Inflation Linked Annuities - A Quick Guide
Inflation linked annuities (commonly known as RPI annuities) offer the chance to protect your income against the problem of inflation. The most popular annuity purchase in the UK is a level annuity that pays the same amount of income each year throughout the whole of your retirement. However, although you will be receiving the same amount of income each year, your actual spending power decreases each year due to inflation. If inflation remains particularly high over a long number of years, this can have a substantial impact on your living standards. Inflation levels have surpassed 5% in the past few years, following a long period of low inflation of less than 3%. No-one can of course accurately predict future inflation levels, but one thing is certain which is if you receive X amount in annuity income today, that money will be worth a lot less in 10 or 20 years time.
To deal with rising prices some retirees choose to opt for an inflation linked annuity. Instead of the same amount of income being paid each year, your annuity income is linked to the performance of the Retail Prices Indes (RPI). This measure of inflation excludes certain costs such as mortgages which is measured using CPI (Consumer Prices Index). When you choose an inflation linked annuity your starting income level will be lower compared to a level annuity because you are in effect just deferring income. It can be as much as 40% lower compared with a standard annuity which is why most retirees choose this option as it has the highest starting amount. If they have not received any financial advice they may not even be aware they had alternatives however.
Although it is wise to consider the impact of inflation on your retirement income, an inflation linked annuity may not be the best way to do so. To ‘benefit’ from taking one, inflation would have to remain at a high level (over 5%) for a protracted number of years, a pattern which has not occurred recently in the UK economy. In fact prior to 2008 inflation had remained below 3% for over ten years. Some experts believe you would have to live well into your 90′s in order to benefit from an RPI annuity. Moreover your income could fall if we have a period of deflation which occurred back in the Autumn of 2009. So although they help mitigate the impact of inflation on your income, they are in themselves a risk as your are basing your future income level on what inflation will do. One alternative that will ensure your income rises is an escalating annuity which gives you the option to choose by how much your want you income to increase each year. This is normally between 1% and 3% but gives you control over what your income will be.
