THE retail price index (RPI) hit 5% last month – an unwelcome reminder that those approaching retirement really do need to protect the value of their income or face increasing hardship as the years go by.
Retirement has never lasted so long – it could stretch for more than 30 years, until you’re well into your 90s. Bearing that in mind, look back just 20 years and compare how much £1 would buy then and what it’s worth now. Then look ahead two decades and ask the same question. The answer is that, even if inflation rises by only 3% a year, it will be worth only 51p – about half what it’s worth today.
Could you live comfortably on half the income you retire on? Unless you’re very wealthy the answer is almost certainly “No”.
That’s why it’s so important to get everything right when you set up your annuity because there will be no second chances. Once an annuity is in place it can’t be changed. What are your options?
Level annuity
If you choose what is known as a “level” annuity, its value will never rise. Of course, it will pay you the highest income at the start, and it is tempting to take the highest starting income – it is cash in your pocket now – but in real terms, remember that its buying power will shrink over time because of inflation.
If you do set up a level annuity – and most people do – and it provides you with a higher level of income in the early years, you could consider, if you can afford to, putting some of that money aside each month, perhaps investing it in a tax efficient ISA. Then you could have something to fall back on if money starts to get tight in the years ahead. However, this is not guaranteed as an investment could fall in value so you may get back less than you invested.
Increasing annuity
Another option could be to choose an increasing annuity. On the face of it, this is not so attractive because it will reduce the amount of income you get at the start. The advantage is that this will retain more of its buying power so that you are unlikely to be worse off in the years to come.
You can choose from fixed increases or index-linked rises that track the retail prices index (RPI). Common fixed escalation rates are 3% and 5% – these simply mean your income increases by 3% or 5% each year. RPI annuities are regarded as the best protection against inflation but they tend to be very expensive, partly due to supply and demand.
There are so many institutions chasing so few inflation-linked investments that RPI annuities command a premium. That partly explains why, although annuity rates generally are currently at a six-year high, most index-linked annuity rates have fallen recently.
Mix and match
Another annuity strategy could be to split your fund, mixing and matching the kind of investments you make.
You don’t normally have to set up your annuity all in one go. You could keep some invested in the hope of stock market growth – although remember the value of your fund can also fall. You could also go for different combinations of annuities, some increasing and some level, perhaps over a period of time.
It’s important to bear in mind, though, that you are likely to get a better overall rate on one larger annuity than you are if you split it down.
Income drawdown
Finally, although most people choose an annuity, there is another option. If you are prepared to take more risk, you could consider income drawdown, also known as an unsecured pension.
Instead of handing your annuity pot to an insurance company in return for a secure income, you keep control of the money, choose where it is invested and take a variable income directly from these funds.
It means that you do not have to make a one-off decision and can potentially pass some of your pension fund on to beneficiaries if you die before the age of 75, less a 35% tax charge. A surviving spouse even has the option of converting the plan into his or her own name to continue with income drawdown if requested.
There are strict rules about how much you can withdraw annually and there has to be a review of your fund every five years to calculate the maximum income you can receive.
This arrangement offers the potential for growth and increasing income if you have invested wisely. At first glance, income drawdown might appear a saviour to those worried about the inflexibility and limited death benefits offered by annuities. With these benefits, however, come significant risks.
In the worst case scenario your pension fund could be massively, if not completely, eroded meaning you have little or no income to live on in retirement. It is, therefore, only a consideration if you are in a position to accept these risks.
It is important that you understand the risks and commitments and you would be wise to seek professional advice before going down this path.
- The author can be contacted at Allchurch Bailey Investment Consultants Ltd, Almswood House, 93 High Street, Evesham, Worcs. WR11 4DU; t6elephone 01386 442597, e-mail invest@allchurchbailey.co.uk; website www.allchurchbailey.co.uk.
