Escalation v Level Annuities

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
Copyright © 2008 William Burrows

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