategy is to split the fund by buying both a level annuity and an investment-linked annuity,” says Billy Burrows of the Better Retirement Group.

“The benefit is that you will have the security of income from your level annuity but also the potential upside from your investment-linked annuity to top up your income. Of course, there is always the risk of poor investment performance.”

Fixed-term annuities

Lifetime annuities cannot be changed once they have been set up. However, a fixed-term annuity can be secured for a period of time, such as five years, and used as an indirect hedge against inflation.

“You may be able to secure a better annuity rate in five years’ time, for example, if your health has declined,” says Gemma Goodman, head of The Annuity Bureau. “But the gamble you take is that overall annuity rates will be lower at the end of your fixed term.”

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