The soaring cost of living is damaging retirement pots and is particularly detrimental for pensioners on fixed incomes. In May, the UK Consumer Price Index (CPI) rose to 9.1 per cent, placing pressure on retirement incomes that are failing to keep up with rising prices.
Inflation is predicted to reach 11 per cent in the autumn, further reducing spending power, while global stock markets have fallen in 2022, making it particularly challenging to manage pension withdrawals while giving markets enough time to recover.
However, whether your retirement income will last for the rest of your life and manage to combat inflation depends on a wide range of factors, including the size of your pot, and what you choose to do with your retirement savings.
We can all do as we wish with our defined contribution pension pot from the age of 55. This gives flexibility, but retirees choosing income drawdown are finding it difficult to manage withdrawals in a market downturn, with expectations that there may be further falls on the horizon.
Becky O’Connor, head of pensions and savings at interactive investor, says: “Using income drawdown seems like a challenging road ahead now that markets have taken an about turn following inflation, interest rate rises and the war in Ukraine.
“It’s fraught with difficulties around choosing funds that pay you a decent amount of income, as well as where to invest the money you don't need in the next few years so that it can continue to grow.”
An alternative is to buy an annuity with some or all of your pension savings to benefit from the certainty of a guaranteed income in retirement. An annuity takes the value of some or all your pension at a point in time and converts it into a guaranteed income, so you don’t need to worry about managing withdrawals as you do with drawdown.
There was also some recent good news for those buying an annuity as rates increased to their highest level in eight years in June. Annuities are impacted by yields on government bonds, known as gilts, which have fallen in 2022, and interest rates, which have risen, thereby increasing the amount of income produced from annuities.
Tom Selby, head of retirement policy at AJ Bell, says: “Whether or not to annuitise part or all of your retirement pot will depend on your personal circumstances and appetite for risk. If you don’t want any investment risk at all and prefer a stable income, then an annuity is likely to be the right option.”
There are several factors to bear in mind when buying an annuity. The younger you are, the lower the rates, which usually rise as you get older, and with stock markets generally down, you might prefer to leave as much as possible invested to give your pot a chance to rise in value again.
Helen Morrissey, senior pensions and retirement analyst at Hargreaves Lansdown, says: “Remember that you do not have to annuitise your entire pension in one go. Annuitising in slices can mean you secure a guaranteed level of income and you benefit from rising rates as you age when you annuitise later on.
“If you annuitise in slices, then you can keep the remainder of your pension invested in an income drawdown arrangement where it has the opportunity to grow further.”
There are different types of annuities to choose from, and whether or not your retirement income rises in line with inflation will depend on which you pick. Pensioners who opt for a ‘level’ annuity with their pot will be among those on a fixed income who will be feeling the impact of rising prices in particular as the amount of income they receive won’t change over time.
However, if you choose an index-linked annuity, will receive a lower starting income, but this can make an enormous difference to your retirement income, warns Morrissey. A 65-year-old with a £100,000 pot can now receive an income of £6,149 a year from a level annuity – a huge increase on the £4,495 they would have got in the aftermath of the Brexit vote in 2016. By contrast, an inflation-linked annuity has a much lower starting income – currently around £3,476. “This income will rise but will take years before it catches up with what you would get from a level annuity so that is something to bear in mind,” says Morrissey.
If you’re buying an index-linked annuity, it’s important to consider how long you need to receive income from this type of annuity to make up for the amount you miss out on by not buying a level annuity. While no one can be certain when the inflation may fall, the Bank of England is aiming to bring prices back down to its 2 per cent target. Generally, index-linked annuities can be a good option for pensioners who live for many decades past retirement age who will see periods of high inflation.
O’Connor said: “While all annuity rates are much higher than they were a few years ago, leading to a higher income, index-linked annuities are currently paying out roughly 60 per cent of the annual income that a fixed, or level, annuity will pay. That's quite a big income sacrifice to accept for the knowledge it will rise in line with inflation. But then again, in this time of high inflation, which happens to coincide with higher annuity rates as a result of interest rate rises, it may be worth it.”
Alternatively, you could get an ‘escalating’ annuity that rises by a fixed percentage each year, which may be considered a halfway house, so you get more income than an inflation-linked annuity but less than a level annuity. You also get some comfort that your income will rise each year, even if not in line with inflation.
You may also have the option of an impaired or enhanced annuity that pays a higher income if you suffer ill health and expect to have a reduced life expectancy.
If you decide an annuity is the right option, it’s important to shop around for the best possible rate and type for you, as once you buy an annuity, there’s no going back. Of course, you do not need to invest all of your pension pot in an annuity, but just a portion to perhaps meet essential bills which, alongside your state pension, will provide a basic level of secure income.
Meanwhile, some or all of your defined contribution personal pension can remain invested in a drawdown plan to benefit from future potential investment returns, and to be passed to your beneficiaries when you die. This may ultimately give you the greatest control over how you take your retirement income.
Whatever you decide, it’s important to regularly review your strategy, seeking professional financial advice when needed, and taking a strict approach to withdrawals during market volatility. Using other sources of income, such as cash individual savings accounts (Isas) or rent from buy-to-let property could also provide a short-term buffer while you wait for markets and inflation to moderate.
Emma-Lou Montgomery, associate director for personal investing at Fidelity International, says: “Before moving into drawdown, consider using guaranteed income sources. These could include income from a defined benefit pension, your state pension or an annuity. The idea is to at least meet all or some of your essential expenditure and provide you with underlying guarantees and diversification during periods of uncertainty.”
The state pension in retirement usually keeps up with rising living costs as it’s subject to the ‘triple lock’ guarantee, meaning that it increases by the highest of September’s inflation figure, earnings growth, or 2.5 per cent. However, the triple lock was temporarily suspended in 2022 as high earnings growth when furlough ended would have made the increase too expensive. It rose by 3.1 per cent to £185.20 a week in April, in line with September’s inflation figure, but the government has promised to reinstate the pension triple lock in April 2023, which it will rise substantially alongside inflation.
If you receive some of all of your retirement income from a public sector defined benefit, or final salary pension, you usually don’t need to be concerned about inflation. Your income will be guaranteed to rise alongside inflation for the remainder of your life. However, beware that increases in private sector defined benefit pensions are usually capped at about 5 per cent, which won’t keep up with the current level of inflation.