Which is a better value: a level annuity or one linked to inflation?

Is a level annuity or one that is linked to inflation a better option for a retirement plan?

There are concerns about whether purchasing an inflation-linked annuity is still worthwhile given the low inflation rate at the moment, which is only slightly higher than the Bank of England's 2 percent target.

The most recent inflation rate for the UK in the 12 months ending in March 2025 was 2 points 6 percent. This represented a significant decrease from the double-digit inflation observed during the peak of the cost-of-living crisis, as well as a decrease from the 2 percent figure recorded in February.

Annuity rates have been rising at the same time. According to the Standard Life Annuity Rates Tracker, average annuity rates have risen by about 8% since January 2024, or 11,020 more for men and 12,960 for women.

Hargreaves Lansdown claims that a single-life level annuity with a five-year guarantee (as of May 1, 2025) can provide an annual income of up to 7,881 for a 65-year-old with a £100,000 pension pot. Throughout your lifetime, this sum remains constant.

Retirees may choose to purchase an inflation-linked annuity, which rises annually and is sometimes referred to as an escalating or index-linked annuity. Compared to a level annuity, the starting value is lower, but the amount rises over time.

With a five-year guarantee and a 3 percent annual growth rate, the same 65-year-old can start with up to £5,785 annually in an inflation-linked annuity. The income that someone with a level annuity would receive is more than 2,000 times higher than this.

Are inflation-linked annuities worth taking out? We do the math to determine how long it would take for the income to equal that of a level annuity and how many years it would take you to receive the same total amount. What circumstances call for the consideration of an inflation-linked annuity?

Which is preferable, level annuity or inflation-linked annuity?

The most common kind of annuities are level annuities, which provide a constant lifetime income. This type of annuity accounted for 81% of all annuities sold in 2024, according to the Association of British Insurers (ABI).

Escalating annuities, which offer an annual income increase, accounted for the remaining 19 percent. Pensioners' continued concerns about the significant increase in the cost of living may have contributed to the one percentage point increase in the proportion of escalating annuities sold compared to 2023 and an eight percentage point increase since 2015.

Although it gradually decreased, inflation stayed above 5 percent until September 2023, when it was at 10 percent in January 2023. However, inflation is now approaching the Bank of England's 2 percent target. Annuities linked to inflation may become less popular as a result of this.

The Consumer Prices Index, which measures inflation, is predicted by the Office for Budget Responsibility (OBR) to average 2 percent in 2025. After that, it ought to fall to 2 percent in 2026, 2 percent in 2027, 2 percent in 2028, and 2 percent in 2029.

The head of retirement analysis at Hargreaves Lansdown, Helen Morrissey, warns against disregarding these retirement products, though, and suggests they might still be worthwhile.

"Even though inflation has been subdued, it should still be a major consideration when planning your retirement income," she says.

"Your purchasing power can be eroded over the course of 20 years or longer of retirement, even in the most benign inflationary conditions. As we have recently witnessed, a period of double-digit inflation can severely disrupt your plans, so it is wise to be ready.

Gary Smith, a financial planning partner at Evelyn Partners, a wealth management firm, notes that "the ability to buy the same level of goods would reduce substantially" if you were to live for another 25 years with a fixed annuity income of, say, 7,000 annually.

He goes on to say: "For instance, by the end of 2023, the average price of a pint of milk had nearly doubled to 67p, from 34p in 1999.

What kinds of annuities are linked to inflation?

Escalating annuities come in a variety of forms. Some increase by a set amount, while others rise in tandem with inflation.

Smith offers the following list, which retirees might find useful.

There are annuities that increase at two to five percent annually, three percent annually, five percent annually, and in accordance with the annual change of the Retail Prices Index (RPI), a measure of inflation. In the event of a decline in inflation, the annuity would stay constant during that year. a predetermined rate that you decide upon initially.

Do annuities linked to inflation offer good value?

The duration required for an escalating annuity to provide the same income as a level annuity will be examined.

If a 65-year-old has a £100,000 pension fund, they can receive up to £7,881 annually with a five-year guarantee and a level annuity. A five-year guarantee is currently offered by an RPI-linked annuity, which can yield up to £5,345 annually. According to Hargreaves Lansdown, one that increases by 3% annually will put you at 5,785 at the beginning.

Morrissey remarks: "Despite the fact that both escalating annuities are significantly less than a level annuity, you will value any inflation link more the longer you live.

When the escalating one rises at a rate of 3 percent annually, it will take about 10 years to catch up to the level annuity.

In other words, it would take you until you were 77 years old to gain the same income. Additionally, you would have to wait about 20 years to receive the same total income (approx. 150,000) that you would have extracted from the level product," Morrissey says.

In the event that you chose the RPI-linked product and it increased by 5% annually, it would take eight years to recover your losses and approximately seventeen years before you could draw the same total income as you could have from the level product.

You would obviously catch up more quickly if RPI inflation were higher, but it might take longer if inflation is lower. Morrissey advises, "To make the best choice for yourself, you must carefully consider how long you are likely to live."

Source: Lansdown, Hargreaves. standard annuity for a 65-year-old single life.

Is an inflation-linked annuity the best option for you?

This depends on several factors. For instance, an escalating annuity might not be a good choice if you are in poor health or have a short life expectancy, as you might not live to see the increases catch up to a level annuity.

Additionally, a number of retirees continue to receive inflation-adjusted pensions from their previous employers, and their state pensions also increase annually through the "triple lock" benefit". Because they won't be as affected by future cost increases, buying the level annuity may be more appealing to these people, according to Smith.

An escalating annuity, however, might be something to think about for people who don't profit from other incomes that increase in line with inflation.

"Those in good health may benefit from an increasing annuity," Smith says, citing the Office for National Statistics' projections that a male's life expectancy at age 65 could be 18 points three years and a female's 20 points eight years.

Whether you choose to purchase an inflation-linked annuity or not, there are a few key considerations when converting your pension fund into an annuity income.

First, purchasing an annuity is not necessary. Instead, you could do drawdown or a combination of drawdown and annuity.

Moreover, there is no age requirement for purchasing an annuity. As long as you are 55 years of age or older, you are free to do it whenever you choose.

Suddenly converting your entire pension into an annuity is not necessary. At age 60, for example, you might want to purchase an annuity with a portion of your pension and then later in retirement, you might want to convert additional pension funds into an annuity.

Lastly, don't settle for the rate your pension provider offers you; instead, compare rates to find the best annuity rates.