The chart below compares the future payments from a level annuity compared
to an annuity increasing at 3% compound per annum.
The point at which payments from the escalating annuity overtake the level
annuity is after 14 years. Thereafter the payments from the escalating annuity
exceed the payments from the level annuity. However as we will see below
this example is too simplistic.
Cumulative Payments
The above example is too simplistic because it takes no account of inflation.
A better way of comparing the returns from a level annuity and an escalating
annuity is to take account of the cumulative payments adjusted for inflation.
The advantage of this is that it shows the running total of real (inflation
adjusted) income received as time goes by.
The chart above shows that the cumulative payments from the escalating
annuity overtakes the total pay out from the level annuity after 30 years.
By this time the man and women, if they were still alive would be 90 years
old.
Inflation linked annuities
The chart below shows a comparison of an index linked annuity and a level
annuity. Assuming inflation at 3%, the break even point is not reached until
after 33 years
However if inflation was 1% higher at 4% per annum, the break even point is brought forward by nearly 10 years
Conclusions
Although at first sight escalating annuities may appear to offer poor value
compared to level annuities, this is not always the case and many cases
it will be sensible and prudent to have escalation.
Individuals tend to focus on short term cash flow and forget that an annuity
may be paid out for several decades and this leaves them vulnerable in the
future if inflation is higher than expected. When preparing the figures
for this page I was surprised that if inflation was 1% higher than projected
(e.g. 4% p.a. rather than 3% p.a. this would have the effect of bringing
the break even point forward by nearly 10 years. The message is don't under
estimate inflation.
For those who are concerned about inflation, but don't like the idea of
escalating annuities there are a number of strategies:
- Consider have some level and some increasing annuities
- Consider a with profit annuity for some of your
annuities