Inflation proofing annuities
Craig Muir, Senior Intermediary Development and Technical Manager, breaks down the complexities of protecting your annuity clients through inflation.
There’s been a great deal written about the resurgence of annuities, which is no bad thing. Customers now have more options of what to do with their retirement pot and for many years the much-maligned guaranteed income for life (gifl), also known as an annuity, was the poor relation to income drawdown.
But as interest rates have improved, annuities are back in favour. However, with greater choice comes greater confusion, none more so than which type of annuity should be selected. Should you have joint life or single life, should you have a guaranteed period and if so, how long? One area which is often overlooked by customers though is should they take out an escalating annuity?
The latest stats from the ABI show that almost 90%* of all annuities purchased were on a level basis with no escalation built in.
The Impact of inflation
If an annuitant doesn’t build in some form of inflation proofing, then their income is decreasing each year in real terms, but by how much?
If we assume a monthly income of £1,000, and inflation is running at rates of 2.5%, 5.0%, 7.5% or 10.0% then the impact is as follows:
| Term (years) | |||||
| Inflation (%) | 5 | 10 | 15 | 20 | 25 |
| 2.50% | £881 | £776 | £684 | £603 | £531 |
| 5.00% | £774 | £599 | £463 | £358 | £277 |
| 7.50% | £677 | £459 | £311 | £210 | £142 |
| 10.00% | £590 | £349 | £206 | £122 | £72 |
| Term (years) | |||||
| Inflation (%) | 5 | 10 | 15 | 20 | 25 |
| 2.50% | 11.9% | 22.4% | 31.6% | 39.7% | 46.9% |
| 5.00% | 22.6% | 40.1% | 53.7% | 64.2% | 72.3% |
| 7.50% | 32.3% | 54.1% | 68.9% | 79.0% | 85.8% |
| 10.00% | 41.0% | 65.1% | 79.4% | 87.8% | 92.8% |
At the extreme, if inflation remains at 10% for 5 years then the purchasing power of a level annuity is reduced by 41%, down from £1,000 to £590. Even if inflation rates return to 2.5%, over 15 years the purchasing power of income is reduced by almost a third (31.6%) and over 25 years it’s almost halved in value (46.9%).
I was speaking at an event last September and mentioned this to a couple of advisers. They told me, quite smugly (and rightly so), how impressed their annuity clients were because they’d secured their annuities in 2021 and despite their protestations had advised they should increase their annuities by RPI. You can imagine how grateful their clients were.
The elephant in the room of course is if an escalating annuity is selected, the initial income is reduced. For example, a 65 year old purchasing a standard level annuity on 9th February 2023, according to Hargreaves Lansdown best buy rates would receive £6,637 per annum. However, building in 3% escalation and a 5 year guarantee will reduce the income to £4,715. Therefore, an annuity escalating at 3% per annum will take 13 years for income to be greater than a level income and 23 years to surpass total income.
The ideal solution for a client will of course depend on their objectives and individual circumstances. For some, purchasing a guaranteed income to cover their basic income needs and leaving the rest invested will provide the security and flexibility they seek. And the reality is some clients may not need inflation proofing for their annuity, for example if the majority of their income is already being provided by their defined benefits and new state pension. Both have some inflation proofing locked in. But for those who are more reliant on their annuity, then explain the impact inflation can have on their income. It’s a sobering message when you show them how the purchasing power of their income erodes over time if they don’t build in some form of escalation.
*Source: ABI Q4 2022
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