Any insurance salesman will give you the ‘you can never have too much insurance’ patter. While this isn’t technically true, one de facto form of cover has long been wrongly ignored by many retirement savers because of potential cost and opaque information on whether to ‘buy’ it. We’re talking about defined contribution pension pots being ‘fire-proofed’ and the insurable event is inflation, specifically the RPI. Unfortunately, the majority of retirees don’t take out an index-linked pension because the financial hit is so great, yet its implications are far-reaching.
An RPI-proofed policy is the only investment guaranteed to beat inflation for pensioners, yet many prefer not to invest in them.
However, retirees who take out a ‘level’ fixed annuity (or annual income for life in exchange for a lump sum) can be pole-axed by the annual rises in the cost of living. With only a set sum of cash every month, the creeping price of fuel, food, bills et al can clobber the finances over the years.
Imagine a £100,000 pension pot buying a pension of roughly £6,400, thanks to low annuity rates (dependent on gilt yields and long-term saving); if inflation averages 2% a year over a quarter-century, it would be worth just £3,900 in real terms in 2036. But if inflation proves more virulent, the cost can be cruel; say RPI averages 5% a year, the real value some 25 years later would barely nudge £2,000 a year.
These statistics should be shocking enough to prompt pension savers to sign up for RPI-proofing in droves but there’s a bigger hurdle: the ‘point of sale’.
When a pension saver finally sits down with his working life’s pot of cash and pores over the annuity tables in front of him, weighing up what is already a difficult decision, the difference between a fixed annuity and an inflation-proofed alternative can be shocking. Let’s take another £100,000 pot of hard-earned cash for a 64-yr-old male non-smoker set to retire in 10 months or so. Using tables from annuity broker, the best policy his money can buy if he chooses a fixed annuity is £6,876 from Aviva. Pick a proofed policy, though, and the best deal on the table now is still Aviva but the annual income is now £4,264.
So which to take?
Knowing the whys and wherefores of inflation over those two decades is, of course, an impossible ask for most retirees, let alone the brighter City analysts. As Tom McPhail, pensions guru at Hargreaves Lansdown independent financial adviser (www.h-l.co.uk), points out, inflation-proofed annuities still look pricey, demanding 5.2% inflation over a typical life expectancy in retirement to represent good value.
However, as alternatives, it can be cheaper instead to consider an annuity which increases at 3% each year, or ‘mix up’ your retirement income. By divvying up your pension pot between a fixed annuity and RPI-proofed equivalent, you can hedge your bets. Or, as long as you’re prepared to shoulder a degree of investment risk, you can invest a share of your retirement fund in drawdown as well.
What’s to blame for paltry RPI annuity rates? A mix of factors, given that annuity rates depend on our longevity (rising), the yields from fixed interest investments bought by insurers (a blend of gilts and corporate bonds among others) and plump industry charges and expenses.
It’s worth pointing out that, if Bank of England interest rates do rise, then it could translate into better annuity rates as falling demand for less attractive gilts leads to higher yields. However, such a boon is likely transient. The sclerotic longer-term structural problem remains: workers amassing small pension pots and starved of decent RPI-proofed annuity rates will continue to prefer fixed annuities, and leave themselves exposed to pension erosion.
Much of the pension world’s political and financial will is focused on the semi-compulsory NEST scheme scheduled for general introduction over the next year or two. Its capacity for soaking up the pensions limelight means problems such as RPI-proofing will sadly continue to corrode our faith in retirement saving.
Sam Dunn is a freelance journalist