Hedging pensions against inflation

PENSIONERS failing to protect themselves against inflation could find their retirement income vanishing at an alarming rate. Yet, while the impact of inflation on pensions has become more severe as life expectancy has risen, few pensioners have taken steps to minimise the damage.

According to Standard Life, someone buying a level annuity with a pension fund of £80,000 would spend their entire monthly income on basic living costs – such as fuel and food – within 20 years.

"If pensioner inflation remains at around 6 per cent per year, people with a fixed income could lose as much as half of their spending power over as little as ten years," said Andrew Tully, senior pensions policy manager at Standard Life.

The problem is exacerbated by the particular vulnerability of elderly people to inflation. According to Alliance Trust, the real rate of inflation for the over-65s is closer to 4.3 per cent, rather than the official rate of 3.3 per cent, while for the over-75s it is 4.8 per cent. This is because the elderly spend a higher proportion of their income on expenses that are rising fastest, such as basic foods and utility bills. However, as Tully indicated, many view that as a conservative figure, with some research putting pensioner inflation closer to 9 per cent.

Despite that, most of the 900,000 or so investors buying an annuity this year will opt for level annuities, which don't provide a hedge against inflation. And with almost two thirds of 65-year-olds expected to live for another 20 years, making the wrong choice can have increasingly serious implications on their level of income.

"The need for those investors to protect their income against the ravages of even moderate inflation is paramount," said Nigel Callaghan, pensions analyst at Hargreaves Lansdown. "Inflation of 4 per cent for the next 20 years would reduce the purchasing value of £100 to just £46."

Buying an annuity in which the income increases in line with the retail prices index (RPI) is the traditional method of combating inflation – but that's no longer so clear cut. One problem is that, in return for the link to RPI, investors compromise significantly on the initial income received compared to that from a level annuity. What's more, rising inflation has prompted insurers to charge increasingly expensive premiums for the guarantee of inflation-linked annuities.

So, what are the alternatives?

For investors who find that RPI-linked annuities are too expensive at the present time, 3 per cent fixed-rate escalating annuities could be a better bet, said Callaghan. "A fixed 3 per cent a year escalating annuity offers a cost-efficient partial hedge against inflation. It also gives a chance of a reasonable starting income and the upside of any increases in annuity rates."

With fixed-rate escalating annuities, your income is guaranteed to rise each year by a fixed amount, whereas income from RPI-linked annuities can rise or fall with inflation.

According to Callaghan, a 65-year-old man with a pension fund of £100,000 can buy a level annuity with a starting income of £7,848. If he opts for an annuity that rises in accordance with RPI, the starting amount would be just £4,758. If inflation continues at 4.3 per cent, he would have to live to 92 to receive more total income from an RPI-linked annuity than that from either a level annuity or a 3 per cent fixed escalating annuity. In contrast, the latter would pay more total income than a level annuity from the age of 85.

Another possibility is to keep your options open by leaving your pension pot where it is for the time being. "Equity markets have fallen steeply so if you stay invested you might benefit from a market bounce," said John Lawson, Standard Life's head of pensions policy. "Equities are also a good hedge for wage inflation in particular as shares tend to rise in line with wage increases over the long-term."

The traditional equity-based alternative to annuities is income drawdown, although this is riskier than buying an annuity as it involves leaving your pension pot invested until the age of 75 but drawing down more income than you would have taken with an annuity.

This is where so-called "third way" or variable annuities come in, said Lawson.

These essentially combine the growth potential of drawdown with the guarantee offered by annuities. They can be expensive – although costs are likely to fall as more companies enter what is still a young market – and are unsuitable for pension funds of less than £50,000.

"You could put some of your pot in a third way plan in the short-term as you can take 5 per cent income regardless of market conditions, while the money you leave invested could benefit from any rise in markets."

There are several other permutations through which investors can limit their vulnerability to inflation. For example, a 3 per cent fixed escalating annuity could be bought with half of the retirement fund, with the remainder used for income drawdown. Similarly, you could start with income drawdown, where you can take an income – say, 5 per cent of the fund a year – but your cash is still invested and then buy a level or index-linked annuity at age 75. Professional advice is highly recommended for investors exploring those possibilities.

Or, as Lawson pointed out, you could stick to the traditional route and put your faith in level annuities. "There's a possibility that annuity rates will rise," he said. "The inflationary pressure we have could be around for a while, in which case we'll see higher interest rates in the long-term which will mean higher annuity rates too."

The option that works best for you depends on the level of income you need and when, so it's vital to understand your income requirements.

Either way, said Callaghan at Hargreaves Lansdown, the erosion to pension funds that inflation can cause should be taken into account by those contemplating their retirement income options. "Even if inflation peaks at 4 per cent this year before decreasing again, as the Governor of the Bank of England has suggested it will, it is still imperative to hedge against inflation because the average 65-year-old has 20 years or more of fluctuating inflation ahead."