The inflation risk to your retirement income

12th April 2013

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Give us your money and if you live to 83 we will give it you all back. Not only that, we will also pay you a return of 5.75 per cent a year from 2030 onwards for every year you are still alive.

But we won’t give you any money back if you die early, and the money we gradually give you back will be worth less in real terms each year because of the effect of inflation.

It’s hardly the greatest investment proposition in the world writes pension writer John Greenwood. In fact nobody would take it up if they weren’t forced to convert their pension pot into an income at retirement. But that is the deal on offer from annuity providers to people retiring today.

People reaching retirement today are amongst the hardest hit by the Government’s strategy for dealing with the nation’s epic debts.

The Bank of England’s historic low interest rates mean low annuity rates. And printing money raises the risk of higher inflation down the line. A combination of low interest rates and rising inflation adds up to an acutely painful situation for the majority of pensioners who buy so-called level annuities that do not go up in line with prices.

Just how low annuity rates have fallen in recent years is demonstrated by the latest annuity index from MGM Advantage. (MGMAdvantage/newsroom). The report shows that, even if rates have edged up 3 per cent on where they were a year ago, today’s average level annuity will pay a 65-year-old the princely sum of £2,875 a year if they surrender a £50,000 pot. Fifteen years ago an identical annuity paid over £4,800 a year.

So what are you getting for your money? Let’s double the figures to make the maths easy – £5,750 a year on a £100,000 pot – a return of 5.75 per cent.

That would sound good if it were a standalone interest rate. But this is not an interest rate, it is the rate at which the annuity provider will give you back the money you gave them.

MGM Advantage’s report says the average 65-year-old male has historically lived a further 18 years in retirement, which in our example means they can expect to get £103,500 back before they die, on an outlay of £100,000.

Even if you use the more generous prediction of what life expectancy is expected to be in the future – 65-year-old men and women living a further 21 years and nearly 24 years respectively – that is still an average payback of £120,00 for men and £138,000 for women.

For men that works out at a rate of return of less than 1 per cent a year. This is, crucially, considerably less than inflation is likely to be going forward. The reality is, in real terms, most annuity customers get back less than they hand over.

Just how much less in real terms depends on the effect of the billions of pounds of newly printed money put into the system by the Bank of England. A recent paper by Ewen Stewart of the Centre for Policy Study is a timely reminder of just how much money has been pumped into the system.

(CPS publications). Stewart points out that the £832bn injected in the five years since 2008 is two-and-a-half times the amount of gilts ever issued prior to that – £33,000 for every household in the land.

The problem with annuities is they have to invest in gilts, yet gilts are so expensive at the moment. With 10-year gilts delivering yields hovering around 2 per cent, and inflation running considerably higher than that, annuities are investing in assets that do not keep pace with inflation.

So what are people approaching retirement meant to do when faced with this situation? For most people buying an annuity remains the only option. While you are expected to live for another couple of decades, an increasing proportion of us will live to see our telegram from the Queen. Annuities insure you against ‘living too long’.

And buying a level rather than an inflation-protected annuity actually makes a lot of sense for most people. We are all more active in our sixties and seventies and level annuities give you more in the early years of retirement.

But what the current pressure on annuities also tells us is that staying invested in the market for as long as possible is becoming more attractive for more people. Done right, income drawdown can give you income with at least some protection against inflation. By investing in dividend-paying shares, which tend to go up as prices rise, retirees can to an extent have their cake and eat it, with, of course, the caveat that with this increased potential return comes increased risk.

Better still for those that can afford it, secure an income through an annuity with some of your money and keep the rest invested in the market.

The cost of living has risen 75 per cent since 1993 – the next two decades could be even worse.

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