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Don’t put all your eggs in RPI basket

I am in the process of buying an annuity with my pension fund and have been offered a contract which increases annually in line with the retail price index, subject to a maximum of 5 per cent a year. The initial annuity equates to my current annual spend. Am I right in assuming that if inflation is less than 5 per cent a year, I will be able to maintain my current standard of living?

There are many issues you need to take into account, such as your likely expenditure in retirement compared with before retirement. However, I believe that, even if your income were to increase each year in line with the retail prices index, this might not be sufficient to maintain your standard of living.

Most retired people rely on a mixture of their savings, investments and pensions to provide an income they can comfortably live on. It is essential to structure these effectively to ensure that income outpaces inflation. But to achieve this, you may require more escalation than the Government’s official inflation measures may suggest.

Double-digit headline rates of inflation were commonplace 30 years ago and no one doubted the impact this could have on their standard of living. Based on the RPI, 100 in 1975 is now worth only 14.

Inflation today is low but the threat it poses to your standard of living has not disappeared. Again, using the RPI, 100 in April 1995 is now worth 78.

However, the RPI is only part of the story and I believe it is dangerous to rely on it as an indicator of what is required to maintain standards of living.

The RPI is calculated by reference to what is called a shopping basket of goods and services. The value of this shopping basket is calculated each month by gathering around 120,000 price quotations covering 650 representative consumer goods and services from 150 areas across the UK. These items are then weighted to reflect their use by the average consumer.

In reality, your shopping basket may contain more of some items than others, making it quite different to that used to calculate the RPI. For example, the rate of inflation you are exposed to could be higher than RPI if you consume fewer of those items in the basket which tend to fall in value, such as hi-fi systems and DVD players, and more of those items which tend to rise in value, such as food and wine, recreation and culture, restaurants and hotels.

To confuse matters further, in December 2003, ostensibly to bring the UK in line with the rest of Europe, the Government replaced the RPI as the main measure of infla- tion with the less comprehensive consumer price index but if you rely on savings and investments for your income, there is a crucial difference between the two.

The RPI covers council tax and costs to owner-occupiers while the CPI does not, although it does cover new cars, personal computers and air fares, which the RPI omits.

Cynics may argue that the introduction of the CPI is simply a further move towards understating inflation. Up to April 2005, while the RPI had risen by 14.35 per cent since Janu- ary 2000, the CPI had increased by only 7.85 per cent.

Let us assume that the prices of the goods you buy do rise by the RPI and that you buy the proposed annuity. Even if the annual increases in the RPI are less than 5 per cent, it is my belief that your quality of life will not be maintained because real inflation is increasing the cost of living generally, not just items in the shopping basket.

The impact must surely be reflected more accurately in the average earnings’ index, which reflects the fact that people demand wage rises to keep pace with inflation and to keep up with the Joneses in terms of standards of living.

The discrepancy between the AEI and RPI is signifi- cant, with average earnings having risen by 28.79 per cent between January 2000 and April 2005 – more than twice the RPI. Therefore, if your income is simply keeping pace with headline inflation, it is highly unlik- ely that it will be keeping pace with increases in average earnings.

As a result, your quality of life and standard of living relative to the rest of the population will decline.

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