Annuity Income and Inflation
Inflation as defined by Wikipedia is “an average index used to measure the rise in the general level of prices of goods and services in an economy over a period of time” which in layman’s terms means the average amount by which goods and services are increasing. Monetarism an as economic theory identifies keeping inflation low as the main goal in achieving sustained economic growth, as opposed to reducing unemployment. The reason for this is that whilst unemployment is a burden on the people without jobs, high inflation (it is argued) impacts the entire population, including all those who are employed. If wage inflation is stagnant or very low (as it is at present) then people’s living standards are reduced by higher prices. For those on fixed incomes, which often includes a high proportion of retired people, the problem is intensified because they have no means by which to raise their income in the future to mitigate against this.
An annuity is a form of insurance that pays a guaranteed income for life, ensuring that retirees never outlive their pension fund. The most popular choice for those buying an annuity is to take a level annuity that pays an equal amount every year until death. Whilst this provides financial security in that the individual will never run out of money, what it doesn’t do it address the problem of rising inflation, which eats into the real terms spending power of each annuitant. Of course the extent to which an individual will be impacted upon by inflation depends entirely on how high or low inflation is over the lifetime of their retirement.
Measurement of Inflation
There are two measurements of inflation in the UK, RPI inflation (Retail Prices Index) and CPI Inflation (Consumer Prices Index). The former includes mortgage costs and Council tax costs which is why it is normally higher than CPI inflation. Small wonder then that the government prefers to use CPI inflation when announcing the monthly rate. Of course retirees may or may not have a mortgage but they will all be liable for Council tax. To illustrate the impact inflation can have on a retired person, consider that after 20 years or more in retirement many compulsory costs such as Council tax may be substantially higher than they were when the person retired. In the UK Council tax has jumped by almost 50% since 1997, with some accusing the then government of using it as a stealth tax. Some recent research carried out by a major UK insurer found goods and services that on average cost £100 in 1991, did in 2011 cost £176. This represents an average annual inflation rate of 2.8% over the period 1991 to 2011. However this only tells half the story because overall Cost of Living includes the prices of all goods and services whereas what really matters to most individuals is the price of goods and services they buy most often, such as food, petrol, and utility costs. These have all in the past five years risen way above the CPI or RPI rate, with domestic gas prices rising by 67% and electricity rising by 28% in the five years since 2007. The price of food has also been increasing at above inflationary levels, with the British Retail Consortium measuring UK Food Inflation at 5.4% in March 2012. So for a retired person who on average will spend more of their income on essential purchases compared to the rest of the population, their ‘real’ inflation rate is much higher than the RPI/CPI rate. This has been dubbed so called ‘grey’ inflation and is a real issue for those on fixed incomes.
Annuity Income vs. Inflation
Given the data above, it is wise for those who have not yet bought their annuity to think long and hard about inflation and the impact it will have on their future living standards. There are several options available. The first is to build in escalations to your annuity income, either by setting a pre determined percentage increase or by tracking your income to the RPI index, known as an inflation linked annuity. In both these instances your starting income will be lower, however your income will increase in the future. In the case of an RPI annuity, the increase is relative to inflation, so if for some reason inflation does not rise, e.g it falls to 0% then you won’t get any increase. If however inflation rises sharply, then you will benefit from the choice you made as your income will keep in line with the rise. The companies that offer RPI annuities give themselves plenty of margin and some industry experts conceded that you need to also live longer than the average time in retirement to benefit from this type of annuity. Aside from escalating annuities, the other way to potentially increase your income is to choose an investment linked annuity whereby your pension fund is invested into equities on your behalf. These are only suitable if you can incur the risk that your income is tied to the performance of these investments, which could go down as well as up.
For those who are retired, inflation becomes more of an issue the higher it is and the longer you live. Neither of these two can be predicted with any great certainty beforehand which can make planning for them more difficult. If you can afford to take a lower starting income from your annuity, it is wise to build in some form of escalation for the future.
Editor’s Note: There are at least two ways to protect your annuity against inflation eroding its value. The first as mentioned in the article is to buy a rider that will index your payout to inflation. In this case you will receive less money at the beginning and more as time goes on (as inflation increases). As mentioned, the insurance company issuing the annuity wants to play it safe and so they will start your annuity low, so they will not lose if inflation gets out of hand. Another problem is that if you don’t live very long, you lose the money you could have gotten had you taken a straight annuity.
The second method involves taking the matter of inflation protection into your own hands rather than relying on a rider. You basically divide your money into two pots. Perhaps 1/3rd and 2/3rds you take the larger portion and buy a regular annuity just like before. But you take the remainder and buy a 2nd deferred annuity that will begin paying out at some point in the future, say 10 years after the 1st annuity started paying. This has two benefits. First if you should die during the interim period (before payout begins) your heirs would still get the full value of the 2nd annuity. And should you live you will get a higher payout because the annual payout is based on the age when payout starts and the older you are the more it pays. Also it will have had 10 additional years to grow so the base value will also be higher, thus giving your retirement income a nice kick.