How much does an inflation-linked annuity cost and is it a good investment?

Annuity offerings have increased in value in recent years, but the best rates are on single life annuities, not indexed for inflation.

For £100,000, a healthy 65-year-old can earn an income of more than £7,270 a year, according to data from Best Buy (see below).

You can deduct £2,000 a year or even more than that amount if you want an annuity that grows by 3 per cent a year or in line with the rate of inflation of the retail price index.

A level annuity may therefore seem tempting now that inflation is back to 2 per cent, but recent history has shown the dangers of securing a lifetime income without protection against a sudden rise in the cost of living.

The headline inflation rate exceeded 11 percent in October 2022, the highest level in 41 years.

If you’re interested in purchasing an annuity, how can you determine if an inflation-protected annuity is the best option for you? Financial experts crunch the numbers and offer advice on how to make the decision below.

Inflation protection with an annuity: how much more does it cost?

A 65-year-old with a £100,000 pension pot can currently get up to £7,220 a year from a single annuity with a five-year guarantee, says Helen Morrissey, head of retirement research at Hargreaves Lansdown.

A warranty period protects against the loss of all or most of your purchase money if you die shortly afterward.

The top rate is more than £2,000 more a year than you would have received three years ago, Morrissey says.

But he warns: “The level of income you get from such an annuity does not change over time, and what may seem like a healthy income today may look downright mediocre 20 years from now.

‘An RPI-linked annuity currently offers up to £4,540 per year for a 65-year-old with a £100,000 pension.

“If the rate increases by 3 per cent per year, the initial price will be up to £5,157.” Both tariffs also come with a five-year guarantee.

Morrissey says the latter two offers may be much lower than what you would get with a fixed annuity, but the longer you live, the more any kind of link to inflation will be valued. This is illustrated in the table below.

“When deciding which is your best option, you’ll need to try to estimate how long it will take for your growing annuity income to reach the initial tier one income,” Morrissey says.

‘If you were to go for the RPI-linked product and it rose by 5 per cent a year, then it would take you 10 years to make up for lost ground and around 20 years before you could achieve the same amount of income overall as you would have earned from the flat product.

“Of course, if RPI inflation was higher it would recover ground more quickly, but lower inflation means it could take longer.”

She says that with the annuity increasing at 3 percent a year, it would take 12 years to catch up, so you would be 77 before you get the same income.

And it would take around 21 years for you to earn the same total amount of income of around £144,000 as you would have earned from the levelised product.

Morrissey says: ‘You have to think carefully about how long you are likely to live to make the best decision for yourself.’

Unless you have an existing health condition or family health history that you think might affect you, the answer to this is unknown.

But at least running the numbers will give you a better idea of ​​the risks you’re taking by purchasing an annuity with or without inflation protection.

Morrissey warns: ‘The beast of inflation may have been tamed, but that doesn’t mean it shouldn’t be a key factor in planning for your retirement income.

‘You could be retired for 20 years or more and even the most benign inflationary environment can erode your purchasing power during that time.

‘A period of double-digit inflation like we’ve seen recently can throw a wrench into your plans, so it pays to be prepared.’

She says you may want to consider other options, such as not annuitizing your entire pension at once.

‘Instead, you could rent out in chunks over time, securing a guaranteed income as you need it and keeping the rest invested where it can hopefully grow.

‘This way, you also have the benefit of locking in higher annuity rates as you age, and if you develop a condition that qualifies you for an enhanced annuity, you could get an additional boost in income that can help you combat the impact of inflation over time.’

Fixed-rate annuities versus inflation-linked annuities: How to decide

Nick Flynn, director of retirement income at Canada Life, offers the following advice.

1. Consider how your annuity income may change in the future

Inflation-linked annuities will generally have a lower initial income than a fixed-rate annuity, however this can change over time.

Some simple assumptions about the future direction of inflation will allow you to model how your inflation-linked annuity may grow in the future, at what age your income may catch up with your fixed annuity rate, and at what age you are likely to have received more income than you originally paid for it.

2. Check how the provider applies inflation to the annuity rate

If you are considering an inflation-linked annuity, it is important to understand how the provider defines and measures inflation and how it will apply changes to your income.

3. Consider your tax situation

Be sure to consider your overall tax position and evaluate any tax impact of your annuity along with any other income you may be receiving.

An inflation-linked annuity that grows over time may suit some people’s current tax situation, while others may prefer the higher initial income that comes with a fixed-rate annuity.

4. Consider a combined approach

Unless you have a very small pension fund, you will usually have more than one option available.

A blended approach (for example, a mix of fixed and inflation-linked annuities, or incorporating a retirement element) may give you the best chance of achieving your retirement goals.

5. Do your research and speak to a regulated financial advisor

Compare prices and get quotes from more than one supplier, and do initial research to better understand your options.

Then speak to a regulated financial adviser who can help you make the decision that best suits your situation and needs.