How much additional expense does an inflation-linked annuity incur, and is it considered worthwhile?

One option on the table is an annuity, but the big question is: how long will it take for your income to catch up with a ‘level’ annuity? Let’s dive into the details.

In recent years, annuity deals have become quite attractive, especially for single life, no inflation-link ‘level’ annuities.

For example, a healthy 65-year-old with £100,000 can secure an income of over £7,270 annually.

But if you want an annuity that increases by 3% per year or in line with Retail Price Index (RPI) inflation, you could lose more than £2,000 annually.

With inflation currently at 2%, a level annuity might seem appealing, but there’s a catch: without inflation protection, you could struggle if living costs suddenly spike.

Inflation has been unpredictable, with rates peaking at 11% in October 2022.

So, should you opt for an annuity with inflation proofing? According to Helen Morrissey from Hargreaves Lansdown, a 65-year-old with a £100,000 pension pot can get up to £7,220 per year from a single life level annuity with a five-year guarantee.

However, inflation-proofed annuities offer much lower initial incomes: up to £4,540 per year for RPI-linked and up to £5,157 for 3%-rising annuities.

While the initial income from inflation-proofed annuities is lower, Morrissey highlights the long-term benefits.

For an RPI-linked annuity rising at 5% per year, it takes about 10 years to catch up with a level annuity’s starting income and around 20 years to draw the same overall amount.

If the annuity increases by 3% annually, it takes 12 years to catch up, meaning you’d be 77 before you reach the same income level.

Over 21 years, the total income matches the £144,000 from a level annuity.

The Risk of Inflation

Even with lower inflation rates, planning for the future is crucial.

As Morrissey warns, “The inflation beast may have been tamed, but it’s still a key factor in your retirement planning.”

Double-digit inflation can significantly impact your purchasing power, so preparing for various inflation scenarios is wise.

Alternative Approaches

Instead of committing your entire pension to an annuity at once, consider a phased approach.

You could annuitize in slices over time, securing guaranteed income as needed and keeping the rest invested for potential growth.

This strategy allows you to benefit from higher annuity rates as you age and possibly qualify for enhanced annuities if your health deteriorates.

Annuities are making a comeback, with sales reaching their highest levels since 2015.

They offer guaranteed income for life, a feature that’s becoming more attractive due to recent interest rate hikes.

However, the possibility of future interest rate drops means you shouldn’t rush your decision.

Fixed Rate vs. Inflation-Linked Annuities

When deciding between fixed rate and inflation-linked annuities, consider these tips from Nick Flynn of Canada Life:

1. Future Income Changes: Inflation-linked annuities start lower but may increase over time.

Model future inflation to see how your income might change.

2. Inflation Application: Understand how providers define and apply inflation to your annuity.

3. Tax Implications: Consider how your overall tax position might be affected by your annuity choice.

4. Blended Approach: Combining fixed and inflation-linked annuities, or incorporating drawdown, might best meet your retirement goals.

5. Research and Advice: Get quotes from multiple providers and consult a regulated financial adviser to make an informed decision.

Final Thoughts on Buying An Annuity

Waiting to buy an annuity until you’re older or less healthy might get you a better rate.

You can mix investment drawdown with an annuity for flexibility, but remember, once you purchase an annuity, you can’t change your mind.

If you’re healthy, a single life, no inflation-link ‘level’ annuity might seem best, but consider future inflation impacts.

Also, think about your spouse’s financial future if you choose a single life annuity.

Lastly, consider a ‘guarantee period’ to protect your investment if you pass away shortly after buying the annuity.

These considerations can help ensure a secure and comfortable retirement.

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