Annuity choices

Steve_666_

For those that plan to live a long retirement, level annuities carry a large risk. I asked this on another thread, but nobody replied as it was a bit off topic.

If you are looking for an annuity with inflation protection, is there any mileage in a strategy that splits your annuity funds into 2 and allocating
50% to an annuity rising by 3%
50% to an annuity rising by the RPI ?

dunstonh

Yes, level annuities carry some risk, the risk is not "large".  Although large probably needs some context as one persons large is another persons small.

Generically, inflation is the risk.   However, commercially, level annuities price better than indexed.  RPI annuities are not favourably priced at the moment either.

When you calculate the breakeven points on level vs indexed, you often find its around 13 years to get to the same amount as the level and another 12 years to get to the same figure cumulatively.      The actual timescales will depend on your health and age.   So, if you are aged 65 and the breakeven point cumulatively is age 90, then maybe it would have been better to take the level annuity and have the extra money when younger and spending more than later when you are spending less.  

Have you modelled your indexed vs level annuity quotes yet to see when your two measurable points are? 

You also need to take into account other incomes that may exist that are indexed and other savings and investments.  i.e. do you need indexation if you have other sources.

JohnWinder

When you calculate the breakeven points on level vs indexed, you often find its around 13 years to get to the same amount as the level and another 12 years to get to the same figure cumulatively.      The actual timescales will depend on your health and age.

The timescale must surely depend on the unexpected inflation rate. Were the inflation rate to be unexpectedly zero until you die, you’d have been better off with the flat annuity. Were the inflation rate to have been 10%/year above what was expected, you’d soon be better off with inflation linked annuity. N’est pas?

dunstonh

JohnWinder said:

When you calculate the breakeven points on level vs indexed, you often find its around 13 years to get to the same amount as the level and another 12 years to get to the same figure cumulatively.      The actual timescales will depend on your health and age.

The timescale must surely depend on the unexpected inflation rate. Were the inflation rate to be unexpectedly zero until you die, you’d have been better off with the flat annuity. Were the inflation rate to have been 10%/year above what was expected, you’d soon be better off with inflation linked annuity. N’est pas?

Correct.   You need to make some reasonable assumptions and rely on the unknown.

JohnWinder

So the annuity provider assumes an inflation rate for the duration of the life expectancy, perhaps an average although they’d have the capacity to envisage (and quote on) a range of inflation values for different time periods through the anticipated life of the annuity.
To the extent that inflation turns out differently from the assumptions that went into the pricing, and how accurate are inflation predictions 5 or 15 years away, the estimated breakeven time will be wrong. I would have little faith in such a calculated value. The choice, index linked or something else for longterm or lifetime annuities comes down to how inflation proof are my other sources of spending it seems to me, and how big my reserves are.

zagfles

I replied in the other thread. I can't see the point of a fixed rate increasing annuity. It provides no inflation protection as it's relative to nominal not real, so you get the same whatever inflation is. There'd be more value in an "index linked minus x%" annuity, rather than a "nominal+x%" as you'd know what your real income will be, if you eg wanted to front load your spend.

The whole point of an annuity is safe guaranteed income for the rest of your life. If you want to speculate in the hope of higher returns, why not drawdown from a portfolio consisting of equities, bonds etc. I find it worrying that even IFAs don't seem to understand the point of annuities when they waffle on about breakeven points etc. 

Yeah, historically you'd be better off with a level annuity. But historically you'd be much better off drawing down from an equity fund. What do you want, a guaranteed real income for the rest of your life, or take a risk on inflation/equity returns to get what history has shown will usually get you the highest income.

Steve_666_

I did a bit of basic graphing a while ago, using figures from the internet, rather than a specific quote for me. I was looking to get a general feel for the cross over points, those came in at 11-12 and 20 years. I get your point about getting the benefits early, and was originally thinking along those lines with a level annuity. However the last 2 years inflation has made me rethink!
If the decision to take an escalating annuity, what do you think of the split rate 3%/rpi strategy, putting one foot into the low and one into the high inflation camp?

dunstonh

So the annuity provider assumes an inflation rate for the duration of the life expectancy, perhaps an average although they’d have the capacity to envisage (and quote on) a range of inflation values for different time periods through the anticipated life of the annuity.

Insurers will use index linked gilts as the investment vehicle and gilt prices/yields will be the primary driver to the RPI starting income.    Then add in a margin for profit along with assumptions of mortality gain and future life expectancy changes and a bit of a margin and you have your rate.

To the extent that inflation turns out differently from the assumptions that went into the pricing, and how accurate are inflation predictions 5 or 15 years away, the estimated breakeven time will be wrong. I would have little faith in such a calculated value.

Predicting the unpredictable is next to impossible.  However, the biggest influence is the gilt yield/price.     This is why you are seeing an increase in posts on this site where people are buying gilts directly with the intention to hold.  They are taking the insurer out of the equation.  

The choice, index linked or something else for longterm or lifetime annuities comes down to how inflation proof are my other sources of spending it seems to me, and how big my reserves are.

The need for indexation will vary across people.  
Someone with say £25k of indexed secure income (state and DB pensions for example) and a spending need of  £5k to be met from invested assets may not care for indexation if their invested asset values are higher
Whereas someone with the same spending need with £10k of indexed secure income and lower investible assets needing to provide 15k a year will have a greater need for indexation.

dunstonh

I did a bit of basic graphing a while ago, using figures from the internet, rather than a specific quote for me.

It has to use your figures and current market pricing.  The year 1 income for each will vary over time.  Sometimes that will bring the breakeven points closer and sometimes further.  Do not rely on generic internet examples.

I get your point about getting the benefits early, and was originally thinking along those lines with a level annuity. However the last 2 years inflation has made me rethink!

An RPI annuity is effectively paying insurance.   At the moment, RPI rates are favouring insurers.

If the decision to take an escalating annuity, what do you think of the split rate 3%/rpi strategy, putting one foot into the low and one into the high inflation camp?

Its a personal decision based on personal risk assessment and the level of other investable assets you have.    The less you have, the greater the need for indexation (see my post above this).

You don't know if your period is going to be like 1993-2021 with very low inflation or have years like 1975 when inflation got to 24.21% (nearly the equivalent of 10 years worth in a single year)

Moonwolf

dunstonh said:

You don't know if your period is going to be like 1993-2021 with very low inflation or have years like 1975 when inflation got to 24.21% (nearly the equivalent of 10 years worth in a single year)

Plus, presumably you are trading one risk for another.  Keeping in drawdown to hedge against inflation would look like the wrong choice if inflation fell and stayed low but then a market crash seriously reduced your pension fund.

All this would be huge fun if it wasn't your own future comfort you were gambling on.

( I also have "Do I take an actuarial reduction and reduce my early drawdown requirements or drawdown a big chunk of my fund bridging to my DB pensions and have a larger guaranteed income later?" )

sgx2000

Simple spreadsheet
At 7% inflation, the real world value of your pound approx. halves in 10 years