You may be considering an inflation -linked annuity as one of your retirement options. With prices increasing, many people choose an inflation-linked annuity as a means of protecting themselves against high inflation. Here we discuss the advantages and disadvantages of an inflation linked annuity…
An inflation linked annuity is linked to the RPI or retail price index. This means that your annuity payments will rise as inflation rises are recorded annually. Whilst a RPI linked pension stays in line with this type inflation, it excludes certain factors such as the cost of mortgages. Some argue the official measure of inflation is the CPI or Consumer Price index. This rose significantly in 2008 to over 5% in the Autumn. Prices rose steeply for petrol and utilities, which made the option of an inflation-linked annuity highly appealing to those who wanted to shield themselves from rising prices. So it is easy to see why some retirees are tempted by these kinds of annuity choices. This is because many believe that they will be better off with an RPI linked annuity compared with those on standard annuities. One thing to bear in mind however, is that when you opt for an inflation linked annuity, the initial payments at the start will be lower.
Moreover, some pension experts have observed that inflation linked pensions may not always be the best option. In fact for an inflation linked annuity to be the most suitable option, inflation would need to run at 5% every year. Considering that inflation has been relatively low in the past 18 years, since the mid 1990′s onwards, it would seem unwise to opt for an RPI linked inflation based on recent inflation figures.
Worse than this, if we were to enter a sustained period of deflation where prices actually fall, those on an RPI linked annuity would see their incomes actually fall instead of rise. The past 18 months has seen interest rates slashed to below 1%, as demand in the economy has fallen. This has put downward pressure on inflation, creating an RPI rate of -1.4% in September 2009. Experts say an escalated annuity, that increases by 3% per year, would in fact be a better option at present. RPI linked annuities have also been described as prohibitory expensive and do not, as mentioned, protect against the threat of deflation. You will in fact pay a premium for opting for an inflation-linked annuity, as insurers seek to protect their own margins. The starting level of income will also be around 40% lower when you take out an RPl linked annuity compared to a standard annuity, which is another reason why they may be the wrong choice. Finally you would have to live until you were in your early 9o’s for this annuity to provide a higher income compared to a standard annuity.