When you choose your annuity, you will need to decide whether to take a level or standard annuity where you will receive the same amount each year, or an escalating one where you income rises each year. If you opt for the latter you are then faced with the choice between an annuity that increases by a fixed rate each year and one that tracks inflation.
Inflation-linked annuities (also known as RPI annuities) can help mitigate the effect that future inflation will have on your income level and spending power. They can be particularly beneficial if inflation remains high over a number of years. Whilst it is impossible to predict what the future holds for inflation over the long term, your spending power will reduce in years to come if your income remains static.
With an inflation-linked annuity, your income is linked to the Retail Prices Index (RPI). Rises in the RPI, therefore, result in an increase in the payments that you receive from your annuity. Whilst this might seem beneficial, it’s not all good news.
Because the pension pot that you use to purchase the annuity is the same whether you opt for a level or inflation-linked annuity, the effect of opting for the latter is that you are simply deferring income. With an inflation-linked annuity, therefore, the amount that you receive at the start can be substantially less than the amount that you would have received had you chosen a level annuity. They can also be more expensive due to the uncertainly about what the RPI might be over the longer term.
Whilst it is important to consider the effect of inflation on your spending power in the future, you will only get a real benefit from an inflation-linked annuity if inflation remains at a high level over a protracted number of years. You also need to bear in mind that your income could actually fall if there is a period of deflation. This means that these annuities are not risk-free.
If you’re unsure of the type of annuity that is right for you, it is a good idea to seek professional advice and make sure that you fully understand how the different kinds work and the risks associated with them. Whilst-inflation linked annuities do offer a way of mitigating the impact of your income falling over time, there are alternative ways to achieve the same aim.
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