Level Pension Annuity versus Index Linked Pension Annuity

Published / Last Updated on 11/04/2024

This is a debate that always takes place when you are at retirement and have decided to take the lower risk approach to income in retirement via an annuity rather than flexible drawdown.

Annuities provide a guaranteed pension income for usually life.

After taking any lump sums (if available), the balance of your pension fund buys an annuity from a pension annuity provider.

You have various options including:

  • A spouse’s annuity pension on premature death
  • Early death 5 year or 10 year guaranteed payments
  • With or without proportion (if you die in the middle of the month)
  • Paid in arrears (at the end of the month – just like your salary) or paid in advance (at the start of the month)
  • Flat, level annuity payments for life that start at a higher level but never increase or increasing annuities at a set % pa or inflation/index linked increases that start at a much lower level than level annuities but gradually get bigger with each yearly ‘pay rise’.

This video is to deal with the debate of choosing level annuities versus index linked annuities.

The simple answer is:  You are gambling of life expectancy and gambling on inflation.

For example, in today’s terms for £100,000 purchase price for a 60-year-old, you might expect:

  • Level annuity rate of 5% to 6% meaning a level, flat rate income for life of £5,000 to £6,000 pa.
  • Index linked annuity rate of 2.5% to 3% meaning a starting income that then increases each year with inflation of  £2,500 to £3,000 pa.
  • Assuming inflationary increases of say 2.5% pa, it will take roughly 18 years for total payments made via index annuities to catch up with total payments made via a level annuity.
  • Assuming inflationary increases of say 5.0% pa, it will take roughly 11 years for total payments made via index annuities to catch up with total payments made via a level annuity.

Our guidance:

  • You should always ensure that you have enough ‘core’ income (including pension annuities and state pensions) that will cover your basic ‘subsistence’ living expenses i.e., you will always be able to pay your bills and feed yourself, not just today but also in the future. 
  • Any excess pension funds over and above this, we will call your ‘leisure’ money.  You can then choose to either annuitise the excess or use flexible drawdown.
  • If you want to have more money when you are in your 60s to do as you wish as you are more active (and will be less active in 70s and 80s) you may wish to consider level annuities so that you have more money to spend whilst you can.
  • If you prefer to build up enough, stable, increasing income to plan for increased costs when/if you need later life care, you may wish to consider index linked annuities to have moore money to cover fees in later life.
  • You should also consider your own health, lifestyle, and family bloodline.  If you are healthy and if your family bloodline tends to live into their 80s or 90s, you are more likely to break even.

Never forget, this is not an ‘exact’ science, we are all gambling on the future and your will never really know until you die or you live a long, happy retirement as to which was mathematically the best option for you.

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