With food, fuel and energy prices becoming increasingly costly, how can you stretch your income far enough in retirement and beat inflation?
Inflation is bad news for everyone. But it's particularly unwelcome if you're on a fixed income, such as a pension.
This is because fixed-income pensioners will receive the same amount of cash, year in, year out - even though the prices of food, fuel and other everyday items are shooting through the roof.
So if you're coming up to retirement and have yet to take your pension benefits, how can you make sure you don't go short?
There is one obvious answer: inflation-proof your pension income.
Sounds simple... but how do you do it? And how much does it cost?
Retirement rewards
First, let's look at what usually happens at retirement and why most pensioners are on fixed incomes:
When you take benefits from your pension, you'll probably buy an annuity which converts the lump sum from your pension fund into an income. You only get one chance to buy an annuity, and once you buy it, you're committed for life.
Most people buy a `level' annuity, which means the income they receive will stay exactly the same every year for the rest of their lives.
An annuity which pays a level income might suit you perfectly well. Perhaps you have other sources of income from savings or investments which supplement your pension. Or -- if you're lucky -- the income from your pension itself may be more than sufficient, so you don't need to protect it from the effects of inflation.
But for the not-so-lucky, you'll need to think carefully about how to make sure inflation does not erode the income you draw from your pension.
The most competitive annuity today will see a pension pot of £100,000 provide you with a level income of around £7,920* a year for men and £7,420* a year for women.
But take a look at the figures below to see how inflation could destroy the value of your fixed income (in real terms) over the next 25 years:
How inflation could reduce your pension income
Starting pension value in 2008 | Inflation increases by X% each year | Value of pension in real terms after 25 years in 2033 |
|---|---|---|
£7,920 | 2% | £4,779 |
£7,920 | 3% | £3,698 |
£7,920 | 4% | £2,854 |
£7,920 | 5% | £2,196 |
If inflation increases by 2% each year, your pension would be worth just £4,779 in real terms in 2033. And 2% may be a pretty conservative estimate, particularly since the government's own measure of inflation -- the Consumer Prices Index (CPI) -- currently stands at 3.3%.
If annual inflation leapt further this year, to 5%, and stayed at that level for the next 25 years, your pension income would reduce even more dramatically from £7,920 to just £2,196 in real terms.
Of course, it's impossible to predict how inflation will behave over the long-term. But even when inflation is low, it will still drastically cut the purchasing power of your pension.
Index-linked annuities
This leads me back to inflation-proofing your income. Did you know you can buy an annuity which is index-linked to protect your income from the effects of inflation? Index-linked annuities rise in line with the Retail Prices Index (RPI) -- which currently stands at 4.3% -- rather than the CPI.
These annuities sound great in theory, but there's one major drawback. The initial income you'll receive will be significantly lower than a level annuity. For example, the most competitive index-linked annuity today -- bought with a £100,000 pension pot -- will provide an income of just £4,815* for men and £4,425* for women. This is around £3,000 (40%) less than an equivalent level annuity.
That might seem like a lot of money to give up just to inflation-proof your income. That said, if you survive to reach average life expectancy (or beyond), an index-linked annuity may actually pay out more overall than a level annuity.
Let's say you are a man with a £100,000 pension pot. For the first 12 years, you will receive a higher annual income from the level annuity than you would receive from the equivalent index-linked annuity.
But after those 12 years have passed, the situation is reversed. You would then start to receive a higher annual income from the index-linked annuity than from the equivalent level annuity. And this will remain the case for the rest of your life.
So if you lived less than 13 years after you had bought your annuity, you would definitely have been better off with the level annuity. But if you lived for 13 years or longer, you might have wished you had gone for an index-linked annuity instead.
What's more, an index-linked annuity would prove better value over the long-term. After 25 years, the index-linked annuity would have paid out almost £209,000, while the level annuity (at £7,920) would only provide a total of £198,000 -- or £11,000 less -- over the same period.
That said, for the total payout from the index-linked annuity to exceed that received from the level annuity, you would have to live until you reach the age of 87 -- or 22 years after retirement. The risk is if you don't survive for that long, the level annuity would provide higher benefits overall.
On top of that, the RPI may be lower -- or indeed higher -- than 4.3% over the course of your retirement. If actual RPI inflation is lower, then the total payout from the index-linked annuity could fall below the benefits provided by the level annuity.
If you're not convinced that index-linked annuities are good value, then you could buy an annuity which increases every year by a fixed percentage instead. This is an escalating annuity, and typically the income it provides increases by say, 3% or 5% a year. If this set increase is less than the current rate of inflation, the escalating annuity will be cheaper to buy than the index-linked annuity.
Even so, depending on how inflation changes over time, the fixed percentage may prove high enough to beat inflation. That said, if inflation runs above the fixed percentage, your income will fall behind.
However -- just like index-linked annuities -- you will need to sacrifice some of the initial income you would have received had you chosen an equivalent level annuity. And again, there will be a crossover point where the income from the escalating annuity begins to exceed the payout from the level annuity.
Other ways to beat inflation
Index-linked annuities may be better value than level annuities in the long run. But when inflation is high, a low initial income could -- quite simply -- not be enough. Our own research at the Fool shows that the RPI measure may radically underestimate how inflation actually effects real people like you and me. If that concerns you, think about alternative ways of financing your retirement, such as equity release, an unsecured pension (also known as income drawdown) or a new third way annuity.
The latter two are both ways that you can leave part of your pension fund invested -- to combat inflation and hopefully provide capital growth -- while drawing an income at the same time. Read Increase Your Pension Income By £1,000 and A New Way To Boost Your Pension Income to find out more about these options.
Above all, it's vital you make the right decision now about how you're going to finance your retirement over the long-term. Don't just take any old annuity, shop around and get the best one. Remember that, hopefully, you'll be on this earth for at least another 25 years or more... and so will inflation!
*Annuities shown are for an annuitant aged 65 who is in good health. No guarantees or income for a spouse/partner have been included.
More: How To Buy The Right Annuity | Will Your Postcode Affect Your Pension?