IF YOU’RE dreaming of spending your retirement savings on exotic foreign holidays, you had better get planning. Four out of five pensioners will see their incomes eaten up by spending on essentials within 20 years of retirement because they chose the wrong type of annuity.

More than 80% choosing a retirement income opt for level annuities that are fixed at the outset and so give no protection against inflation. With average lifespans increasing to the point where three decades of retirement is becoming the norm, inflation is set to slash the spending power of most pensioners.

At least 42% of 65-year-olds will still be alive when they are 90, making the problem of stretching a retirement pot over 30 years increasingly common. But three decades of inflation at today’s retail price index (RPI) rate of 4.3% will cut the real value of a £1,000 annuity income to just £280.

Put another way, that is like a 90-year-old today living on a pension fixed in 1978 when Jim Callaghan was prime minister, Saturday Night Fever was top of the album charts and the average wage was £82 a week.

The problem is made worse for many pensioners because their own personal rate of inflation runs at a higher rate than RPI and the government’s preferred consumer price index (CPI), which excludes mortgage payments. This is because food and fuel bills form a greater proportion of their overall costs than other sectors of society.

Insurer Standard Life calculates someone with a pension pot of £80,000, buying a level annuity, will spend their entire monthly income, from private and state pensions, on basic living costs like food and fuel within 20 years of retirement.

Andrew Tully at Standard Life says: “If pensioner inflation remains at around 6% a year, people with a fixed income could lose as much as half of their spending power over as little as 10 years.”

Taking out an annuity that offers full RPI inflation protection is expensive, meaning you have to accept a starting income around 40% lower than you would get from a level annuity. There are, however, different ways of dealing with the growing problem of inflation.

How can I protect my pension from inflation?

The traditional way to hedge against rising prices is to opt for an annuity that goes up in line with prices. Level annuities, after falling consistently for two decades, have bounced back to their highest level since 2003 and now stand 12% higher than they were in 2006.

A 65-year-old male with a £100,000 pension pot can buy a level annuity at £7,848 a year. Buying an annuity that will increase in line with RPI will give a starting income of £4,758. Based on today’s inflation of 4.3%, that 65-year-old would have to live six years longer than his normal life expectancy of 86 to get back more than the total payouts he would have received from a 3% a year or level annuity, according to figures from adviser Hargreaves Lansdown. The 3% escalating annuity beats the level annuity at age 85.

Any other options?

Although much maligned, with-profits funds offer a way to give your annuity exposure to the stock market, with the aim of boosting your income over time. With-profits annuities link your income to the performance of the insurer’s with-profits fund. Income is usually made up of a minimum starting income at a low level which is always paid unless investment conditions are very poor, and an annual bonus related to market performance.

How well you do depends on what point in the investment cycle you join. Investors who took out with-profits annuities with Prudential in 10 of the 17 years since it started offering them have been better off than those taking conventional annuities, in some cases by more than 10%. There are seven years when investors have ended up worse off, though by no more than 5%.

Could I keep my pension invested?

Income drawdown is the riskiest retirement solution, and is only suitable for those who can afford to lose money on the stock market and still maintain a decent standard of living. Through income drawdown you can leave your entire pension fund in the stock market until the age of 75 and draw down income of up to 125% of what you could have received from an annuity.

After 75 you can still remain in shares, but your withdrawal limits are lower. “Staying invested in the stock market has proved a hedge against inflation, although you need to go in with your eyes open to the risks,” said Hargreaves Lansdown.

“A prudent way to deal with inflation and still draw an income is to opt for shares with high dividend yields of up to 4%, and then limit your withdrawals to the dividend yields if you can live off that. In that way your income can grow with the stock market, although you will have to be prepared to weather the troughs too.”

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