level versus escalating annuity ...

sord

I'm trying to understand the benefits of going with a escalating annuity but having difficulty in seeing the attraction of them .....

Here's a typical quote published recently in a sunday paper ....

50,000 sum

single life

starting age 60

level annuity - 3112 pa

escalating - starting at 1634 pa and + 5% pa thereafter

I've prepared the following table to illustrate the cumulative total income from both types of annuity over the years and also how long it takes for the escalating annuity pa income to equal and then exceed the fixed annuity income ....

col 1 = year
col 2= age
col 3 = level annuity cumulative value (building up at 3112 pa)
col 4 = escalating annuity pa (increasing at 5%pa)
col 5 = escalating annuity cumulative value

you can see it takes 15 years for the escalating annuity to get to a sum pa approximately the same as the level annuity i.e. level = 3112 and escalating = 3235

it takes 25 years before the total cumulative value of the escaling annuity exceeds the level annuity i.e 77,986 versus 77,800

1 60 3112 1634 1634
2 61 6224 1716 3350
3 62 9336 1801 5151
4 63 12448 1892 7043
5 64 15560 1986 9029
6 65 18672 2085 11114
7 66 21784 2190 13304
8 67 24896 2299 15603
9 68 28008 2414 18017
10 69 31120 2535 20552
11 70 34232 2662 23214
12 71 37344 2795 26009
13 72 40456 2934 28943
14 73 43568 3081 32024
15 74 46680 3235 35259
16 75 49792 3397 38656
17 76 52904 3567 42223
18 77 56016 3745 45968
19 78 59128 3932 49901
20 79 62240 4129 54030
21 80 65352 4335 58365
22 81 68464 4552 62918
23 82 71576 4780 67697
24 83 74688 5019 72716
25 84 77800 5270 77986

Am I missing something? .....

ManAtHome

Nope - I did similar calculations some time ago - depends how long you expect to live. Taking the level annuity and investing the early years surplus, even in a standard deposit account, makes the numbers even worse by the way.

The big unknown is the RPI escalator - pass me my crystal ball...

dunstonh

In real world examples, you tend to find the escalating annuity passes the level annuity around year 8 and then goes on to provide better value for money from year 13/14. If you commence an annuity below the age of 60, then increasing it annually can make very good sense. If you commence it later in life, then the benefits of an increasing annuity may not seem as attractive.

If you can get enhanced annuity rates (smoker, poor health, manual worker/shift worker) then the drop may not be so bad.

Where GARs exist, the drop may be more significant as many pensions do not apply a GAR on an escalating rate but only on level.

jamesd

As ManAtHome sugggested, you missed an allowance for investment or savings return you'd get if you invested the difference between the level and escalating annuity in equities then started income drawdown of the difference once the level annuity value became lower than the escalting annuity.

This won't help to make the escalating annuity look any better...

sord

many thanks for the replies ...... I re-ran my table with three other company quotes and all gave practically the same results ....

All in all I see zero attractions to the "escalating" option which is a surprise to me .......

dunstonh

If you live past age 75 you will probably regret not doing an RPI annuity.

jamesd

dunstonh wrote:

If you live past age 75 you will probably regret not doing an RPI annuity.

Why?

Lets assume 25% of the extra payment of the level annuity surplus compared to the escalating is kept as profit and the remainder invested. Then drawdown of the full difference is started once the escalating fund payment exceeds the level.

With 7% return I see that at the end of the 73rd year there is a fund value of 17270. If I start drawdown of the full difference between level and escalating annuity at that point the fund still has 21655 available at the end of the 84th year.

At 5% return there's a fund value of 14170 at the end of the 73rd year and fund value of 10481 at the end of the 84th year.

At 2% return there's a fund value of 10539 at the end of the 73rd year and 616 at the end of the 84th.

With 5% return until age 75 then 2% return it's 14170 after the 73rd year and 5649 after the 84th, with break even coming a year or two later. With 7%/2% it's 17270/10039.

Eventually the escalating fund will come out ahead, sooner if cautious investments are used. But 75 seems at least 10 years too early for the changeover point.

dunstonh

Retiring at 60 probably means around 25 years income. So, what were you earning in 1980? Could you live on that now? Just compare expenses then to now.

I have seen quotes where the break even point is 13 years and others where it is 25. So, it is not possible to give a 100% answer to the question about whether escalating should be done or not. However, you should consider the consequences of not having an increasing income in retirement (note the careful wording there as increases dont have to come from the annuity).

jamesd

You're definitely right about the need to provide some increase in Pound income to allow for inflation and providing for income to at least age 85 - the life expectancy for professionals - seems prudent.

Your careful wording is definitely noted and with all the different ways to provide for it is very significant.

Paul_Herring

Is there any merit in dividing the pension fund in two, buying an escalating annuity with one half and a level one with the other? (This presumes that one has decided to purchase an annuity instead of drawdown or any other alternatives)

moonrakerz

I recently bought a level annuity for the very reasons the OP put forward.
Plus, the reason that is put forward for an escalating annuity is "to keep up with inflation" - to that I would say, do you really need to ?

My annuity will be in year 11 before I would get any extra payment, and as a previous post said, that's ignoring any extra cash I could generate by investing the difference between the two types of annuity over those 11 years.

Also, I firmly believe that your financial needs will diminish as you get older. You may need more for fuel and heat, but your travel requirements will undoubtedly drop markedly, apart from which when you get into your 70s, the travel insurance costs more than the holiday ! Your food requirements will fall. No TV licence to buy either !

However, I would think very long and hard about putting ALL my pension income onto a "level" basis; if you have two or more sources of income it is certainly worth thinking about if you want/need it all protected against inflation.