One Side Effect of Inflation
Posted: Wednesday, February 02, 2011
by Matt Morris
DMP Financial
There appears to be a belief that the battle between inflation and deflation is now won, the UK is now in an inflationary cycle. The current rate of inflation is near 5% as measured by the old, but still universally accepted, measure: RPI.
Whether this is right or wrong and some still think the inflation/deflation debate is not concluded, the fact is that financial planners and their clients need to work out the effects on the client money, savings, pensions and their general plans that a sustained, possibly even growing, rate of inflation may have.
Economic history is littered with examples of the macro-economic picture changing beyond recognition in surprisingly quick time. Interest rates are 0.5% (i.e. the bank rate) at the time of writing. Where will they be in a year, two tears, three years, no-one (literally no-one) knows. But could they rise to 3%? 5%? 7%? Yes, yes and yes. They could.
This is where one side effect needs to be considered. The people who are looking to buy an annuity in today’s environment could easily be sleep-walking into an expensive mistake.
If interest rates rise then most people with savings will benefit, in the sense that the return on their money will go up. This may well be a false economy because if inflation rises quicker than the savings rate then the real rate of return will be going down but at least savers will see a nominal rise.
Most annuity purchasers however will not see any benefit, nominal or otherwise. This is because annuity buyers generally buy into fix rates at the prevailing rate.
So someone buying an annuity today is likely to be fixing their lifetime income at today’s rate. Now imagine a scenario where someone does buy an annuity today, for example at a lifetime rate of 5% per year and then interest rates start to rise quickly shortly after their purchase. This person will not see any rise in their annuity rate, it was fixed (pegged, if you like) at the rate they bought at. We know that annuity rates rise as interest rates rise; this is one of the more secure correlations in the financial world.
It is perfectly feasible in a high inflation world that interest rates could increase quickly and that annuity rates could rise in line as a consequence. Could annuity rates rise by 50% in the next 3 years? Yes, they could. They might not, but they could. If this happened the 5% annuity rate would rise but not for the person who buys today and locks in for their lifetime. They will be getting their 5% forever.
The concluding point is this: does the average annuity purchaser, of which there are currently about 40,000 every month, consider the prospect that their purchase could be highly inefficient and that they may be buying low – which in annuity terms is not good? Does this annuity purchaser know there are other options? Does this person know that they can buy into annuities which are not pegged or that there are alternatives which allow them to get an income now but defer their decision on the fixed rate until a later date? These alternatives exist and now will be a very good time for those looking to buy an annuity to start researching them.
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