Vanessa Owen looks at the effect inflation can have on a retirement income
In our world we acknowledge the risk of inflation is a significant threat to a comfortable retirement. Indeed, over half (55%) of people over 50 and approaching retirement say they are concerned about the rising cost of living.
However the real impact that inflation will have on retirement income seems to have been overlooked with only one in four (26%) claiming to have considered its impact on their retirement income in the future*.
The Bank of England has been targeted with achieving a 2% inflation rate and recent data showing that the rate has dropped to its lowest in over a year is positive news for those worried about the rising cost of living. As anyone with savings and investments knows, a 2% growth rate isn't much so surely inflation risk is diminishing?
Well perhaps.... But consider this. Typically pensioners** do not have significant disposable income once all essential living costs, such as household bills, food, clothing have been paid.
If we assume disposable income equals 10% of total income at outset, just 2% p.a. inflation will reduce that income by 97% in just five years and in year six they will need to cut back on essentials.
Even if you assume 25% disposable income at outset this will have more than halved in five years and what's left of course won't buy as much as it did five years before.
So those little treats, gifts for grandchildren, holidays and other pleasures they now have time for quickly become unaffordable luxuries.
And this will be a lot faster than the BoE number led them to believe because the ‘Silver Inflation' rate (as inflation for the retired population is often labelled) is generally higher as a greater proportion of expenses usually go on bills and less on luxury items.
And it gets worse if you factor in increasing longevity. For a healthy man aged 65 retiring now, their life expectancy is approximately 18 years.
For a healthy female of the same age this is approximately 21 years (according to ONS figures) so the likelihood of reaching a point where making ends meet becomes a problem is very high when you consider the effects of inflation after just five and 10 years.
So what to do...? Ideally, some form of inflation proofing. However, the majority of annuities sold today are still on a level basis. For enhanced annuities, the life expectancy may limit the time for the inflation impacts to take effect and the higher income will help offset this. However, healthy people looking forward to a long and happy retirement should look at alternatives to purchasing a level payment annuity.
Investment linked annuities, where a client's pension income varies to reflect changes in the value of investments such as stocks and shares, provide a strong mix of security and growth potential.
They have become increasingly good value with the fall in standard annuity rates and can often match and even exceed starting income levels with growth potential depending on the options selected. They can be used either as an alternative or mixed with another product to meet the needs of the client.
Other options include fixed term annuities, where a client uses all or part of their pension fund to buy an annuity for a set number of years, or if the client has sufficient funds and is comfortable to forgo guarantees they should consider drawdown. All these options can be mixed and matched to create a retirement income portfolio which meets the clients specific needs, risk profile and fund size.
While much is being done to raise awareness of the open market option, and this is certainly a positive step towards ensuring the best outcome for consumers at the point of retirement, there is still more that the industry can do. Retirement needs are changing as life expectancy increases, interest rates remain low and people continue to under-save.
The majority of people approaching retirement would benefit from a full review of their needs including a minimum income requirement check, health assessment and a full appraisal of the risks that they may face, inflation being just one of these.
So while shopping around for the best annuity rate gives consumers access to greater choice, advice can open the door to wider range of retirement income solutions.
Vanessa Owen is head of annuities at LV=
* LV= Home is Pension (HIPpies) research conducted by Opinium on behalf of LV= in September 2013. 1,014 homeowners aged 50 - 64 (in employment and 65+ (retired) polled.
** Based on someone who has a level annuity income equal to the basic state pension they also receive
‘Important to have an anchor’
Report to be written by TPR
Lack of innovation for solutions
Some 2,000 consumers affected