Guaranteed life annuities and inflation

What is inflation and why is everyone talking about it?

Inflation put very simply is rising costs. Inflation is typically measured by the Consumer Price Index or CPI which relates to a basket of goods that an average person will buy. But in retirement it is important to recognise that a pensioner may also experience different types of inflation like medical or lifestyle inflation (the rising medical or lifestyle costs associated with ageing), which can be greater than CPI.

How does inflation affect pensioners income – should I be worried about a negative inflationary impact on my retirement income?

Inflation doesn’t affect a pensioner’s income; what it does affect is what you can buy with it (i.e. your purchasing power).

At retirement, whether you’re retiring from a pension fund, a provident fund or a retirement annuity, you’re required to purchase an annuity with at least two thirds of your retirement savings to provide a regular income in retirement (like a salary). There are a number of different life annuity solutions available that provide different levels of income and behave differently in terms of annual increases.

It is vital that you understand the different options available to you when you retire so that you can protect yourself from rising inflation and reduced purchasing power, and most importantly increase the propensity to cover your essential expenses.   

How do different annuities protect against inflation?

Level annuities

A level annuity pays a pre-determined monthly income paid from the start of your retirement until you die. Many people choose level annuities due to affordability issues, as they normally offer the best starting income. However, you should avoid looking at starting income in isolation when weighing up your options, as it can skew your perception of a product’s long-term value.

This is demonstrated by the table below, which provides a level annuity’s real value after one, five and 10 consecutive years, assuming 5% inflation.  It is clear to see that level annuities do not protect you against rising inflation; and that already within one year, your purchasing power is negatively impacted.

Source: Just SA

Fixed escalation annuities

When opting for a fixed escalation annuity, you have the power to choose your own escalation level between 1 and 10%. Our experience shows that people tend to use the most recent inflation percentage as a benchmark at the time of purchasing a fixed escalation annuity. However, this means you may gain in years where inflation is low but lose out when inflation is high.

Inflation-linked annuities  

An inflation-linked annuity does exactly as its name implies - annual increases are in line with CPI. This protects you against official annual inflation increases. However, remember the difference between CPI-index inflation and inflation as experienced by a pensioner. An inflation-linked annuity will not necessarily provide enough purchasing power to protect you from medical or lifestyle inflation, which means that you could suffer a real loss year on year.

With-profit annuities

A with-profit annuity increases your chances of beating inflation over the long term. This is because increases are linked to the performance of a balanced investment portfolio, which typically tries to beat inflation by between 2-4%.

Pensioners can choose their annuity increases to target a percentage of inflation, which could be more or could be less than annual CPI. While this does not mean it will beat it every year, over 5 years it has been shown to outperform inflation by 0,4% p.a. and over the past 10 years 0,5% - 1% p.a.

How important is inflation when considering a guaranteed (or life) annuity?  

Guaranteed life annuities use the latest daily market rates when priced, which means the best estimate of future inflation is accounted for in your starting income. When an annuity is purchased, you can lock in the guaranteed increases with a non-profit annuity or one that targets (and can outperform) inflation, known as a with-profit annuity.

At Just, we believe that a with-profit annuity offers the best protection from inflation as it is linked to a balanced fund that consists of a fair amount of exposure to equities, which are commonly used to hedge inflation. With this comes the added security from the guarantee that your income will never decrease.