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Will you still need me; will you still feed me, when I’m… 96?

Will you still need me; will you still feed me, when I’m… 96?

The government’s answers to the Beatles’ questions are no and not very much respectively.  So it’s clear that it is up to individuals to provide for themselves in their old age.  But what should annuitants do to maximise their return from their pension pot?  Well one of their best options may well be to keep on doing what they are doing instinctively, and ignore advice from the pension experts.

The great and good of the pension world are never done denouncing the lack of foresight of those foolish annuitants who purchase level annuities with their pension pot.  Dazzled by the higher income level, these ‘financial illiterates’ are said to be condemning themselves to a poverty-stricken future by buying level annuities and maximising their initial income stream; foregoing all the cleverly designed inflation-proofing options that have been provided as part of current annuity products.

And yet, despite all the warnings from the annuity advisers, 85% of all annuitants purchase a level annuity.  Proof positive, say the experts that annuitants need to spend money on professional advice, as they are not capable of making a rational decision on their own.

But maybe the annuitants are cleverer than the pension experts think.

Annuities can either be escalated at a fixed rate, commonly 3%, or in line with a standard indicator such as the retail price index (RPI) or the consumer price index (CPI).

If a fixed rate of 3% is chosen, the annuity is designed to match a level annuity at the average life expectancy level.  Surely this means that at least 50% of annuitants are better off taking the level annuity approach, as they will get more for their pension pot across their lifetime?

Worse off again are those who picked escalation in line with an indicator.  Recent research from Hargreaves Lansdown shows that those who chose the more generous indicator – RPI – would need to live to 96 before it would match the a level annuity by average life expectancy, based on the average inflation rate over the last twenty years.  Presumably, it’s actually impossible for those who chose CPI escalation to ever catch up on those who stuck with a level annuity.

And given that the Bank of England’s official target for inflation is 2%, it means that government policy is actively aimed at making sure that most RPI / CPI linked annuities will be bad value compared to level annuities.

It appears that most annuitants are better off sticking with their gut instinct – live for today.  At least they can make sure they maximise their take from their pension pot.  And if they set aside the extra amount a level annuity gives them over and above an escalating annuity and invest it in a good tax-efficient vehicle like an ISA, they can even provide a level of inflation proofing for themselves – in case they live to 97.

Tom Murray

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