Resting on their laurels

Some 43 per cent of people don't take any financial advice before buying an annuity, according to a recent report by the Association of British Insurers. You can understand why so many retirees, at first glance, simply go for the easiest option - that of a level annuity.

Why would anyone take an index-linked annuity when, at current rates, a 65-year-old male taking a single life policy with no guaranteed payment periods, having a pension fund of £500,000 would receive a level annuity of around £27,500 but an RPI-linked annuity of just around £15,300?

There are several points to consider, however, when clients make their own decision at retirement:

• Even at the government's target inflation rate of 2 per cent, the value of a retiree's money could easily halve over the years in which they are retired.

• Things that retirees spend a greater majority of their income on are increasing in price at a faster rate than standard inflation measures. For example, energy costs are up 170 per cent in the last ten years, and food prices have increased well beyond consumer price index (CPI ) rates in the recent past.

• In our experience, the vast majority of people choose a level income when buying an annuity because they do not perceive the value of an increasing income. This is mainly because of the catch-up time required and the overall time taken to be 'in pocket'.

• When looking at the time taken to be 'in pocket', many people underestimate their life expectancy (the wealthier you are, the longer you are likely to live).

The potential for misunderstanding the risks of inflation in retirement are great when millions of annuity purchases are undertaken without financial advice. A level income may be the right answer if people have other assets to call on when inflation starts to bite. But it would be best to undertake some form of cashflow projection before making any decision. What might seem a good level of income on the first day of an individual's retirement may look a bit paltry 20 years on.

Many individuals will look at their position today and not think much further ahead than that. It's a big problem. Worrying about what their financial circumstances will be in 20 years, for example, isn't something that they consider enough. Those that do consider the future very often underestimate their life expectancy.

On average, a 65-year-old male or female could expect to live about another 20 years. But they fail to realise that to get an average there are likely to be many people living well beyond the average, who take account of those not so fortunate. A girl born in 2013, for example, has a one-in-three chance of living to 100, with a boy having a one-in-four chance.

Beyond average

Certainly those with substantial pensions and other wealth are likely to be living well beyond the average, as statistics show. Also consider that for couples planning retirement, there is an increased likelihood that at least one will have a long life. In most circumstances, where health issues are not present at the time of planning, it would be sensible for clients to take a cautious approach and assume they will live well into their 90s at least.

Once you consider potentially having a longer life, taking some form of rising income suddenly doesn't look quite so bad. Even if a level income is still the right option, it will bring into focus the need to have a fall-back position when inflation inevitably starts to eat into the buying power of the income being received.

Retirement is probably one of the biggest decisions that clients will make in their lifetime. Without professional, trusted advice, it could lead to the wrong outcomes. If an annuity has been purchased, it is a decision that cannot be changed at a later date.

Andy James is advice policy manager at Towry

Copyright & permissions