How to calculate level vs escalating annuity?

chris1

I'm setting up a spreadsheet to work out level versus increasing annuity and seem to be doing something wrong...

Example: Level annuity rate 5.221%, and increasing at 3% annuity rate 3.385%, £50K pot, basic rate taxpayer.
Option 1 (level) gives £2088.40 p.a. after tax (Pensioner L)
Option 2 (escalating 3%) gives 1354 p.a. after tax in year 1 and increases by 3% p.a. (Pensioner E)

Let's say Pensioner L can live on the same amount as Pensioner E and puts difference each year into a bank account paying say 2.4% after tax.

According to my spreadsheet, the monthly income would equate in about year 15, but Pensioner L would have saved up (with interest compounded) £7862. From here Pensioner L then has less income and uses savings pot to make up the difference. According to my spreadsheet, the pot doesn't run out until Year 31!

The figures are even worse for 5% and RPI - I must be doing something wrong, at this timescale no-one would do this! What have I missed please?

Linton

I agree with your calculations but disagree with your comparative annuity rates - what was the pensioner's age?

For a male aged 65 using figures from here I get the pot running out after 26 years - aged 91. This is only a few years beyond average life expectancy, many people can be expected to exceed it. Using different assumptions on expenditure and interest rates you could get a different answer, though I guess not that much different.

So the 3% increment gives a rather more long term security. This is even more true for inflation matching where of course inflation could spend some time at over say 10% - it has in the past 40 years.

IMHO when planning for retirement it is foolish to plan on being average - you have a 50% of living too long for your money. If you have the money it makes sense to me to use some of it for future security rather than current income.

jamesd

chris1 wrote: »

The figures are even worse for 5% and RPI - I must be doing something wrong, at this timescale no-one would do this! What have I missed please?

Your figures are right enough in principle even if possibly wrong in detail, I haven't checked because I already know you're right on the principle. One submission to the government about whether the minimum income to qualify for flexible instead of capped drawdown explained in fine detail that it didn't make sense to require RPI annuities because they were poor value compared to level annuities.

What you've missed in part is the nature of the market in annuities: it's selling lack of investment risk.

RPI and other escalating annuities are an additional premium product that caters to those concerned about another type of risk who are willing to pay the premium to get some protection from it.

Think of it like any other retailer using price segmentation techniques to make more money from some customers than others based on how price-sensitive they are.

Most purchases are level annuities.

Now you should look at the death benefits provided by annuities compared to income drawdown (100% inherited by spouse) and see whether the price premium for that protection looks sensible compared to alternatives like life assurance purchased with the extra income from an annuity with no or lower spousal benefit.

The more familiar you are with the various markets the better able you are to make good choices between the options. A lot of what we do in replies here is point out things that other consumers just didn't know or do some basic mathematics to illustrate the effects of choices.