Pension providers are hitting retirees with huge premiums on inflation-linked annuities as more people look to protect their retirement income from escalating prices.

The official measure of inflation, the Consumer Price Index (CPI), hit 4.7% in August while the Retail Price Index (RPI) – which is considered more relevant to households as it includes mortgage repayments – currently stands at 4.8%. However, personal inflation is thought to be a lot higher, especially for pensioners who typically spend a bigger proportion of their income on fuel, food and council tax.

Inflation is forecast to continue to rise in the months ahead as soaring crude oil costs put upward pressure on petrol, gas and electricity, as well as food prices. As a result, many retirees may be tempted to opt for an RPI-linked annuity that changes on an annual basis in line with inflation.

On one hand, this is unsurprising. The income from standard annuity products, which provide a static level of income, will be eroded by rising inflation. Figures from Hargreaves Lansdown show a £1,000 annuity income for a 65-year-old man will be worth just £400 assuming inflation of 4%.

In contrast, an RPI-linked annuity protects your retirement income from inflation. Although payments will start off lower than a standard annuity, they will increase over the years enabling you to beat rising inflation.

Outlook for inflation

But experts warn RPI-linked annuities are not necessarily the answer.

Firstly, you would have to live until you were nearly 92 in order for this type of annuity product to provide a greater income to you than a standard one.

Secondly, insurers are aware of rising inflation – and have stuck premiums on RPI-linked annuities in order to protect their margins. While prices on standard annuities are at a five -year high, prices on inflation-linked deals have seen falls of around 4% since last September.

Nigel Callaghan, pensions analyst at Hargreaves Lansdown, says some insurance companies have increased their 20-year view on inflation, and have therefore increased the “risk premium” on annuities that track inflation accordingly.

“Assuming the current rate of inflation of 4.3% continues, a 65-year-old male investor with a £100,000 pension fund would only receive more total income via an RPI-linked annuity from the age of 92 onwards,” he adds. “If inflation falls to 3% this would delay that break-even point until the age of 162.”

Data from financial planning firm Alexander Forbes also shows rates on RPI-linked annuities continue to look lacklustre, with the best monthly income provided down by around £75 since January.

David Marlow, director at Alexander Forbes Annuity Bureau, says: "The fact that inflation-proofed annuity rates have not improved at all this year shows that providers are awake to the risk of returning inflation."

So, what’s the answer? Opt for a standard annuity and face losing out to the inflation-monster, or go for an inflation-linked product and pay a higher price?

According to Callaghan, an alternative could be an escalating annuity; these typically increase at a rate of 3% per annum, thus providing some protection against inflation.

“Inflation rarely goes below 3%, so a 3% escalating annuity is a good half-way house,” he adds. “The cross-over point for this type of product to pay more total income than a standard annuity would be the age of 85 – the average life expectancy for a 65-year-old man.”

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