Pensioners hit by falling inflation
Pensioners with certain annuity products could see their income frozen or even decrease as a result of falling inflation.
Earlier this week, government statistics revealed that one measure of inflation – known as the Retail Prices Index – hit zero in February for the first time in 49 years. Although the official rate of inflation – the Consumer Prices Index – rose slightly last month, economists expect it to also eventually hit zero and even potentially turn negative.
The falling cost of living should be welcome news for pensioners, especially as retirees tend to suffer from higher personal inflation than other members of society because their income is fixed and a large proportion is spent on food and utility bills. However, for those claiming an income through an annuity, the news could mean their incomes actually start to fall.
This is because many annuity products track inflation through the Retail Prices Index. When inflation was high last year, inflation-linked annuities grew in popularity, as people tried to beat the devastating impact rising prices can have on a retirement pot.
While the income from standard annuity products is static and can, over time, be eroded by rising prices, an inflation-linked product protects your retirement income as payments start off lower and increase over time.
However, with deflation now very much on the cards, people with inflation-linked annuities could see their income frozen or even fall, depending on their annuity provider.
According to the Association of British Insurers, around 27,000 people bought an inflation-linked annuity in 2007, but there are likely to be hundreds of thousands people with such annuities.
Laith Khalaf, pensions analyst at IFA Hargreaves Lansdown, says that annuity providers use the rate of inflation three months prior to you taking out the policy. Each anniversary, the provider again looks at the rate of inflation three months previously and amends your rate accordingly.
So, people who are approaching their anniversary at the moment should manage to escape deflation – but those whose anniversary falls in the summer months could be less lucky.
Research from Hargreaves Lansdown reveals that only four of the leading insurers offer inflation-linked annuities with rate guarantees, meaning the income a pensioner receives will not reduce even if inflation does.
This means many retirees are exposed to falling retirement incomes, at a time when they are least able to afford it. At best, insurers will freeze an investor’s income until inflation returns to positive territory.
As inflation-linked annuities are reviewed on an annual basis, pensioners will have to suffer the consequences of deflation for a full year - and they won't see their income rise again until inflation exceeds the previous positive pricing level.
Two of the biggest annuity providers, Prudential and Standard Life, do not offer rate guarantees (see table below).
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|Source: Hargreaves Lansdown|
According to Hargreaves Lansdown, inflation needs to run at 5% a year for an RPI-linked annuity to be worthwhile.
Partnership, which provides annuities to people with ill-health, is another provider that does not offer customers a rate guarantee and, as such, will reduce customers' income in-line with any falls in inflation.
Ruth Clarke, marketing director at Partnership, says less than 1% of its customers have this type of annuity. She argues that the cost of offering customers a floor would significantly reduce the competitiveness of the annuity.
“In common with many others we expect inflation to take off again following the government move to adopt quantitative easing in which case income payments will increase accordingly,” Clarke adds.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Association of British Insurers
Established in 1985, the ABI is the trade body for UK insurance companies. It has more than 400 member companies that provide around 90% of domestic insurance services sold in the UK. The ABI speaks out on issues of common interest and acts as an advocate for high standards of customer service in the insurance industry. The ABI is funded by the subscriptions of member companies.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).