David Harris goes through the issues retirees face when tackling the impact of inflation on their retirement income
Individuals reaching retirement have to strike a balance between competing factors when converting a pension into an income stream. One hot topic, due to all the recent headlines about spiraling fuel and food prices, is inflation.
Those on fixed incomes need to understand the likely erosion of their purchasing power - inflation of just 4% will halve the value of their income in less than 17 years, a shorter period than the average retirement.
The problem is that no-one has a crystal ball and inflation is only one number in a complex equation that includes annuity rates or investment returns as well as issues closer to home such as an individual retiree's future health or life expectancy. Retirement advice has to strike a balance between all these competing issues.
Inflation-proofing is also clearly not top priority for the majority of retirees. In 2006, 87% of the 350,000 annuity contracts sold paid a level income for life, just 6% included some element of escalation with the remainder made up of impaired/enhanced annuities and investment-linked contracts.
What is putting off retirees? Some probably felt the income reduction in the early years of retirement was too much and that, in any cases, their income needs were likely to ease with slowing lifestyles. Others may have other options for boosting income at a later date, perhaps through drawing on non-pension assets, inheritances or through downsizing or releasing equity from their homes.
The high perceived cost of inflation-proofing is an obvious stumbling block. A 65-year-old, non-smoking male investing a £100,000 pension fund in a single-life annuity guaranteed for 10 years could receive a level income of £7,692 a year from the best paying lifetime annuity provider. This is a significant £3,012 a year more than the retail price index (RPI)-linked equivalent (£4,680).
If inflation averaged 5%, it would take 12 years for the RPI-linked annual income to exceed the level income, and 20 years for it to have paid out more overall. However, if inflation averaged 2%, it would take 26 years for the RPI-linked annual income to catch up, and the buyer would have to live to age 113 before they had received more overall.
An alternative strategy is fixed escalation, either through a conventional lifetime annuity that pays out for life, or a fixed-rate annuity that pays a secure income for an agreed period then matures, allowing the retiree to rethink their financial strategy according to their personal circumstances at that time. The 65-year-old above could receive a starting income of £5,664 from the 'best buy' lifetime annuity which, rising at a fixed 3% a year, would exceed the level annuity annual income in year 12 and the overall income by year 21.
Solutions targeted at wealthier and more financially sophisticated retirees such as income drawdown or with-profits annuities effectively keep funds invested in a range of assets. The hope is that positive investment performance will outweigh any negative effects from inflation plus any extra costs of advice or running the plan.
However, as recent stock market gyrations remind us, there are no guarantees this will work. A retiree in income drawdown faces both inflation and investment performance risk. Even those willing to pay for the guarantees of 'third way' variable annuities have no certainty their income will grow to match inflation, or indeed grow at all.
The bottom line is that hedging pension income fully or even partly against inflation either means higher costs or risks, and often a combination of the two. Wealthier people may be able to bear the costs and risks but this still leaves the majority - the hundreds of thousands of people each year who make up the mainstream retirement income market - still needing to find the best solution possible.
We believe that increased life expectancy is driving fundamental change in the retirement income market, change that is likely to accelerate. Actuarial forecasts suggest men will on average live to age 88 and women to 91. About one in 10 of today's retirees will live to 100. Two-thirds buy their lifetime annuity at the point of retirement - typically between ages 60 to 65 - effectively locking themselves into the fixed benefits for many years to come with no ability to change their retirement income to reflect changing economic or personal circumstances.
The majority of buyers fail to exercise their open market option to ensure they receive the most competitive annuity rates. They also lock into 'healthy lives' annuity rates, just at a time when the chances of succumbing to ill health are starting to increase. In fact, although retirement is getting longer, we are spending a greater proportion of those years in poor health. Finally, lifetime annuities offer no income flexibility in contrast to unsecured pension products like income drawdown or fixed term annuities that allow retirees to tailor their incomes to changing needs over the years.
If the inflation cycle picks up over the next few years, those locking into the fixed income of lifetime annuities now without inflation proofing could be storing up trouble. Those that wait could be rewarded with higher future annuity rates as central banks try to stem the rise with higher interest rates, lowering the costs of assets such as bonds and shares and pushing up yields. If inflation stabilises, retirees who wait until they are closer to age 75 can still retain flexibility and control over their funds without foregoing income.
If inflation falls and annuity rates ease back, those clients who wait could be faced with the prospect of a lower retirement income. While the risk of lower annuity rates in the future is one important factor for clients to bear in mind, many of these could potentially benefit from being able to respond to their changing individual circumstances - for example, through becoming eligible for higher impaired rates, future product innovation, legislative changes, or being able to extend death benefits for longer. Absolute income is obviously an important factor for retirees but, when the future is so uncertain, there is also considerable value in being able to rethink the strategy and tailor the solution through the course of a long retirement.
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