How a lot additional does an inflation-linked annuity value?

Annuity deals have soared in value over the past few years but the best rates are on single life, no inflation-link ‘level’ annuities. 

For £100,000 a healthy 65-year-old can lock in income of well over £7,270 a year, according to best buy data – see below.

You can lop £2,000 a year or even more off that if you want a annuity which rises by 3 per cent a year or in line with the Retail Price Index inflation rate.

So, a level annuity might look tempting with inflation now back at 2 per cent, but recent history has shown the dangers of locking in an income for life with no protection against a sudden spike in the cost of living.

The headline inflation rate topped 11 per cent in October 2022, a 41-year high.

If you are in the market for an annuity, how do you work out whether an one with inflation proofing or none is the better option for you. Money experts crunch the numbers and offer tips on how to make the choice below.

Inflation proofing an annuity: How much extra does it cost?

A 65-year-old with a £100,000 pension pot can get up to £7,220 per year right now from a single life level annuity with a five-year guarantee, says Hargreaves Lansdown’s head of retirement analysis Helen Morrissey.

A guarantee period protects against the loss of all or most of your purchase money if you die shortly afterwards.

The top rate is more than £2,000 more a year than you would have got three years ago, notes Morrissey.

But she cautions: ‘The level of income you get from such an annuity doesn’t change over time and what may seem like a healthy income today may feel decidedly lacklustre in 20 years’ time.

‘An RPI linked annuity is currently delivering up to £4,540 per year for the 65-year-old with their £100,000 pension.

‘One that rises by 3 per cent per year will start you off at up to £5,157.’ Both these rates will also include a five-year guarantee.

Morrissey says the two latter deals might be far lower than you would get with a level annuity, but the longer you live the more you’ll value any kind of inflation link. This is illustrated in the table below.

‘When deciding what your best option is, you will need to try and work out how long it will take for the income of your escalating annuities to catch up with the starting income from the level one,’ says Morrissey.

‘If you opted for the RPI-linked product and it rose at 5 per cent per year, then it would take you 10 years to make up lost ground and around 20 years before you would have caught up in drawing the same amount of income overall as you would have got from the level product.

‘Of course, if RPI inflation were higher you would make up ground more quickly, but lower inflation means it could take you longer.’

She says with the annuity escalating at 3 per cent a year it would take 12 years to catch up, so you would be 77 before you got the same income.

And it would take around 21 years before you had taken the same overall amount of income of around £144,000 than you would have from the level product.

Morrissey says: ‘You need to think carefully about how long you are likely to live to come to the best decision for you.’

Unless you have an existing health condition, or a family health history you think could affect you, the answer to this is unknowable.

But at least assessing the numbers will give you a better idea of the risks you are running when buying an annuity with inflation proofing or not.

Morrissey warns: ‘The inflation beast may have been tamed but that doesn’t mean it shouldn’t be a key factor in your retirement income planning.

‘You could be retired for 20 years or more and even the most benign of inflationary environments can nibble away at your purchasing power over that time.

‘A period of double-digit inflation as we have seen recently can bite huge chunks out of your plans, so it pays to be prepared.’

She says you can consider other options, like not annuitising your entire pension at once.

‘Instead, you could annuitise in slices over time securing guaranteed income as you need it while keeping the rest invested where it can hopefully grow.

‘This way you also have the benefit of securing higher annuity rates as you age and if you develop a condition where you qualify for an enhanced annuity then you could get a further boost in income that can help you fight the impact of inflation over time.’

Fixed rate versus inflation-linked annuities: How to decide

Nick Flynn, retirement income director at Canada Life, offers the following tips.

1. Consider how your annuity income may change in the future

Inflation-linked annuities will typically have a lower starting income than a fixed rate annuity, however this may change over time.

Some simple assumptions about the future direction of inflation will allow you to model how your inflation-linked annuity may increase in the future, at what age your income may catch up with your fixed annuity quote, and at what age you are likely to have received more income than you originally paid for it.

2. Check how the provider applies inflation to the annuity rate

If you are considering an inflation-linked annuity, it is important to understand how the provider defines and measures inflation, and how they will apply changes to your income.

3. Take your taxation position into account

Make sure you consider your overall tax position and assess any taxation impacts from your annuity alongside any other income you may be receiving.

An inflation-linked annuity that increases over time may fit some people’s current taxation position, while others may prefer the higher starting income that comes with a fixed rate annuity.

4. Consider a blended approach

Unless you have a very small pension pot, there will typically be more than one option available to you.

It may be that a blended approach – for example a mix of fixed and inflation linked annuities, or bringing in an element of drawdown – gives you the best chance of meeting your retirement objectives.

5. Do your research and speak to a regulated financial adviser

Shop around by getting quotes from more than one provider, and do some initial research to better understand your options.

Then speak to a regulated financial adviser who will be able to help you reach a decision that best works for your situation and needs.