Is it worth taking out an inflation-linked annuity - or is a level annuity better value?

With inflation hitting 2%, the lowest in almost three years, does it make sense to buy an inflation-linked annuity in retirement?

Older couple looking at paperwork and laptop
Level annuities pay a higher starting income than inflation-linked annuities, but the latter could prove better value for money over the long term
(Image credit: Getty Images)

Inflation has been falling this year, raising questions over whether buying an inflation-linked annuity is worth it anymore.

UK inflation slowed to 2% in the 12 months to May, down from 2.3% in April, hitting the lowest level in almost three years.

At the same time, annuity rates have been on the up, buoyed by rising interest rates

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Annuity rates increased 6.5% over the 12 months to April 2024.

Currently, a 65-year-old with a £100,000 pension pot can get up to £7,222 a year from a single-life level annuity with a five-year guarantee, according to Hargreaves Lansdown.

This amount stays the same for the rest of your life.

However, retirees can opt for an inflation-linked annuity, also known as escalating or index-linked, which increases each year. The trade-off is a lower starting value than a level annuity, but over time the amount increases.

For an inflation-linked annuity rising at 3%, the same 65-year-old can get up to £5,157 per year as their starting amount.

This is more than £2,000 lower than the income someone with a level annuity would receive.

So, is it worth taking out an inflation-linked annuity? We crunch the numbers to work out how long it would take for the income to catch up with a level annuity, and the number of years before you had received the same overall amount. 

Plus, in what situations should you consider an inflation-linked annuity?

Inflation-linked versus level annuities

Level annuities, which pay out the same amount of income for life, are the most popular type of annuities.

According to the Association of British Insurers, 82% of all annuities sold last year were this type.

The remaining 18% were escalating annuities, which provide an income that increases every year. The proportion of escalating annuities sold increased by two percentage points compared to 2022, possibly due to pensioners being concerned about the big rise in the cost of living.

In January last year, inflation was at 10.1%, and while it gradually dropped, it remained above 5% until September.

But inflation is now back at the Bank of England’s 2% target. This could mean inflation-linked annuities fall out of favour.

However, Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, cautions against forgetting about these retirement products and says they may still be worth considering. 

“The inflation beast may have been tamed but that doesn’t mean it shouldn’t be a key factor in your retirement income planning. 

“You could be retired for 20 years or more and even the most benign of inflationary environments can nibble away at your purchasing power over that time. A period of double-digit inflation as we have seen recently can bite huge chunks out of your plans, so it pays to be prepared.”

Gary Smith, partner in financial planning at wealth management firm Evelyn Partners, points out that if you have a fixed annuity income of say £7,000 a year, and you live for a further 25 years, “the ability to buy the same level of goods would reduce substantially”.

He adds: “As an example, the average cost of a pint of milk in 1999 was 34.2p and this had almost doubled to 67.2p by the end of 2023.”

Different types of inflation-linked annuities  

There are different types of escalating annuities. Some rise with inflation, others by a fixed amount. 

Smith gives the following list that retirees may be able to choose from:

  • An annuity that increases at 2.5% per year 
  • An annuity that increases at 3% per year
  • An annuity that increases at 5% per year
  • An annuity that increases in line with the annual change of the Retail Prices Index (RPI) measure of inflation. In the event that inflation were to fall, the annuity would remain level in that year and wouldn’t decrease.
  • A specified rate that you select at outset

Are inflation-linked annuities good value?

Let’s look at how long it would take an escalating annuity to pay the same income as a level annuity.

A 65-year-old with a £100,000 pension pot can get up to £7,222 a year with a level annuity. In contrast, an RPI-linked annuity is currently delivering up to £4,540 per year. One that rises by 3% per year will start you off at up to £5,157, according to Hargreaves Lansdown. 

Morrissey comments: “[The escalating annuities] are both far lower than you would get with a level annuity, but the longer you live, the more you’ll value any kind of inflation link.”

It will take 12 years for the escalating one rising at 3% per year to catch up with the level annuity. 

“So, in other words, you would be 77 before you got the same income. It would also take around 21 years before you had taken the same overall amount of income (approx. £144,000) that you would have taken from the level product,” explains Morrissey.

If you opted for the RPI-linked product and it rose at 5% per year, then it would take 10 years to make up lost ground and around 20 years before you would have caught up in drawing the same amount of income overall as you would have got from the level product. 

“Of course, if RPI inflation were higher you would make up ground more quickly, but lower inflation means it could take you longer. You need to think carefully about how long you are likely to live to come to the best decision for you,” says Morrissey.

Swipe to scroll horizontally
Header Cell - Column 0 Starting incomeApprox income taken after 20 years
Level, single life, five-year guarantee£7,222£144,400
Escalating at 3% pa, five-year guarantee, single life£5,157£138,400
RPI at 5% pa, five-year guarantee, single life£4,540£150,000

Source: Hargreaves Lansdown

Should you choose an inflation-linked annuity?

This comes down to a number of factors. For example, if you have a low life expectancy or you are in ill health, then an escalating annuity may not be a good idea, as you might not survive until the point where the increases catch up with a level annuity.

“Furthermore, some retirees still benefit from old employer defined benefit pensions that include inflationary increases, and their state pensions also increase each year via the “triple lock” benefit. For these individuals, purchasing the level annuity might prove to be more attractive as they will be less impacted by rising costs in the future,” notes Smith.

However, for those who don’t benefit from other incomes that rise with inflation, an escalating annuity could be worth considering. 

“The Office for National Statistics project that life expectancy at age 65 for a male could be 18.3 years and, for a female this increases to 20.8 years, so an escalating annuity could be beneficial for people in good health,” says Smith.

Regardless of whether you buy an inflation-linked annuity or not, there are a few important points to remember when turning your pension pot into an annuity income.

First, you don’t need to buy an annuity (you could do drawdown instead, or you could do a mix of annuity and drawdown). And you don’t need to buy an annuity at a certain age. You can do it whenever you like, as long as you’re 55 or over. 

You don’t need to turn your entire pension into an annuity all at once. You may like to buy an annuity with part of your pension at, say, age 60, and then convert some more of your pension savings into an annuity later in retirement. 

Finally, make sure you shop around for the best annuity rates and don’t just accept the rate that your pension provider offers you.

We have more tips and guidance in this article about buying an annuity.

Ruth Emery
Contributing editor

Ruth is an award-winning financial journalist with more than 15 years' experience of working on national newspapers, websites and specialist magazines.

She is passionate about helping people feel more confident about their finances. She was previously editor of Times Money Mentor, and prior to that was deputy Money editor at The Sunday Times. 

A multi-award winning journalist, Ruth started her career on a pensions magazine at the FT Group, and has also worked at Money Observer and Money Advice Service. 

Outside of work, she is a mum to two young children, while also serving as a magistrate and an NHS volunteer.