Christine Senior looks at the options available to retirees looking to mitigate the effect of inflation on their retirement income
The 'i' word has raised its head again. After years when inflation was considered more or less under control, suddenly it has reappeared on the political and economic agenda. The possibility of inflation hitting 6 to 7% is even mooted, heights unknown in the recent past.
In March the consumer price index stood at 2.5%, while the alternative measure which includes housing costs, the retail price index, was 3.8%. Salaried workers with their annual wage increases may not be too concerned, but the picture is different for retirees. Even the politically acceptable 2.5% inflation level for someone on a fixed income over a 30 year retirement period can erode their income massively. Should it rise to 5% or even higher and stay there for a while, and the effects for a retiree could be catastrophic.
Add to that rising longevity - a man of 65 can now expect to live another 20 years - and the cumulative effect of inflation has longer to take its toll, with the result that even more of a retiree's income falls victim to inflation.
The problem is compounded because retirees face generally higher inflation than the working population. A higher proportion of their income goes on life's necessities like food, gas, electricity, and petrol, and the last few months have seen prices rocket for these, while falling costs for plasma screen televisions, champagne, and PlayStations leave them relatively untouched. For retirees inflation is more likely to be nearer to 6% than 3%.
Because inflation has become such a hot topic, many IFAs are devoting more time and effort to advising clients in this area - both in terms of how inflation affects their spending, and in the range of products available to help them counter its effects in retirement. One source of help is the website of the Office for National Statistics (www.statistics.gov.uk), which allows individuals to input data about their spending to work out their own personal level of inflation. It would seem IFAs are increasingly using such tools to educate clients on the effects of inflation over time.
Mike Morrison, pension strategy manager at Winterthur, commented: "A fund management house has told me they have some IFAs who have sat with clients and worked through the inflation rate, calculating with particular clients to show individuals what their own personal level of inflation might be. It can't be an exact science but it's a pretty good way of starting."
While escalating annuities that increase in line with inflation are an option when retirees take out their annuities, most tend to opt for a level annuity, to get a higher income now. And no wonder. According to the Annuity Bureau, currently a 65-year-old man with a savings pot of £100,000 can expect to get an annual income of £7,543 with a level annuity (from Prudential), but he will see that drop to £4,814 for one that escalates in line with RPI (from L&G). It's generally reckoned that you have to live around 14 years on an escalating annuity before you see your income catch up with a level annuity, and around the same time again before you recoup the funds you have foregone.
So level annuities tend to be the default option for those taking an annuity. However, these products carry risks of their own according to Steve Lewis, managing director of the Retirement Partnership.
"I think we need to recognise level annuities have a significant risk and it's inflation risk, that's perhaps not explained clearly enough to people," he said. "But there are some products you could use to hedge against inflation. I'm not saying annuities are bad I'm saying a cocktail of solutions is perhaps appropriate."
At the other end of the scale from annuities, drawdown allows retirees to stay invested (until the age of 75, when regulations dictate they must buy an annuity), thus participating in equity market gains. The obvious risk here is that if markets plummet, retirees' savings follow them downwards.
However, a 65-year-old may well have 20 or more years of living to fund, and over the long term equities do provide a hedge against inflation. However, drawdown is only seen as an option for the relatively well-off. A figure of £100,000 is often quoted as a minimum necessary to make drawdown viable; some IFAs quote a figure of £250,000. However, new products are opening up drawdown to the less wealthy. For instance, Prudential launched a drawdown product last year with a minimum of just £37,500.
"It's definitely becoming more accessible for Middle England," said Aston Goodey director of retirement income at Prudential. "More people can access drawdown which gives them the ability to invest in the stock market or certain funds which may then give returns greater than inflation. You have to recognise the risk with that kind of proposition, particularly if you put all your eggs in one basket and go for some kind of Chinese or Japanese fund that you expect to have great returns."
Other options that sit between annuities and income drawdown are the American style variable annuities, or third way annuities, offered by the US providers MetLife, Hartford and Lincoln. These enable people to maintain their exposure to the stock market, allowing them to benefit from potentially higher returns of equities, while at the same time offering a guarantee to limit downside risk.
Peter Carter, head of product marketing at MetLife describes its product as a drawdown plan, offering guaranteed income within a SIPP. Investors are guaranteed to get their money back, and this can be taken as a lump sum at the age of 75 or in the form of income payments of 5% over a maximum of 20 years. The minimum investment is £50,000.
The main criticism of these kinds of products is the level of fees, which mean investment returns need to be relatively high to produce inflation-busting returns, net of fees. MetLife's actively managed funds with 85% equities carry an annual management charge of 2.5%. A recent change to the product to include index funds brings the charge down to 1.2% for this option.
"The argument on cost is entirely dependent on how much value the consumer puts on the guarantee," said Carter. "When you see the three year stock market we had from 2000 to 2002 where the market fell by 50% most people would have been happy to pay for a guarantee if it had protected them from that."
However, while these products would seem to offer an ideal route between annuities and drawdown they have attracted more than their fair share of criticism.
"You are probably looking at total charges of 3 to 4%, quite a significant proportion," said Laith Khalaf, pensions analyst at Hargreaves Lansdown. "If you consider you are taking perhaps a 5% income a year and on top of that you pay charges of perhaps 3%, you are going to have to get 8% from your portfolio just to tread water."
However, these fears could be alleviated by the planned entry of Standard Life and Aegon. It is hoped that the increased competition will drive down prices.
Blend of products
Another way of potentially increasing annual payments from an annuity is to choose a with-profits annuity. Clients chose an anticipated bonus rate (ABR) and if the provider's declared bonus exceeds this the annuity payments increase, but if it's lower annuity income drops. Most people choose a mid range ABR, which gives them a similar starting income to a conventional level annuity.
"The fund itself is a low to medium risk proposition because it is a well balanced fund, which is actively managed," said Goodey. "This is probably appropriate for the mass market. Drawdown tends to be a more expensive, more high risk proposition. With-profits is a happy middle ground between the two."
However, while all these products have their merits no one product can successfully mitigate inflation. Lewis at the Retirement Partnership favours using a combination of products to beat inflation. For instance, using fixed term annuities, which at the end of the fixed period allow people to reassess their needs and their strategy. Another possibility might be to combine annuity and drawdown, he said.
"If you have a £250,000 portfolio perhaps put £200,000 in a conventional annuity with £50,000 in a deferred pension or drawdown. Holding back to a later date would not be a bad concept. You are hedging against inflation and before 75 retaining a death benefit as well. Taking on an alternative strategy doesn't necessarily increase risk overall because you are offsetting some inflation risk with some investment risk."
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