Escalating Annuities: Choices
There are different
annuities to suit different needs. The main types are:
-
level;
-
increasing; and
-
investment linked
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Level Annuities
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.
Compare level and
increasing annuities
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Increasing Annuities
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.
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