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13 November 2012 last updated
Retirement annuity income eroded by higher UK inflation

There has been a sharp rise in UK inflation with the consumer price index (CPI) up from 2.2% to 2.7% increasing the cost of living for pensioners who are already suffering from record low retirement annuity income.

The Office of National Statistics (ONS) has released the latest figures for CPI and the Retail Price Index (RPI) has also seen a significant increase in inflation from 2.6% to 3.2%.

The reason for the increase were university tuition costs as well as higher food costs where manufactures reduced product sizes and retained the same price thereby making the cost rise.

This will make life harder for pensioners as the majority will purchase level annuities at retirement so over time the value of money will eroded and decrease. To protect against inflation, annuity rates can escalate by a fixed percentage or by RPI, however, the starting income would be considerably lower.

UK inflation increase hard for pensioners
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Protecting annuity income in retirement

Inflation will erode the value of money in the future so £100 today will only be able to purchase £74 in ten years time if inflation averaged 3% over this time period. Over 15 years the purchasing power of £100 will reduce to £66 and after 20 years £57.

To protect against this reducing purchasing power pensioners can add an escalating rate to their pension annuity and some providers will allow a fixed amount from 1% to up to 8% and also RPI escalation. The usual fixed rates are 3% and 5%.

If you add escalation the providers will reduce the amount of income you can have initially when compared to level annuity rates so to determine if this is reasonable value or not you need to know how much income you will receive over your lifetime.

For example, according to the ONS a 60 year old male will live for 21.55 years and if he had a fund of £100,000 he could purchase a level annuity providing an income of £5,070 pa. Over his lifetime he will receive £109,258 which is his money back plus a little more and many people may feel this is not a great return for their fund over two decades.

Escalation worse option than level annuity

Compared to say a 3% escalating annuity, The same male would receive £3,505 pa and after 21.5 year this would increase to £6,330 pa which is more than the level annuity. looking at the cumulative lifetime income, this would be £103,771 so in fact less than the level annuity.

Given the fact that the fixed escalating annuity will not even return the same amount as the level annuity after 21.5 years, the majority of pensioners are likely to select the level annuity so at least they can have their money back sooner while they are active and can enjoy the benefits of a higher annuity income.

News related stories:
UK annuity rates may lower as QE expected after falling inflation
Current annuity rates helped to higher levels with rising inflation
Annuity rates may lower if UK inflation fall leads to more QE
UK pension annuity income may reduce with lower inflation and QE
Related internet links:
BBC - Inflation rises to 2.7%
Telegraph - Inflation threat to households
Guardian - Inflation increases again
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