May 2007

The threat of inflation

While we quote inflation as being around 2.5 to 3.0%, the reality for those in retirement is very different. Firstly what do we mean by inflation? Which measure are we looking at, CPI or RPI? What about personal inflation based on what we actually spend, rather than assumptions and averages?

Measuring inflation

Pensioner inflation actually runs at more than double our CPI measure of prices. The cost of goods and services vital to pensioners is very different to the average family, and hence their own experience of inflation. Champagne, MP3 players, flat screen TVs, mobile phones, and nursery fees are some of the things used in determining price movements. While it is true many items are becoming cheaper, the essential areas of expenditure for pensioners have risen significantly in the last couple of years.

If you look at the last 10 years, inflation for pensioners has run to 34%! This can be attributed to cost increases in gas and electricity as well as water bills, which have all risen at rates well above inflation. Possibly the most contentious rise relates to council tax bills, which have provoked significant concern among those dependent on level or fixed incomes.

The impact of inflation

The graph illustrates the real effect of inflation on a pensioner's income over the years. If you go on an approximate inflation rate of 2.5%, this would reduce the purchasing power of a fixed income by nearly half over a typical 26-year retirement for a 60-year-old male.

The results make difficult reading, though the much less likely scenario of 5% inflation rate is far worse, highlighting that the purchasing power of £10,000 over a 25 year period would be worth as little as £2,920, a 71% reduction in value!

Looking at the figures it is not surprising that Prudential's (February) latest adviser survey revealed that 90% of advisers believe inflation to be the biggest risk to their clients holding level annuities. However, such annuities still have a 90% share of the annuity market.

Everyone is aware that there are RPI linked annuities available, though the snag with this type of annuity is that the starting income is generally significantly lower than the income from a level annuity. This is one of the reasons why level annuities are so popular. They give a higher starting income than an inflation-linked annuity and they can't go down, which is an important consideration for the risk averse investor.

However, the downside is that the income from level annuities can't go up either, which is where the prospect of circa 25 years without a pay rise, to a 60 year old male, becomes a grim reality.

Real assets

So advisers face a dilemma, do they continue to put clients in level annuities and ensure that they are fully aware of the risks, i.e. that the annuity is virtually guaranteed to go down in real terms, or is it time that advisers consider the alternatives?

Much has been spoken about the 'third way' and for the client who has £50,000 or more this might be an attractive option, but only 9% of external annuity business was greater than £50,000! So for the average UK annuitant they are left with one other real alternative - an 'investment backed annuity' in particular a with-profits annuity (WPA). As inflationary measures start to bite the WPA has become a viable option for middle Britain. The average case size now falling to £50,000 from £75,000, this could fall even further with the introduction of the protected rights option for WPA.

If pensioners are facing a period of up to 30 years of being dependent on capital working for them, it seems self evident that application of modern portfolio planning measures will ensure rising income needs are maintained over the long term. This surely is more palatable than reducing living standards or limiting plans for retirement. Having access to equities, fixed income, property and cash within a portfolio can offer a more risk friendly and efficient long-term portfolio solution (see chart two).

Asset backed annuities, especially with-profits from providers unhindered by investment restriction present an obvious solution.

With-profits annuities

With-profits annuities allow a choice in the level of income you receive, within limits. This is done by anticipating what future bonuses might be and building those bonuses into a client's income from the point they buy the annuity. For example, a customer can choose to match the level of income available from an equivalent level annuity and also have an income that has the potential to grow (income from a WPA can fall as well). This is crucial, as it potentially gives some ongoing inflation protection. Currently, an anticipated bonus rate (ABR) of about 3% from a with-profits annuity will give a starting income that matches that of a level annuity. Broadly speaking, if future bonuses exceed 3%, then the client's income would increase.

What many advisers tell us is that the issue their clients have with an RPI linked annuity is that the income is significantly lower than that of a level conventional and will take many years to match the level annuity income. With the fall in conventional annuity rates, what is now interesting is that the ABR needed to match the RPI annuity is 0%. This has the obvious advantage of being very low but more importantly the WPA guarantees that the income can't fall below the starting income. As the table above shows from the years of 60 through to 75, a conventional RPI starting income is about 38% below that of a conventional.

However with a with-profits annuity an adviser can now take a 0% ABR which is the equivalent of a RPI linked annuity with one key difference - the income (with a positive bonus declaration) is guaranteed to increase. The starting incomes on the 0% ABR for each of the age categories are higher and because it's at a 0% ABR, it is guaranteed to increase and hedge against the effects of inflation.

It's very clear that inflation poses a real threat to pensioners' income and it is the responsibility of advisers to ensure they are purchasing the right annuity to meet their client's risk portfolio but also to consider the effects on the purchasing power of the client over the next 25 years is maintained. Level annuities and RPI annuities still have a part to play in the annuity market, though we would suggest the advisers need to start looking further afield at some of the other annuity options available which provide added flexibility and a good hedge against inflation.

Aston Goodey
Head of Business Development - Retirement Income
Prudential