One of the most overlooked yet crucial decisions when purchasing an annuity is whether to include indexation. This feature can mean the difference between maintaining your standard of living throughout retirement or watching inflation gradually erode your purchasing power. Understanding indexation and choosing the right rate requires careful consideration of multiple factors that will impact your financial security for decades to come.
What is annuity indexation?
A fixed term annuity provides guaranteed income payments for a specific period – typically ranging from 5 to 30 years – rather than for life. At the end of the term, you receive a guaranteed maturity value that can be used to purchase another annuity, invest elsewhere, or spend as needed. This structure bridges the gap between the security of guaranteed income and the flexibility of keeping your options open.
Unlike lifetime annuities where your capital is permanently committed and payments cease at death, fixed term annuities return a predetermined sum at maturity, regardless of how long you live. This fundamental difference creates unique opportunities and advantages that make them suitable for various retirement planning strategies.
Types of indexation
Fixed Rate Indexation
Your payments increase by a set percentage each year, regardless of actual inflation rates. Common rates range from 1% to 5% annually.
Inflation linked indexation
Payments adjust based on changes in the Consumer Price Index, directly tracking official inflation measures. This provides the most accurate inflation protection but can result in variable increases year to year.
The Compelling Case for Adding Indexation
Purchasing power protection
The primary argument for indexation is maintaining your standard of living throughout retirement. Even modest inflation of 2-3% annually can cut your purchasing power in half over 20-25 years. For retirees potentially facing 30+ year retirements, this erosion can be devastating.
Healthcare cost inflation
Medical expenses, which typically represent a growing portion of retiree spending, have historically inflated faster than general prices. Indexation helps ensure you can afford increasing healthcare costs as you age.
Longevity protection
As life expectancy increases, retirees face longer periods during which inflation can erode their income. A 65-year-old today has a significant chance of living to 90 or beyond, making 25+ years of inflation protection crucial.
Peace of mind
Knowing your income will grow over time provides psychological comfort and allows for more confident financial planning. This peace of mind has real value in reducing retirement anxiety and improving quality of life.
The case against indexation
Significantly reduced starting income
The most substantial drawback is the immediate reduction in your initial payments. Indexation typically reduces your starting income by 20-40% compared to a level annuity. For someone needing maximum income from day one, this trade-off may be unacceptable.
Break-even timeline
It often takes 15-20 years for indexed payments to surpass the cumulative value of level payments. If you don’t live long enough to reach this break-even point, you’ll have received less total income than you would have without indexation.
Front-loading financial needs
Many retirees have higher expenses early in retirement when they’re healthier and more active. Indexation provides less money during these early years when you might need it most for travel, home improvements, or other goals.
Factors to consider when choosing indexation
Your age and health
Younger retirees and those with good health should lean toward indexation, as they’re more likely to live long enough to benefit from the growing payments. Those with health issues might prioritize higher immediate income.
Other income sources
If you have other inflation-protected income (such as State Pension), you may need less indexation from your private annuity. Conversely, if your annuity will be your primary income source, indexation becomes more critical.
Family financial history
Consider your family’s longevity and spending patterns. If your family tends to live long lives and maintain active lifestyles late into retirement, indexation becomes more valuable.
Conclusion
Indexation represents one of the most important but often overlooked decisions in annuity purchasing. The choice between immediate income and long-term purchasing power protection requires careful analysis of your personal circumstances, risk tolerance, and economic outlook.
Remember that this decision will impact your financial security for potentially 30+ years. Take time to model different scenarios, consider your family’s longevity patterns, and perhaps most importantly, think about how you’ll feel watching your purchasing power slowly erode if you choose not to include indexation.
The goal isn’t to maximise your income in year one of retirement, but to maintain your desired lifestyle throughout your entire retirement. Indexation is one of the most effective tools for achieving that objective, making it worthy of serious consideration in your annuity planning process.