One of the most difficult choices that retirees often face when looking to select an annuity is whether to opt for the instant riches offered by a fixed annuity or opt for an escalating annuity to safeguard the income from the inflation demon.
A common mistake is to be allured by the higher starting income provided by the fixed or level annuity without fully understanding how it will impact your lifestyle in the years to come.
As always, your choice of annuity is a very personal decision that depends on multiple factors like your health, your financial circumstances, your lifestyle, your lifestyle goals for the retirement years and healthcare costs.
But if you are standing at that crucial juncture twiddling your thumb, then let’s take a closer look and compare what each type of annuity has to offer.
Fixed Income Annuity
A fixed income or a level annuity will pay you a fixed income for the rest of your lifetime. It starts off with a higher yearly annuity payment as compared to other types of annuities. But the payments will taper down with time but not go below a minimum guaranteed payment.
- You will receive a higher amount to start with.
- You will know beforehand what your retirement income will be, allowing to you plan ahead
- Since you will receive the same amount year after year, inflation will erode its value with its sandpapered tongue.
- You will be able to buy lesser with the same amount after a decade
- The payment will be lesser during the later stages of the annuity
Is it the right choice for you?
If you have multiple pension pots and other funds tucked away that will cover you in the later stages of retirement; then you can take advantage of the higher income payout in the earlier years, offered by a fixed income annuity.
On the other hand, if you anticipate high healthcare costs in the later years, then you should consider other options.
Escalating or Increasing Annuity
An increasing or escalating annuity will provide you with an ‘inflation-proof’ retirement income.
There are two types of escalating annuities.
- Index Linked: Your annual income will be adjusted according to a designated level of inflation which is usually based on the Consumer Price Index or the Retail Prices Index. So, if inflation rises, your income increases too. On the contrary, if inflation reduces as it happened in April 2015, your income may reduce also. But its buying power is retained no matter which way the prices go.
- Increasing Rate: Your income will increase every year at a set rate which can be selected by you at the start of the annuity term. It can be between 0.8 to 5%. The rule of thumb is that the higher the percentage by which you want the income to increase each year, the lower the starting income will be.
- Your monthly income stays inflation-proof, and its buying power does not erode with time
- Your income may increase in the later stages of retirement which may be beneficial if you anticipate healthcare costs.
- You may receive a much lower monthly income than what a fixed income annuity would provide you, especially if you choose a high annual rate of increment.
- Some annuity providers set a cap on the maximum annual increase that you can get. Ensure that you read the fine print and know what you are purchasing.
Is it the right choice for you?
If you have other income sources at this point in time, then you can opt for an increasing annuity. Despite having a lower income to start with, you will be well protected against inflation which can be beneficial in the later stages of retirement.
Most people underestimate the amount of time they may spend in retirement. On an average, you should expect to live at least 20 years in retirement. In the last decade, inflation has led to an average price increase of 3 to 4%.
Make the right choice
Ensure that you compare both options and then make an informed decision.