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Escalating situation

Deflation has officially hit the UK, with the -0.4 per cent March retail price index level the lowest since 1960.

This has sparked fears that pensioners with inflation-linked annuities could suffer declining income, with only four major providers offering guarantees if RPI falls under 0 per cent.

Standard Life and Prudential each have a few thousand pensioners with floorless RPI-linked policies while Norwich Union and Legal & General freeze income and only increase it when inflation hits previous levels.

Despite these deflation fears, most economic commentators suggest it will only be a temporary phenomenon in light of attempts to stave off recession.

Quantitative easing is the main factor here – with the Government flooding the economy with money and buying up long-term debt as a stimulatory measure. If this works, many feel returning inflation is a much greater concern, especially as it could be at higher levels than we have seen in recent years.

Standard Life head of pension policy John Lawson says inflation-linked annuities remain a small part of the company’s book at under 10 per cent, with pensioners put off by lower initial payments.

Based on current rates, a level policy can pay over 40 per cent more income at outset than an RPI-linked equivalent.

For a male aged 65 with a 100,000 pension pot for example, a level annuity would give an annual income of around 7,600 while an RPI-linked policy would pay under 4,500.

Lawson says: “Looking beyond the current deflationary spell, it is hard to predict how quickly quantitative easing will stimulate the economy and potentially bring inflation back.

“It is not inconceivable that we could see higher rates than the recent average in the coming years, with the level hitting double digits back in the recessionary 1970s and 8 per cent to 9 per cent in the early 1990s.”

For advisers and clients, he feels the best approach is to work out the net present value of an RPI-linked annuity based on various inflation levels and then see how that stacks up against a level policy.

He says: “If you believe inflation will remain in the 2 per cent to 2.5 per cent range in the long term, as the Government managed until recent issues, the RPI annuitant would have to live to over 100 to get value for money.

“But if you can see inflation approaching 10 per cent, this crossover point moves back to the early 1980s and the RPI policy looks better value.”

Average life expectancy rates for 60-year old annuitants are now around 87 for men and 89 for women. Lawson also highlights fixed-rate escalating annuities as a possible compromise.

“Again, this requires some thinking on future inflation levels but if you feel it will stay around the 2 per cent to 2.5 per cent mark, a 3 per cent escalating annuity will keep your income ahead of that,” adds Lawson. “This type of policy will also protect against any future deflation fears and if the RPI goes negative again, as the 3 per cent increase is guaranteed year on year.”

According to Lawson, the main value for money issue with RPI annuities lies in the fact they can only be backed by index-linked gilts.

With defined-benefit pensions required to offer index-linked payments since 1997 and chasing the same assets to back this, demand typically outstrips supply in this area.

Lawson says: “RPI polices are priced based on assets that are effectively in a bubble while level and escalating annuities are backed by normal gilts and corporate bonds where the supply/demand profile is more balanced.”

William Burrows Annuities director Billy Burrows also warns against underestimating inflation but he acknowledges that many economists see little inflationary pressure in the near future as businesses have spare capacity and big stockpiles.

On the level versus escalating argument, Burrows says individuals tend to focus on short-term cashflow and forget that annuities may be paid out for several decades.

He says: “It is only natural to want the highest income but you should not forget the effects of inflation. Although RPI annuities may appear to offer poor value compared with level, this is not always the case and it can often be prudent to have escalation.”

Figures from Burrows’ analysis show how much difference a 1 per cent change in inflation can have.

At 3 per cent for example, a 60-year old taking out an RPI-linked annuity would not break even against a level policy until 93, if the rate increases to 4 per cent, this crossover comes forward to 84.

Hargreaves Lansdown head of pension research Tom McPhail says modelling for inflation-linked annuities is done with RPI assumptions between 2.5 per cent and 3 per cent but a higher figure could significantly change the numbers.

McPhail says: “Current conditions make it very difficult to call the market. Six months ago, we could say with confidence that annuity rates would fall but now there are conflicting pressures at work.

“Quantitative easing, all things being equal, should drive rates down but then you have the sheer level of borrowing required by the Government and renewed equity strength, which could bring them up.”

Overall, McPhail sees legitimate reasons to suggest the inflation outlook is not healthy in the medium term.

“The Bank of England will not bring interest rates back up until it is sure recovery is under way and could react too late to choke off rising inflation,” he says.

“Even a few years of inflation over 5 per cent can be really damaging for level annuities.”

With this in mind, he stresses it is essential not to dismiss inflation risk and beas flexible as possible.

McPhail says: “We could easily see a year or two of 5 per cent RPI or more if the Government loses control.

“If someone has a pension of 50,000 and income drawdown is not a realistic option, we would suggest a split of level, inflation-linked and possibly fixed-rate escalating annuities.

“For those with a six-figure pension, drawdown is a serious option to wait out more clarity on the economic front, although you have to consider investment risk. People will have to make a call on markets but starting drawdown now with a conservative income could prove a good move.”

Looking at how professional investors are playing the inflation situation, Investec Asset Management sterling bond fund manager John Stopford has introduced some index-linking to his portfolio.

He says: “Gilts are currently priced for low inflation but they are being manipulated in the short term and current policies could force yields up.

“To protect against that, we hold some inflation-linked paper and would also buy inflation swaps to hedge out that risk but the situation is still some way in the future.”

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