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Why should you inflation-proof your pension?

Why should you inflation-proof your pension?

Category: Annuities

Updated: 05/07/2016
First Published: 05/07/2016

While there are many different types of annuity available, one of the most common denominators is whether you opt for a level pension or an inflation-linked alternative. But just which one should you choose? While the former is undoubtedly more common, pension specialist Aegon is urging people to consider the latter option.

The current situation

Aegon found that people who purchase an annuity typically opt for a level pension, which will pay out a set amount for the duration of a retirement, rather than a plan that starts at a lower level but increases each year at a fixed rate or in line with inflation.

This is partly because people often underestimate how long they'll live, not to mention the effect that living longer has on their retirement income's purchasing power – they want the higher level of income straight away, but what they don't consider is that the set payment may not be worth quite so much in a few years' time.

Quite simply, if people opt for the level income option, their payments will stay the same throughout retirement, which means that after a few years (or decades), your payments could be worth substantially less in real terms thanks to the corrosive effects of inflation – a concern that isn't valid if you have an inflation-linked pension.

This becomes even more important to think about given the referendum result, says Aegon. The Government has already warned that it may not be able to afford the triple lock on state pensions if economic growth becomes severely negatively impacted, and there are even suggestions that defined benefit pensions could be affected, too.

This makes it incredibly important for pre-retirees to understand the value of such inflation-linked or fixed rate increases, and to lock in while they still can.

Making the choice

The figures speak for themselves: someone who bought a level annual annuity worth £10,000 would still be receiving that same £10,000 income in 20 years' time, whereas someone who opted for an annual 3% increase would receive an income of £18,060 in 20 years' time, or £26,500 if they opted for a plan that rose by 5% each year – it may cost more to buy that type of annuity to begin with, but the value of that kind of increased income can never be underestimated, particularly when things like the higher costs of care in later life are factored in.

"The increasing number of people with a defined contribution pension need to make a choice on whether to opt for a higher initial income that doesn't increase, or a lower initial income with yearly increases," said Kate Smith, head of pensions at Aegon. "This can either be through taking income through drawdown or by buying an annuity with built-in pension increases.

"People may feel that in a low inflationary environment this isn't important, but increasingly people are living 20 or more years in retirement and even low-level inflation can erode the value of retirement income over time. And people need to be mindful that we're experiencing an unusually long period of low inflation and that longer term it might not stay this way.

"If you take a level income of £10k, and if inflation runs at 3% a year, your purchasing power in 20 years' time would be £7,440 a year in today's money terms."

So doesn't it make sense to consider an inflation-linked plan? It's a big decision that requires careful consideration of all the options, so make sure to speak to the experts. Contact our no obligation annuity planning service to get started.

Disclaimer: Information is correct as of the date of publication (shown at the top of this article). Any products featured may be withdrawn by their provider or changed at any time.

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