Should you buy a level annuity or an inflation-linked one?

01 What the two products do

A level annuity pays the same cash amount every year for life. An inflation-linked annuity increases each year with a published index, usually RPI or CPI, sometimes with a cap. The premium is the same; the starting income is not.

The gap at outset is large — commonly a third or more — because the insurer has to fund a rising liability from the same capital. That is the whole of the price difference, and it is not a margin or a fee.

A third option, a fixed escalation of 3% or 5% a year, sits between them. It rises predictably and it is not inflation protection: in a year of 7% inflation it falls behind exactly as a level annuity does, just more slowly.

Source: MoneyHelper: guaranteed retirement income (annuities)

02 The crossover, and why it is the wrong test

The obvious comparison is when the inflation-linked income overtakes the level one, and then when cumulative payments catch up. The first typically happens in the mid to late seventies; the second, several years later.

Presented that way the level annuity usually wins, because most people do not live long enough for the cumulative figures to cross. That is a correct calculation of the wrong quantity.

The relevant question is not which pays more in total. It is what happens to your standard of living if inflation runs at 5% for a decade — and the answer for a level annuity is that it loses a third of its purchasing power while the payment on your bank statement never changes.

There is a second reason the crossover test misleads, which is that it treats the two incomes as the only difference. They are not: the level annuity leaves you carrying inflation risk for thirty years, and carrying a risk has a cost even in the outcomes where it does not materialise. Nobody would describe an uninsured house as cheaper than an insured one simply because it did not burn down.

On the defaults above, the worked example shows 16 years. By then the level income buys what £3,988 buys today — the same payment, a third less shopping.

Source: Consumer price inflation, UK

03 What inflation actually does to a level income

At 2% inflation, a level income loses about a third of its purchasing power over twenty years. At 4%, it loses more than half. Neither of those is a market event or a bad outcome; they are arithmetic applied to a rate the Bank of England targets and a rate it has recently exceeded.

Nothing about the payment signals this. The annuity pays exactly what it promised, on time, every month, while the shopping it buys shrinks. That invisibility is why the level option is chosen so much more often than the analysis supports.

Over a thirty-year retirement, inflation is the risk with the largest cumulative effect and the one an individual can do least about. Transferring it to an insurer is the specific thing an inflation-linked annuity buys.

The effect compounds with the shape of a retirement. Spending in the late years is more heavily weighted toward essentials — heating, food, care — and those are the categories that have run above headline inflation. A level income falls behind fastest in exactly the years its purchasing power matters most.

Source: Bank of England on inflation

04 Longevity insurance is the point of an annuity at all

The economic case for annuitising at all rests on longevity insurance: an annuity pays as long as you live, which is precisely the risk a portfolio cannot cover. That case is strongest for the spending that cannot be reduced.

If the reason to buy an annuity is to make essential spending safe, then buying a version whose real value halves defeats the purpose. The two decisions — whether to annuitise and which shape — should be answered with the same logic, and usually are not.

Which is why the honest framing is: annuitise the essentials, index-link that part, and leave the discretionary spending to a portfolio where flexibility is available.

It is also worth being precise about what a portfolio can and cannot substitute for. A portfolio can be invested for inflation protection over the long run, and it cannot promise it in any particular decade. For discretionary spending that uncertainty is tolerable; for the heating bill it is the thing you were trying to remove.

Source: Uncertain Lifetime, Life Insurance, and the Theory of the Consumer

05 Where the level annuity is right

For income you could reduce later without hardship, the level version is a reasonable choice. Someone using an annuity to fund travel in the active early years, with a portfolio and a State Pension behind them, is buying front-loaded income deliberately.

It is also defensible where health is materially impaired, because a shorter expected period makes the early income worth more and the crossover irrelevant. That is the same reasoning behind an enhanced rate and it compounds with it.

And it can be right where the State Pension already covers essential spending. A household whose non-negotiable costs are met by an index-linked state benefit has already bought its inflation protection.

Source: The new State Pension

06 The middle options

Fixed escalation at 3% costs less than full inflation linking and provides a predictable rising income. It is a partial hedge and it should be described as one — in a decade averaging 5% it falls behind, and the shortfall is permanent.

Capped inflation linking, where increases follow an index up to a ceiling, has the same character: full protection in normal years and none in the years protection matters most. The cap is where the insurer's risk stops and yours starts.

Splitting the purchase is often better than compromising on the shape. An index-linked annuity covering essentials plus a level one covering discretionary spending gives both, and each part does its own job properly.

One practical point on splitting: the two annuities do not have to be bought at the same time or from the same insurer. Buying the index-linked floor first, at whatever age the essentials need covering, and leaving the level tranche until later gives both the protection and the higher rate that comes with age.

Source: Retirement income market data

07 How to decide

Work out your essential annual spending — housing, utilities, food, insurance, transport. Subtract the State Pension and any defined benefit income, both of which are already index-linked. What remains is the gap that an inflation-linked annuity should cover.

Buy that much index-linked, whatever the starting income looks like next to the level quotation. Then decide separately whether to annuitise anything else at all, and if so, on what terms.

And get both quotations on the same day from the same panel, with the same shape on everything else. A level quote from one provider against an index-linked quote from another compares two things at once.

Finally, ask for the quotation to show the income in year ten and year twenty as well as year one. Very few providers present it that way unprompted, and seeing three numbers instead of one changes how the choice looks to almost everybody who does it.

Source: FCA consumer information