Petrol nearly £5 a gallon, 20% up on last year. A pack of butter up 62% from last year. These are common stories at the moment. The headline rate of inflation reached 4.2% in May, with Government figures showing everyday items such as food increasing at 7% with utilities up more than 9%*. Recent reports suggest the inflation rate for pensioners is even higher as the items retired people spend their money on are particularly affected.
Pensioners relying on a fixed income will feel the impact of these big increases. And according to recent ABI research, more than 90% of people reaching retirement in 2006 bought a level annuity. As it is the necessities in life, like food, fuel and power which are increasing the most it is difficult for people to significantly reduce the impact of these price rises.
So what does this mean for people reaching retirement now?
If inflation for pensioners is around 6% each year, pensioners with a fixed income could lose as much as half of their spending power over 10 years. Assuming people don't want this result, choosing an option which gives an increasing income may be attractive. An individual could simply buy an RPI linked annuity. An inflation-linked pension starts off lower than a level pension. But it does increase in line with inflation, maintaining its purchasing power, unlike the level annuity where the real value is constantly eroded. But these are not necessarily great value at the moment. Based on current annuity rates, a 65 year old male will need to live beyond age 90 before an RPI linked annuity is worth more than a level annuity.
One compromise option is to buy an annuity that rises by a fixed amount - say 3% a year. This will give an element of inflation-proofing and may represent a better deal. The best decision does, of course, depend upon the buyer's view of future inflation and their current state of health.
There is a wider question though. Given that many people will now live for 25 or 30 years in retirement, is an annuity with no exposure to investment growth a good long-term option?
A person could opt for income drawdown, allowing continuing investment in property and equities. Hopefully these investments will produce a rising income over time. But, generally, people need fairly significant pension funds before drawdown is a suitable option. That is because there is a risk the pension fund could be significantly (if not completely) eroded in adverse market conditions, or if poor investment decisions are made. This will, in turn, lead to a lower income in later life.
An alternative is to invest in the stock market but pay for a guarantee that the pension income won't go down. Many new guaranteed income, or third way, products are starting to appear which do exactly this. These can address the issues many retirees face, trying to secure an income that not only pays the bills but will hopefully keep pace with the rising costs of living.
After a long period of low inflation, it appears significant price rises are part of the immediate future at least. Unless people consider the effects of inflation eroding their retirement income, many people will find their pension income swallowed up by the basic costs of living. A whole new wave of solutions are being launched which begin to address these issues, offering guaranteed income levels but allowing people to benefit from any investment growth. And while these new solutions are not suitable for everyone, they are another useful option in the adviser's toolbox.
Andrew Tully
Senior Pensions Policy Manager
*In the year to April 2008
Tax and legislation are liable to change. This information is based on Standard Life's current understanding of law and HM Revenue & Customs practice.
Tax rates and reliefs may be altered. The value of tax reliefs to the investor depends on their financial circumstances. No guarantees are given regarding the effectiveness of any arrangements entered into on the basis of these comments.
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