Is it better to go for an index-linked pension or a steadily rising annuity

As I discussed last month, people often underestimate how much it costs to protect your pension from the ravages of inflation.  We saw, for example, that a £100,000 pension pot might typically buy you a level annuity of £5,448 a year.  This would remain constant for the rest of your life, which could easily be another 30 years.  If, however, you wanted your income to increase by 5% a year, your starting annual income would almost half to £2,815.  To put that into perspective, you would have to live until you were 90 before you broke even on your decision to opt for a 5% annual escalation.  That is six and a half years longer than the current male life expectancy.

However, a 5% annual increase is actually considerably above the current inflation rate.  Indeed over the past year the Retail Price Index has increased by just 0.9%.  Even if you go all the way back to 1981, the average only climbs to 3.85%.  In view of this, if you merely wanted your pension to increase by the rate of inflation, rather than a fixed 5%, you might expect that your starting level would be higher.  And you would be correct!  Instead of starting at £2,815 and increasing by 5% a year, you would start at £3,294 and rise in line with inflation.

Of course we’ve got no idea what inflation will be over the next few months, let alone the next 30 years.  However, if you assume that inflation going forward will be the mirror image of what it has been over the past 25 years, i.e. starting low and then building to peaks to reflect the spike in prices in the early 1990s, you come up with some interesting figures.  You would, for example, have to live until 97 before you would have been paid as much by an RPI-linked annuity as by the level annual payment.  A clearer indication of just how expensive it is to protect yourself against future inflation is that you would only have to live until 78 (having retired at 65) to be better off opting for an annual 5% increase rather than a rise based on inflation.

This illustrates two things.  Firstly it is very expensive to provide an escalating pension, especially one linked to future inflation risks.  This is because you are asking the annuity provider to effectively “insure” you against unknown future price increases.

The even more significant risk that all annuities insure you against is longevity risk.  That is the risk that you live longer than you or your annuity company have budgeted for.  An annuity will, generally, keep paying out until you die, whether that is at 66 or 106.  It is true that you can pay extra to have the income guaranteed for a minimum period of 10-years.  This means that your beneficiaries don’t lose the value of the entire £100,000 if you drop dead far sooner than you might have hoped.  However, this generally doesn’t cost that much (but I will cover this in another update).  By far the greater cost to your annuity provider is if you live on to a ripe old age.

The point is that the “insurance” element shouldn’t be underestimated, both in terms of its cost, but also in terms of its value.  One way of appreciating how much you are being charged is to consider that the average male life expectancy is 83.5 years.  If you were simply to keep your £100,000 pension pot and take an income of £5,448 (equivalent to the level annuity and assuming no investment growth whatsoever), your pot would last until you were a little over 83  years and four months old.  Basically the price you are paying the insurance company for agreeing to sustain your pension until you die is equivalent to every last penny you may have earned on your £100,000 for almost 20 years.

This is not to say nobody should buy an annuity, or that they shouldn’t have it inflation-linked.  What it is saying though is that these things cost money and you can only really appreciate how much if you delve a little deeper.

Take care out there

PensionMan