Which annuity is the best way to fund your retirement – a level annuity or an escalating annuity?
- A level annuity provides a fixed income that won’t change until the day you die. In real terms though its value is gradually lapped away by inflation’s sand-papery tongue.
- An escalating annuity (also known as an index-linked annuity) will offer a comparatively puny income today. But it will grow over time – its fortunes are hitched to the Retail Prices Index (RPI) or Consumer Prices Index (CPI).1 [1]
Jam today
When you compare [2] the two types, it’s hard not to be seduced by the instant riches offered by the level annuity.
For example, I can currently bag a £20,800 level annuity2 [3] for the same price as a £12,500 escalating RPI annuity. That’s over 66% more income for taking the fix.
That’s gotta be worth something, right?
And as it turns out it is.
Compelling research [4] by Professor of Retirement Income, Wade Pfau, suggests that the most efficient asset allocation [5] for retirees may well be a mix of equities and level annuities.3 [6] In this scenario, any surplus cash generated by the level annuity over and above the retiree’s income needs is invested 100% into equities to create some upside.
So, continuing the example above, I can invest £8,3004 [7] of my £20,800 level annuity income into the stock market (in year one of my retirement), given that I had intended getting by on the £12,500 a year offered by the escalating annuity.
As and when inflation erodes the level annuity’s real income below my minimum income floor [8], then the equity portfolio can be tapped for a top-up or to buy another annuity.
Equally, the equity portfolio can be a source of lifestyle income, emergency funds, or a legacy when the time comes.
[9]
Hold the jam, pass the spreadsheets
Let’s say I am 65. I took to my spreadsheets and worked out that I could maintain my income for 44 years until I age 109 using the Pfau strategy.
If I shuffled off at 84 then I would leave an inheritance of £120,000 in today’s money into the bargain. If I lived any longer, then I spend the lot on another level annuity to keep myself going.
£120,000 is a lot of buffer money and I got there assuming historically average levels of inflation and equity growth.5 [10]
Indeed the major flaw in my calculations is that I assume inflation and asset growth trot along smoothly at their historically average levels.
In reality that never happens – for better or worse – as the violent swings of the UK’s inflation history [11] shows:
[12]Source: Bank of England
A Monte Carlo sim [13] would give me a better idea of the range of possibilities. In some inflation and growth rate scenarios I’d end up filthy rich. In others, filthy poor.
Hang on, I’m running out of jam
Where things really come unstuck for the level annuity though is when inflation [14] makes like David Banner [15] and bursts out of its corset in a big, green, income smashathon.
You can estimate the damage for yourself using a level vs escalating annuity [16] calculator.
If inflation pootles along at 3%, the escalating annuity only pays out a higher annual income by the time you’re 83. You’ll have to hang on until age 97 for it to pay out a higher income overall.6 [17]
From then on you can die happy.
Right now, UK males live on average until 79 and females until 82. So you’ll need exceptionally youthful genes to make an escalating annuity worth your while. (Or the kind of bitterly tenacious grip on life that’s normally reserved for Dickensian crones with scores to settle.)
But, but, the tide can turn against the level annuity very quickly when inflation runs wild. If prices rise by 13% a year then the escalating annuity pays a higher income within five years. And it pays a higher total income in just eight – that’s shockingly fast.
So when did inflation last average 13% a year in the UK?
In the 1970s, peaking at 25% in 1975.
Ultimately, a level annuity offers more flexibility, growth, and value for money, but it does not offer certainty, security, or safety [18].
An escalating annuity is the superior product if those are your retirement goals, and frankly who doesn’t want some of that in their retirement?
Take it steady,
The Accumulator
- You decide as part of selecting your escalating annuity which inflation index to track, or you can choose a fixed number say 3% or 5% a year. [↩ [23]]
- 100% conventional: no dependents, no guarantees, no bells, whistles and big bass drums. [↩ [24]]
- Level annuities are known as fixed Single-Premium Immediate Annuities or “fixed SPIAs” in the US. [↩ [25]]
- I can actually invest £6,640 after tax. [↩ [26]]
- I assumed a consistent inflation rate of 3% p.a. and a real equity return of 5% p.a. The personal allowance is £10,000 (2014-15 rate) and uprated by 3% inflation p.a. My minimum required income was £12,000 after tax. My level annuity income was £20,800. When inflation forced my level annuity income below my minimum required income (in real terms) then I used the accumulated equity portfolio to buy another level annuity. This worked until age 104 when my final £5,000 went into cash and kept my head above water until I was 109. Even then I wasn’t out of money. I was just forced to live on less than £12,000 a year as the level annuity continued to grind down. Perhaps I’d sell my house at that stage. Or an antique kidney. [↩ [27]]
- I’m still using the £12,500 escalating annuity vs the £20,800 level annuity example. [↩ [28]]