Only if inflation picks up well beyond the Bank of England’s current core projections, or an investor lives significantly beyond their current projected life expectancy, will an RPI-linked annuity prove to have been a good deal.

By contrast, the fixed-increase annuity rising at a level three per cent per annum offers investors the prospect of a better overall return.
 
Buying a level, non-increasing annuity almost guarantees a falling standard of living in retirement. If inflation runs at three per cent then after 25 years the purchasing power of a level income has fallen to less than half its original value.
 
Nigel Callaghan, pensions analyst at Hargreaves Lansdown, says, ‘Protecting your income from the ravages of inflation is as vital as ever. However, we feel that if you are going to buy an annuity then a fixed-increase annuity at three per cent is likely to be a much better deal than RPI linking.’

The Hargreaves Lansdown research points out that, despite the fact that level annuity rates have risen steadily over the past three years, RPI-linked annuity rates have actually fallen four per cent since last summer.

Callaghan suggests that level annuity rates have improved because bond yields have been rising: ‘One consequence of the credit crunch is that the market now demands a higher yield before it is prepared to invest in corporate bonds (which are largely used to back level annuities). This is down to a lack of liquidity and a lack of trust. When annuity providers invest in corporate bonds, they are able to get a better return on investors’ money, and this is being passed on in the form of higher rates.’

Fixed-increase annuities are also largely backed by level corporate bonds, even though the annuity providers are having to meet a rising liability – in the form of the increasing income.

Annuity providers manage the mismatch between the assets (level-income corporate bonds) and the liabilities (an increasing income) through interest rate swaps. This means that fixed-increase annuities have followed the level annuity rates upwards over the past three years.
 
By contrast, the supply of index-linked securities, which are used to back RPI-linked annuities, is very limited and relies largely on government-issued debt.

Demand for RPI-linked gilts is sustained by institutional investors who need to match their inflation-linked liabilities with appropriate investment assets. With the current threat of inflation looking more serious than at any time in the past ten years, the market is charging quite a premium for inflation proofing. As a consequence of this supply/demand effect, the yield on index-linked gilts and index-linked annuities has been dropping, even while the yield on conventional bonds was rising.