This is one of a series of 8 chapters which we hope will stimulate thought around the difficult issues that people may face while investing in retirement. Spire Platform Solutions does not provide advice and does not advocate any particular investment solutions.
As sure as eggs are eggs, prices will go up during retirement, so if a standard of living is to be maintained then the monthly pension income must increase too.
One way of achieving this is to purchase an annuity from an insurance company that rises over time in line with the Retail Prices Index (RPI). To see what value this offers, the author a healthy 61 year old, went to the Money Advice Service online annuity portal and extracted two quotations, one for an annuity with level payments every month and a second quote for an annuity linked to RPI.
The level annuity starts at almost twice the monthly payment that the RPI linked one offers, but it never gets any bigger, whereas the RPI one will increase every year. This huge difference in starting levels means that, assuming inflation is 21/2% pa, I will need to live to age 88 before the monthly payments from the inflation linked annuity have caught up with the level annuity. And I’ll need to live to age 110 before the total payments under the inflation proofed annuity have caught up with my total receipts from the level annuity. I’d be what demographers call a “super-centenarian”!
It’s clear from the numbers that inflation linked annuities are very expensive, what’s less clear is why. But I think it’s a question of supply and demand for the asset class that underpins these instruments, namely UK Government Index-Linked Gilts. HM Treasury issue them only sparingly, because they shoulder the next generation of taxpayers with a debt that will not be lessened by inflation, in the way that rising inflation normally reduces the burden of Government debt for future generations. So, supply is limited.
On the other side of the coin, demand for these securities is high. That’s because final salary pension schemes, that have guaranteed inflation increases, need to buy them. As do the insurers who, in many cases, have taken on the liabilities of older, now closed, final salary pension schemes. It’s a technical issue but if they didn’t buy these assets that guarantee RPI increases then the reserves they need to hold would be much higher.
The important question for those of us who don’t have a final salary pension, is do we need to guarantee that our pension income will always rise precisely in line with RPI? If the answer to that question is “no”, then we can explore other, potentially better value, ways of planning for a pension income that is expected to rise over time.
One such way is to split your pension pot between a level annuity and an income drawdown plan. In years when the value of the income drawdown pot goes up, profits can be taken, and a further slice of level annuity purchased. In this way, the level of secure income will increase over time, potentially maintaining a standard of living in the face of rising prices.
Bear in mind the increases will be a little erratic, as it’s the nature of an investment portfolio to bob up and down with market volatility, and in some years there may be no profits with which to buy more annuity!
However, what this strategy of combining a level annuity with an income drawdown plan achieves is to enable the pensioner to hold other assets that are less expensive than index-linked gilts, but which can be reasonably expected to appreciate over time in much the same manner as rising prices.
The moral is simple – if someone else wants to over-pay for certain assets, let them have them and look around instead for better buys.
By Adrian Boulding - Chief Innovation Officer at Spire Platform Solutions.