Will your pension support you for the rest of your life?

With average life expectancy at age 65 now about 82.4 years for men and 85 for women (ONS October 2009) and steadily increasing, anyone buying an annuity today faces some pretty tough decisions.

The annuity they are buying will be part of the income they will have to live off for the rest of their lives, which for those retiring at 65 will on average be 17.4 years for men and 20 years for women. All of whom will obviously hope and plan for it to be much longer and for many it will be.

So do you buy an annuity for life which pays the same amount, year after year, with no protection from the ravages of inflation, or do you opt for inflation-linking, which is prohibitively expensive?

You could be forgiven for thinking that high inflation is a thing of the past – it is 35 years since it hit 25 per cent and 20 years since it hit 10.9 per cent, but who knows what is going to happen over the next few decades.

Inflation is just one of the unknowns that those retiring must take into consideration when planning their retirement. Another major uncertainty is the potential costs of social care they may face as they grow older.

But even modest levels of inflation can seriously erode the value of the pound in your pocket. At 4 per cent, it will reduce the value of a £1,000 annuity by over 40 pounds a year resulting in it retaining the buying power equivalent to £442 pounds in just 20 years.

With Retail Price Inflation, currently at 5per cent, it is already an issue for prospective annuitants.

However, buying an inflation-linked annuity can cut your initial income by up to 50 per cent, compared to that payable by a level annuity.

A 65 year old man buying the top level paying annuity with 10,000 pounds would get 573 pounds, but only 292 pounds with 5 per cent inflation-linking (Moneyfacts 5/8/10).

That’s a big reduction in initial income, especially when it takes around 16 years to re-coup the income you forfeit for this protection.

Small wonder, then, that few annuitants index-link their annuities and instead opt for a higher initial income.

So what can be done about this?

One solution is for individuals to buy a mix of annuities, with, say, 75 per cent invested in a level paying annuity, and 25 per cent in an investment-linked annuity, which invests in stocks and shares in the hope of generating a higher investment return than that provided by gilts, which back level paying annuities.

There are also with profit annuities, which involve you investing your pension fund in a with profit fund, which again should rise in value over time, although there is no guarantee that this will happen and your annuity income may fluctuate from year to year and could even fall.

Billy Burrows of annuity firm, Burrows & Cummins, says: “While investment-linked annuities incur some risk, the hope is that shares will rise over time and provide a hedge against inflation over a 20 to 30 year period.”

In other words, annuitants will be expected to share some of the investment risk with insurers, if they are to have any prospect of protecting themselves against inflation. As with everything to do with personal pensions, little is simple, cheap or without risk.

But as those who have retired over the last few years will tell you, you cannot rely on equities to be at their peak when you need them and many people’s retirement fund will not stretch to make the above flexibility a feasible option. The average personal pension fund for annuity purchase is around £24,000.

Unless the Government is prepared to grasp the nettle and provide more ways for those retiring to protect at least some of their savings and pension income from inflation then saving for your pension will always be a gamble, which for many will fail to pay off.

Pam Atherton is a freelance journalist

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