Living costs have rocketed over the past year, making escalating annuities, which provide an income that increases by a set amount or in line with inflation each year, appear an increasingly appealing option for those reaching retirement.
An escalating, or inflation-linked annuity will initially pay a lower income compared to a standard annuity (which pays a fixed income) but this will increase each year. The aim is that over time you’ll end up receiving a higher level of income than a standard annuity, although this can take decades.
Here, we look at how inflation-linked annuities work, whether they are good value, and when they might be the right choice for you.
If you’re considering getting professional financial advice, Unbiased is offering Rest Less members a free pension review. It’s a chance to have a qualified independent financial advisor (IFA) take a look at your pension arrangements and give an unbiased assessment of your retirement savings.
The review is free and without obligation, but if the IFA feels you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.
What is an inflation-linked annuity?
An annuity provides a guaranteed income for life, or a fixed term, in return for handing over some or all of your pension savings. Read more in our guide Annuities Explained.
An index-linked annuity provides an income that will keep pace with rising living costs. The income you receive from this type of annuity is usually linked to the Retail Prices Index (RPI)measure of inflation, that looks at the prices of consumer goods we spend our money on, such as food, clothing and other essentials. RPI also includes housing costs such as mortgage interest payments and council tax. Read more how inflation affects your retirement income in our guide How does inflation affect my pension?
How popular are inflation-linked annuities?
Many people approaching retirement will be concerned about the rising cost of living, even though inflation is finally showing signs of stabilising. Even so, the majority still choose to buy a standard annuity, which provides a fixed income, rather than one that increases over time. As mentioned, the starting income for an escalating, or index-linked annuity is lower, but will rise in line with inflation or a set percentage over the years.
Just 15% of all annuities bought are inflation-linked, on average, according to data from the Financial Conduct Authority (FCA). That’s despite inflation rocketing in recent years and rising costs making it harder to make ends meet in retirement.
Are inflation-linked annuities good value?
The so-called ‘annuity payback period’ when choosing an index-linked annuity is an average of 22 years, compared to a level starting income, according to research by Canada Life. This is the time it takes for the income from an inflation-linked annuity to catch up with the income from a level annuity.
According to the insurer’s calculations, someone buying an annuity at age 65, and choosing an escalating income over a level income, would be aged 87 (based on a fixed 3% annual increase) or aged 91 (based on inflation) before their total income beat the level income (see table below). This assumes an average RPI rate of 4%. Of course, RPI could average higher than, or lower than, 4% over any timeframe.
Nick Flynn, retirement income director at Canada Life, said: “Annuities are the only 100% secure and risk-free way of generating a retirement income that lasts as long as you do. However, inflation has the power to erode your buying power over time, which is why annuity providers offer the ability to inflation proof or index link your income, so that your income can increase in line with your bills.
“While it’s easy to get lost in the myriad of options available on annuities, one thing appears to be a sure-fire bet. For most people, when you’ve made the decision to buy an annuity, choosing the certainty of a level income is likely to be the best economic decision they will make.”
How much income you receive from a level vs inflation-linked annuity
| Escalation | Starting income pa | Annual income break even | Total return break even | Total income to year 22 | Total income to year 26 |
| Level | £7,175 | – | — | £157,856 | £186,557 |
| RPI | 630,225 | Year 15 (£7,410 pa) | Year 26 | £146,558 | £189,624 |
| 3% | £4,279 | Year 12 (£7,178 pa) | Year 22 | £158,357 | £199,928 |
Source: Canada Life annuity rates, as at 24.10.2023.
Assumptions are based on a customer aged 65, with a pension of £100,000. No guarantees. Assumes average RPI rate of 4%.
It could take decades for the income from an inflation-linked annuity to catch up with the income from a level annuity. You need to live for long enough to start receiving the same amount you receive from a level annuity for an inflation-linked annuity to be worth buying. If you don’t expect to live that long, a level annuity might be a better option. Also, bear in mind that if you have certain health conditions or smoke, you might qualify for an even higher annual payout from an enhanced annuity (read more below).
Rebecca O’Connor, from PensionBee, said: “In times of high inflation, as we’ve just experienced, the appeal of an inflation-linked annuity may be stronger. But if inflation returns to its regular pattern of hovering around 2% before too long, and staying there, inflation-linked annuities are unlikely to beat fixed rate products over the course of a retirement. If you live through a prolonged period of relatively high inflation, that equation might be different.
“Unfortunately, no one knows what’s around the corner for the economy at the moment. However, the near term forecasts are for much lower and steadier inflation. If that’s the case, then unless the starting rate on offer from the inflation-linked annuity is uniquely high, it seems unlikely that it could beat the higher fixed rates currently on offer.”
If a level annuity initially provides more income than you need, you should be able to cover your living costs for some time, even as the cost of living rises. You could save the remainder to cover rising living costs. Bear in mind, too, that you may spend more in the early years of retirement when you are more active, and less as you get older and lead a quieter lifestyle. You might not need the increase in income that comes late into retirement from an inflation-linked annuity.
You may already have other parts of your retirement income that are inflation-linked. The State Pension rises in line with the triple lock guarantee. This means that it increases each year with whatever is highest from average earnings, the previous September’s consumer price index inflation (CPI) or 2.5%. Read more in our guide What is the pension triple lock?
When might an inflation-linked annuity be the right option for you?
An inflation-linked annuity might be worth considering if, other than your annuity income, you don’t have either retirement income that’s increasing in line with rising costs. Tax is also an important consideration in retirement. You don’t want your annuity income to push you into a higher rate tax bracket. In this scenario, a lower starting payout from an escalating annuity might be better, particularly if other taxable income is likely to decrease as you get older.
Alternatively, you may choose to take a ‘mix and match’ approach, buying both a level and inflation-linked annuity with your pension. This way, you can get some protection against inflation, and some higher income too. You may also choose to buy an annuity with some of your pension pot, while leaving the remainder invested in a flexible drawdown plan.
Flynn said: “For those concerned about inflation, often a blend using annuities and income drawdown can deliver an optimum retirement income. Annuities deliver the security of income, while leaving some of your pension invested in drawdown can be a natural hedge against cost-of-living pressures.” Read more in our article Your pension options at retirement.
What other types of annuity can I choose from?
You don’t have to go for the annuity offered to you by your pension provider. In fact, it’s essential you compare annuities from a wide range of providers, as the annuity rates (and therefore the retirement income) you’ll be offered can vary widely.
As well as standard or inflation-linked annuities, you may choose a joint life annuity, which pays you an income until you die, at which stage your partner or spouse will receive the income. You may also choose a temporary or fixed term annuity that pays out for a set period of, say, three years. So, you’ll only receive an income for a certain period of time rather than the rest of your life which may work if your circumstances are likely to change in the future. For example, you may receive pension income from elsewhere.
If you’re a smoker, are overweight, or there are other factors which might shorten your life expectancy, you might be eligible for an enhanced annuity. This type of annuity will typically offer you a higher income than other lifetime annuities, as the provider assumes that with a shorter expected lifespan, they will need to make payments for a shorter period of time.
Where to seek advice on buying an annuity
Choosing which type of annuity to buy is a major financial decision that could have a significant impact on your retirement income. It’s important to shop around for the best deal, as well as seek financial advice to choose the right type of annuity for you. It’s also important to note that since the introduction of pension freedoms in 2015, you are no longer compelled to buy an annuity. There are other popular options such as income drawdown to provide an income in retirement. Read more in our guides Your pension options at retirement.
If you’re considering getting professional financial advice, Unbiased is offering Rest Less members a free pension review. It’s a chance to have a qualified independent financial advisor (IFA) take a look at your pension arrangements and give an unbiased assessment of your retirement savings.
The review is free and without obligation, but if the IFA feels you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.
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