Is an inflation-linked annuity right for you?
Annuities have increased in popularity recently as they offer a reliable retirement income. Learn whether an inflation-linked annuity could be right for you.
When planning your retirement, you’ll need to consider how you will draw from your pensions to generate an income.
Accessing your pension pot and making withdrawals as and when you need them – known as “drawdown” – could be a suitable option because you have a good amount of flexibility.
However, in recent years, annuities – a type of insurance product that provides a guaranteed income for a set period, sometimes the rest of your life – have become more popular again.
According to the Association of British Insurers, the number of annuity sales increased by 24% in 2024, reaching a 10-year high.
This increased interest in annuities could be a response to the recent cost of living crisis and global economic uncertainty. In times of turmoil, the idea of using some or all your pension savings to purchase an annuity and receive a guaranteed income could be attractive to you.
If you want to explore this option because you’re worried about rising living costs, you could benefit from purchasing an inflation-linked annuity. However, these annuities aren’t suitable for everyone, so it is important to assess carefully before opting for one.
Read on to learn more.
Inflation could erode the spending power of your income in retirement
When you purchase an annuity, you spend some or all your retirement savings in exchange for a guaranteed income for a set period. This could be a fixed number of years or for the rest of your life.
If you have a level annuity that pays the same amount each month for the entire period, inflation could erode the spending power of your income during retirement.
For example, imagine you purchase an annuity that pays an income of £2,000 a month, and you spend this amount on your general living costs.
If inflation is 2% – the Bank of England’s (BoE) target – the same goods that cost £2,000 a year ago would now cost £2,040. After another year with 2% inflation, your monthly expenses would cost £2,080.80.
As you can see, even a low level of inflation will cause your outgoings to rise over time. If your annuity was still paying a fixed income of £2,000 a month, you would likely have to make sacrifices to your quality of life.
It’s also worth noting that inflation could easily reach a much higher level than 2%, as it has in recent years, amplifying the effect.
An inflation linked annuity provides an income that may rise in line with the cost of living
If you’re concerned about the rising cost of living, an inflation-linked annuity could be more suitable for you as your income increases in line with inflation.
The payments might rise to reflect the Consumer Prices Index (CPI) – a measure of the prices of a variety of common goods – each year. Alternatively, you can choose for the payments to grow by a set amount, such as 3% or 5%.
This means that your income will reflect the rising cost of living over time.
However, before opting for an inflation-linked annuity, there are some important pros and cons to consider.
The pros and cons of purchasing an inflation-linked annuity
Pro: You receive a regular income
One of the key benefits of an annuity is that you receive a regular income, potentially for the rest of your life.
In comparison, when you flexibly access your pension, you can no longer generate an income once you spend everything in the pot.
If you’re worried about the potential for running out of money in retirement, an annuity might give you more peace of mind.
Pro: You may be better protected from inflation
The other important benefit of an inflation-linked annuity is that you have some protection against rising costs.
As your income is increasing at a similar pace to the cost of goods and services, you may be more likely to maintain the same quality of life throughout retirement.
Con: Annuities are irreversible and don’t offer as much flexibility as drawdown
While annuities could benefit you in some ways, they are not especially flexible.
Once you purchase an annuity, you can’t reverse the decision. You also receive a set income each month and although it may rise with inflation, you don’t have the option of increasing or decreasing your income should you need to.
For example, flexible drawdown would give you the opportunity to take a large lump sum to purchase a new car or pay for a holiday. You wouldn’t have this option with an annuity.
You might be able to use savings from other sources to pay for these larger expenses but the lack of flexibility with an annuity could be a challenge for you.
Con: Inflation-linked annuities could be more expensive and may offer a lower initial income
Another potential issue is that inflation-linked annuities may be more expensive than a level annuity.
More importantly, the amount you receive at the beginning of the period is normally lower, to account for higher payments in the future as your income rises in line with inflation. Depending on your situation, it could be more difficult to maintain your desired standard of living with these reduced payments.
It’s important to consider these potential drawbacks when deciding whether an inflation-linked annuity is right for you.
Get in touch
Your Kellands financial planner can discuss the most suitable ways to generate an income in retirement.
Email us at hale@kelland.co.uk, or call 0161 929 8838.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulation, which are subject to change in the future.