If there were to be a substantial rise in inflation, the real value of retirement benefits could be severely eroded. The question is; can DC members afford to ignore inflation? And is there anything they can do to protect themselves?….
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Mark Humphreys, Head of UK Strategic Solutions
Introduction
Around 95% of individuals are forgoing inflation protection for their retirement income by opting for fixed rather than inflation-linked annuities . This leaves them open to inflation risk. If there were to be a substantial rise in inflation, the real value of their retirement benefits could be severely eroded. The question is; can DC members afford to ignore inflation? And is there anything they can do to protect themselves?
We conclude that:
Pensioners should not ignore the possibility of inflation rising significantly in the coming years.
A rise in inflation would erode the real value of a fixed rate annuity, as living costs would rise, while nominal annuity income would remain the same.
Behavioural biases may underlie the widespread selection of fixed over inflation-linked annuities by DC members upon retirement. However, inflation-linked annuities also seem to be expensive relative to fixed annuities.
In our modelling, the ‘payback period’ of inflation-linked annuities exceeded the expected lifespan of our example member unless inflation was between 5% and 6% (significantly higher than market estimates of breakeven inflation of 3.46% over the same period).
The solution to the problem is therefore not as simple as persuading members to purchase inflation-protected annuities.
Delaying annuitisation for as long as possible, or avoiding it entirely and investing instead in an inflation-linked income fund (with some degree of principal protection to ensure its suitability for low risk investors) both appear to be appealing alternatives. However, there are various issues associated with these solutions.
Delaying annuitisation reduces the length of time for which members are fully unprotected from inflation risk and could provide optionality benefits by allowing them to wait for rates to improve before making their purchase (however there is of course no guarantee that annuity rates will not worsen!).
With regards to avoiding annuitisation entirely, the minimum requirements for guaranteed annual income (currently £20,000) mean that only a small proportion of DC members are eligible for the flexible drawdowns they would need to allow them to invest a sufficient amount in an income fund. Many pensioners are therefore left with no alternative but to annuitise at unfavourable rates, and without adequate inflation protection.
The absence of a feasible solution to the problem highlights the need for regulatory change in the DC space (in particular a relaxation of the minimum income requirement rules) and for the development of new funds with suitable characteristics to provide DC members with a retirement income (i.e. high income, inflation-linked, principal protection).
Source: Schroders
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