Why a flat annuity beats an inflation-linked annuity

It seems sensible to retire with an income that rises with inflation. But the premium charged for inflation-linked annuities means you may actually lose out.

When you reach your 50s or 60s, you will probably sell three-quarters or more of your pension pot – or other savings and investments – in return for an annuity. It's what millions of us do.

An annuity is a guaranteed income, usually paid monthly, and it's usually paid for the rest of your life.

What everyone gets is the certainty of an income. What they don't all get is certainty that the income is safe from inflation.

Level or rising retirement income

You can choose to get an annuity that pays you the same amount until you die. Alternatively, you can choose one that rises every year to help combat inflation.

At first glance, taking a rising annuity seems like the obvious call. However, if you do, the starting income is much lower.

Recent figures show that a 60-year-old selling a £100,000 pension pot for an annuity might expect this:

*Inflation as measured by the Retail Prices Index, the most comprehensive state measurement.

Your actual annuity will vary depending on health, shopping around, whether you want your pension to be paid to your spouse after your death, and other personal factors.

It will also vary depending on financial conditions at the time you buy your annuity. When interest rates are higher, for example, you can generally expect to get a larger income when you cash in your retirement savings for an annuity.

All that aside: looking at that table you can see that, if you choose a rising annuity, your income from your private savings in the first year might be half as much as it would be with a level annuity.

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Which is best for you?

A company called Retirement Assured recently estimated that, at the annuity rates you can get today, a 65-year-old male taking a rising annuity might have to wait 14 years before his income catches up. He will then have to make up the losses during those first 14 years, which will take another four years.

For male smokers, the crossover age could be 11 years, but you might not have been paid an equal, cumulative amount until you've received an annuity for 22 years.

The conclusion for everyone, according to Retirement Assured, is that if you live an average life expectancy or less, you can expect to be better off with a level annuity. I'm sure financial advisers come across individual cases where a rising annuity is appropriate, but all my own tests for those retiring at different ages show much the same conclusion.

Even if you expect to live longer, there's still a good argument for choosing a level income. As Peter Quinton, head of annuities at Retirement Assured, said: "Consider that people are generally active when they first retire and move into the so-called “gardening phase” later in life, when they tend to spend less."

If you need long-term care

Quinton acknowledges that long-term care can't be funded “from this arrangement” of a level annuity, but he proposes no alternative. A rising annuity isn't likely to cover those bills for most of us either.

Currently, there is no cheap, or even cost-effective, way to save or plan for the potential costs of long-term care. I'd much rather give you a solution to this expensive problem but the truth is that, since most of us struggle to save enough for retirement as it is, we just have to take our chances on long-term care.

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Level or rising – it might not matter much either way

Most people don't put aside enough for retirement. People buying annuities now are generally getting an income of around one-quarter of that shown in the table above.

That's why the bulk of pensioners' incomes are increasingly being paid by the taxpayer through the State Pension, topped up with housing benefits, pension credits, Council Tax credits, and other means-tested benefits, to ensure they can get by. You can read a typical, real-life example of this in How can pensioners in the same situation get different benefits?

Private annuities – whether rising or level – form a small part of many pensioners' overall income. Whether that income is £2,000 or £4,000, this income is typically topped up to more or less the same amount through benefits, so a good number of people will not really notice the difference whichever annuity they choose.

The problem is that this might not always be the case for them, or for future retirees. It's dangerous to rely too heavily on handouts funded by taxpayers, because sometimes taxpayers probably won't be willing or able to pay as much. This makes it extremely difficult to plan your retirement or choose an annuity.

Consider alternatives to pensions and annuities

The future is very uncertain, but there are four things we can do to either improve our pensions or prepare for retirement in other ways. I'll be writing about these things next month, including why I have turned my back on pensions altogether.

What do you think? Will you be buying an annuity when you retire? Do you think you're saving enough? Let us know your thoughts in the comment box below

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How to make sure you have enough money in retirement

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