First, how long will you live? Right now, a 60-year-old man with a pension pot of £100,000 can buy a level annuity paying £5,038 a year or a retail price index (RPI)-linked one paying £2,810 a year. This implies that if RPI inflation averages 2.5 per cent a year - roughly consistent with the Bank of England hitting its 2 per cent consumer price index (CPI) target on average - it will take almost 24 years for you to become better off with the RPI-linked annuity. And the longer you live, the better off you'll be.
As the average 60-year-old can look forward to another 23 years of life, this implies that for the average man, the flat rate annuity is the better deal.
But there are other considerations.
One is: how likely is it that inflation will exceed 2.5 per cent a year? The more likely it is, the better are RPI-linked annuities. Here, there are three distinct risks: the large chance of small overshoots of the target; the chance that the inflation target will be replaced by something (such as an NGDP target) which accommodates higher inflation; and the chance - which is minuscule in the near term but unknowable in the longer - that we'll get a return to 1970s-style double-digit inflation.
These risks are unquantifiable. They tell us that buying an RPI annuity might be expensive - depending on how long you live - but it gives you peace of mind. It's a form of insurance policy. The more this matters to you - the more risk-averse you are - the more attractive are RPI annuities.
One complication here is that our attitudes to inflation can be coloured not just by objective risk assessment, but also by our formative years. Ulrike Malmendier at the University of California Berkeley has found that people who experienced high inflation in their lifetimes are less likely to hold bonds (whose value is destroyed by inflation) than those who didn't. This implies that people with especially vivid memories of the 1970s - those who were young adults then - might be more disposed to buy RPI annuities than younger or older people for whom the 70s are either distant history or just one experience of many.
A corollary to this is that those who distrust governments more than average should also hold RPI annuities. This is because you might attach more weight than others to the possibility that our rulers will try to inflate their way out of debt. (Note that what matters here is your distrust, relative to others; an average level of distrust is priced into annuities.)
There's another consideration. It's about your rate of time preference. A level annuity gives you a high real income in the short term, but a lower one in future, whereas an RPI annuity gives you a flat real income. Which is better depends upon how impatient you are; the more you want to spend now, at the risk of harder times in future, the more attractive are level annuities.
This seems to suggest that level annuities appeal to the profligate spendthrift while RPI ones appeal to the prudent. However, there's a sound economic reason for at least some profligacy, pointed out by Erzo Luttmer, Matthew Notowidigdo and Amy Finkelstein, three US economists. They show that the marginal utility of consumption falls when we become ill. There's little point buying books or fast cars if our eyesight is shot, or music if our hearing is going, or foreign holidays if we can't get around.
Conversely, there's a case for us spending while we're healthy to build up a stock of consumption capital - a store of happy memories, or appreciation of books and music, which can make us happy in our dotage.
On the other hand, you might regard spending and health not as complements but as substitutes - if, say, you want to buy better nursing care in future. This argues for an RPI annuity.
In all these senses, the choice of annuity is a personal one.
Like all investment decisions, though, it might be clouded by cognitive biases. On the one hand, the optimism bias might tempt us to buy RPI annuities because we exaggerate our longevity. But on the other, impatience might tempt us into level annuities. And then there are self-serving biases. Your correspondent has a family history of heart disease. Does this mean I should take a level annuity as I might not live long? Or is this thought just a way of rationalising my short-termist desire for immediate income?
You might think this issue doesn't apply to you, because you're not planning on buying annuities. However - to paraphrase Trotsky - you might not be interested in annuities, but annuities are interested in you. The question of how much you can safely take out of your retirement wealth depends upon the rate of return upon safe assets - just as annuity rates do. The question of whether you take a lot now, and have less in future - and whether you think of this decision in real or nominal terms - arises however you are planning for retirement. Whether you buy an annuity, self-annuitise or use drawdown, the parameters are similar.
But there's another, more general point. This important investment decision depends not just upon idiosyncratic factors such as how long you'll live, but upon psychological ones such as: how scared are you by inflation? How far, relative to the market, do you trust policy-makers? What is your attitude to future spending, your time preference? In this sense, there's more to financial planning than mere money, futurology and bureaucracy. And this is why the subject is more interesting than you'd imagine from listening to the desperately dull 'experts'.
