Fixed or index-linked annuities?
If you choose to buy an annuity, you will need to decide whether you want the income you receive to stay the same every instalment, or increase each year.
Fixed income annuities
With a fixed income annuity (sometimes called a level annuity), your income will stay the same each year for the rest of your life. This means you will know exactly what your future income will be, which could help you to plan ahead. A fixed annuity will usually offer a higher starting income than an increasing annuity, and that amount is guaranteed year to year.
The drawback is that you could see your buying power significantly eroded over time by inflation. The longer you live, the more pronounced this effect is likely to be.
If you have other incomes or assets and don't think you will need as much income towards the end of your life as you do early in retirement, a fixed income annuity could be suitable. If the opposite is true, perhaps because of anticipated health care costs, a long-term care annuity could be the answer.
Increasing annuities (sometimes called escalating annuities) are designed to protect your income from the effects of inflation, in other words the increasing cost of goods and services over time.
If you choose an increasing annuity with a high annual increase, your starting income will be a lot lower than with a fixed annuity; it takes on average 12 years for the level of income to catch up. Some providers set a maximum on the annual increase you can get.
There are two main types of increasing annuities to choose from:
- Increasing rate: your income is guaranteed to increase each year by a fixed amount. You can usually choose an annual increase of between 0-8.5%, but the higher the rate you want it to increase by each year, the lower your starting income will usually be.
- Index-linked increasing rate: your income is adjusted each year in line with a designated measure of inflation — usually the Consumer Price Index (CPI), which is based on a sample of common shopping items. This means your income could potentially go down as well as up, but the tendency of inflation is nearly always for prices to go up steadily, even in lean economic times. So inflation index-linking is designed to protect your annuity's buying power, keeping it more or less the same to protect your lifestyle.
Making your decision
Since 'pension freedom' legislation came into force in April 2015, a range of alternatives to annuities has become yours to consider. If you do still decide to go for an annuity, which type is right for you?
The answer will depend on a number of things, including your age, health, lifestyle and whether or not you have a partner. Read more about whether a joint or single annuity is right for you.
Compare fixed annuities and increasing annuities
If you're making a decision about your retirement income, it's important to consider all the options available. To help you make an informed decision, you may want to take financial advice tailored to your needs and circumstances.
Last updated: 19 May 2015