LPI annuities offer poor value

13 Oct 2003 | 01:00
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purchasers of an index-linked annuity would have to live to 114 to equal level annuity benefits

Index-linked annuities continue to offer poor value for money, according to research from Standard Life.

In the current low inflation environment, the group found, a 60-year-old male purchaser would need to live to the age of 114 to receive benefits from an index-linked annuity equivalent to those from a level annuity product.

While at the moment it is compulsory for all pension savers to buy an annuity before age 75, depending on the type of pension, it may also be compulsory to carry inflation proofing.

Protected rights, the fund built up from contracting out of Serps and/or the State Second Pension, and pensions saved through occupational money purchase pension schemes must carry limited price indexation (LPI).

John Lawson, senior technical manager, said although having LPI attached to a defined benefit scheme provides valuable protection, the average person does not get good value for money from LPI in any other form.

Lawson gave the example of a man who has just retired, aged 60, with a total pension fund of £30,000. This was accumulated via a contracted-in money purchase scheme paid into for the previous five years and a contracted-out personal pension he had saved into previously.

Investing in a Standard Life LPI-linked annuity would yield an initial annual income of £1,022.40, paid monthly in advance. Such an annuity would protect him against rising inflation, up to a maximum of 5% per year.

"However, had he been allowed to buy a level, non inflation proof annuity on a similar basis, his fixed annual income would have been £1,836," Lawson said.

Based on inflation being 5%, the man would need to live until the age of 88 to get good value from the LPI-linked annuity.

The average 60-year-old man now lives to the age of 79, according to the Office for National Statistics. Therefore, even if inflation is 5%, the average man will die before achieving the same value from an index-linked annuity as from a level annuity.

The Bank of England's (BOE) central inflation target rate is only 2.5%, which means LPI annuities are an even poorer deal.

"The break-even age for an LPI annuity within a 2.5% inflationary environment is 114," Lawson said. "Assuming the BOE continues to steer a steady course, our man needs to start breaking world records to get good value for money."

One of the reasons LPI annuity rates offer poor value is that people are paying for inflation proofing to 5% - double the BOE's projected rate. LPI annuities also need to be supported by assets that increase with inflation, and only index-linked gilts do this.

The supply of these gilts is limited, yet demand is being artificially driven higher as more people retire with pensions linked to LPI. In other words, demand is exceeding supply. Where annuity purchasers can choose between LPI and level annuities, the former are unpopular, accounting for just 1%-2% of sales. IFAs generally steer their clients away from these on the open market, acknowledging they represent poor value, Lawson said.

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