Mark Carney is settling into his role as the new
governor of the Bank of England. Moreover, he seems determined to distinguish
himself from the old guard. So whereas the headline policy of keeping interest
rates bumping along at 0.5% looks oh-so-familiar, his reasons for doing it are
slightly different. Carney is targeting unemployment, and until that falls to
7%, interest rates will remain low. In contrast to previous policy, inflation
is deemed ‘sticky’ and is being left to its own devices, but if it starts to
rise ‘too high’ (whatever that means), action will be taken to bring it down.
Therefore, predictions are inflation will continue to
exceed the old 2% target, and perhaps even nudge above 3%. Inflation still
presents a danger, especially to pensioners who spend a larger proportion of
their income on essential items that tend to increase in cost more quickly. Pensioner
inflation is often cited to be much higher than CPI, often as high as 9%. In
addition, its corrosive properties to a retirement income over 20 or 25 years
are harsh.
The good news for the state pension is that it is guaranteed
to increase. The Coalition Government famously introduced the triple lock - a
guarantee to increase the state pension every year by the higher of inflation, average
earnings or a minimum of 2.5%. However, that now looks to be in jeopardy. The
triple lock is only written into legislation until the end of the current
parliament, 2015. From there on state pension is only proposed to increase in
line with average earnings, which over the long term, will give less protection
against inflation.
Private pension incomes are at even more risk from
inflation. Those in a defined benefit scheme will find at least part of their
pension will increase each year, and some might even be lucky to find it’s
inflation-linked. However, those buying annuities on the open market have
options - to buy a level income, one that increases at a fixed rate (often 3%)
or an inflation-linked income. The vast majority plump for the level income - partly
because it is by far the higher starting income, and it can be difficult to see
beyond that - certainly to a distant point in time 20 years’ hence.
Even if the retiree took a closer look and did some
basic maths, index-linked annuities don’t look good value for money. A 65-year
old with £100,000 today could buy a level annuity of £6,100 a year or an
annuity that increases each year by 3% of £4,267 a year1. (I’ve
assumed no spouses’ pension, a five-year guarantee, and no medical or lifestyle
conditions.) That means the retiree
would have to live to 88 before the accumulated fund from the increasing
annuity outstripped that from the level annuity2.
However, if the person chose a RPI-linked annuity, their
starting income would be only £3,6661. If RPI was 5% a year, our
retiree would be 85 before their accumulated fund from the RPI-linked annuity2
beat the one from the level annuity, but if RPI were 3%, the retiree would be a staggering 97 before the break-even point.
Nothing disintegrates under the glare of inflation like
a fixed income. Therefore, of course, keeping some investment exposure and the
possibility of investment growth for retirement income is an effective way of
combating it. This is one of the main reasons behind income drawdown’s historic
success.
However, income drawdown is only a temporary solution
for most. The absence of mortality cross-subsidy – present in annuities – means
the underlying investment fund has to work harder in income drawdown than in
annuities. This is particularly true for those over the age of 70.
Investment-linked annuities as well as offering the key advantages of
investment exposure, income flexibility, and a maximum income of 120%, also have
the benefit of mortality cross subsidy and may be a better option for older
clients wanting to fight inflation.
Obviously, there are risks with maintaining investment
exposure, and the usual adage that investments can go down as well as up. As
longevity continues to increase and the average lifespan grows, it’s clear one
of the greatest risk for retirees is simply ignoring inflation altogether.
1.
Source: MGM Advantage analysis of Money
Advice Service annuity rate tables 11.9.13
2.
Source: MGM Advantage calculations
No comments:
Post a Comment