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Annuity options

Prudential head of annuities Aston Goodey says that as inflation bites into pensioners’ income, their only real alternative for making their money work for them is an investment-backed annuity and with-profits are a viable option.

The issue of inflation has been largely ignored. For many, it had been bagged and tagged as historic, with little future impact. Try telling today’s generation of low, fixed-income pensioners that inflation is no longer a problem and you may get a different opinion.

We quote inflation as being around 2.5-3 per cent but the reality for those in retirement is very different. Depending on which measure is used, either CPI or RPI or if personal inflation is based on what we spend rather than assumptions, you get a very different view.

Pensioner inflation runs at more than double our CPI measure of prices as the cost of goods and services vital to pensioners is very different to the average family and hence their own experience of inflation.

Champagne, MP3 players, flatscreen TVs, mobile phones and nursery fees are some of the things used to determine price movements. It is true that many items are becoming cheaper but the essential areas of expenditure for pensioners have risen significantly in the last couple of years.

If you look at the last 10 years, inflation for pensioners has run to 34 per cent. This can be attributed to increases in the cost of gas and electricity as well as water bills, which are all rising at rates well above inflation. Possibly the most contentious rise relates to council tax bills, which have provoked significant concern among those who depend on level or fixed incomes.

With an inflation rate of 2.5 per cent, a pensioner’s purchasing power can be reduced by half in 26 years (not an unrealistic timeframe for someone retiring at age 60).

When inflation has such a powerful effect, it is not surprising that it is such a big issue for IFAs. However, what is surprising is the number of people still choosing a level annuity – they still make up 90 per cent of the annuity market.

Everyone is aware that there are RPI-linked annuities available although the snag with this type of annuity is that the starting income is generally significantly lower than the income from a level annuity.

This is one of the reasons why level annuities are so popular. They give a higher starting income than an inflation-linked annuity and they cannot go down, which is an impor-tant consideration for the risk-averse investor. However, how many pensioners would relish the prospect of 25 years without a pay rise?

Advisers face a dilemma. Do they continue to put clients in level annuities and ensure that they are fully aware of the risks, that is, that the annuity is guaranteed to go down in real terms, or is it time that advisers consider the alternatives?

Much has been spoken about the “third way” and for the client who has £50,000 or more, this might be an attractive option but as only 9 per cent of external annuity business was greater than £50,000, this is not an option for most.

The average UK annuitant is left with one other real alternative – an “investment backed annuity”, in particular, a with-profits annuity. As inflationary measures start to bite, the WPA has become a viable option for Middle Britain.

If pensioners are facing a period of anything up to 35 years of being dependent on capital working for them, it seems self-evident that application of modern portfolio planning measures, including real assets, will ensure that rising income needs are maintained at appropriate levels over the long term.

With-profits annuities allow a choice in the level of income you receive, within limits. This is done by anticipating what future bonuses might be and building those bonuses into a client’s income from the point that they buy the annuity. For example, a customer can choose to match the level of income available from an equivalent level annuity and also have an income that has the potential to grow.

This is crucial, as it potentially gives some ongoing inflation protection. Currently, an anticipated bonus rate of about 3 per cent from a with-profits annuity will give a starting income that matches that of a level annuity. Broadly speaking, if future bonuses exceed 3 per cent, the client’s income would increase.

What many advisers tell us is that the issue their clients have with an RPI-linked annuity is that the income is significantly lower than that of a level conventional and will take many years to match the level annuity income.

With the fall in conventional annuity rates, what is now interesting is that the annual bonus rate needed to match the RPI annuity is 0 per cent. This has the obvious advantage of being very low but, more importantly, the WPA guarantees that the income cannot fall below the starting income level. A conventional RPI-linked annuity can have a starting income as much as 38 per cent below a conventional annuity.

With the low levels of conventional annuity rates, it is possible to take a with-profits annuity with an annual bonus rate of 0 per cent and, provided that bonus rates are around 3 per cent as estimated, the increases in payment will more than keep up with inflation.

It is very clear that inflation poses a real threat to pensioners’ income and it is the responsibility of advisers to ensure that they are buying the right annuity to meet their client’s risk portfolio but also to ensure that the purchasing power of the client over the next 25 years is maintained.

Level annuities and RPI annuities still have a part to play in the annuity market although we would suggest that advisers need to start looking further a field at the some of the other annuity options available which provide added flexibility and provide a good hedge against inflation.

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