Now might be a good time buy an annuity for those savers looking for the safety of some guaranteed income in retirement – as annuity rates look set to fall.

After the Bank of England cut the benchmark interest rate on 1 August, bets have snowballed that global central banks will have to slash rates as jobs market and recession fears in the US have suddenly mounted.

Henrietta Grimston, Financial Planning Director at wealth management firm Evelyn Partners,observes: ‘That is sending global bond yields down and the UK’s 15-year gilt yield – regarded as a major determinant of the annuity rates that insurers set – fell as low as 4.07 per cent this week, having been as high as 4.67 per cent as recently as June.

‘That is likely to hit annuity rates in the short to medium term after the incomes on offer to retirees had risen strongly in 2023 and remained high in 2024.’

At the start of 2022, just £4,540 a year lifetime income was on offer for someone aged 65, with no health or lifestyle conditions to declare, with £100,000 to buy annuity – but incomes steadily improved through 2022 and 2023, as interest rates rose. [1]

The average annuity rate for a healthy 65-year-old with £100,000 was 7.08 per cent in June, up from 6.81 per cent in January 2024 – meaning a lifetime income of about £7,080 would be on offer.[2] The best rates could be higher, with one source estimating that a 65-year-old paying £100,000 for a single-life, level annuity with no guarantees could receive an income of £7,263.[3]

Ms Grimston adds: ‘Annuities made something of a comeback in 2023 as rates marched higher alongside the UK base rate from early 2022, helping to bring this option for those accessing their pension slowly back in from the cold. Annuities fell out of favour after pension freedoms were introduced in 2015, particularly as rock-bottom interest rates and gilt yields had made the products poor value because of the low incomes on offer.’

Annuity sales were 46 per cent higher in 2023 than 2022, according to the Association of British Insurers, with a total sales value of £5.2billion – the highest since 2014 when pension freedoms were announced.[4] However, for the financial year 2022/23 the FCA has reported that sales of annuities decreased 13.6 per cent from 68,514 in 2021/22 to 59,163.[5]

As for now, Ms Grimston notes: ‘As Bank of England rate cuts were delayed, because of persistent inflation and wage growth, annuity rates have held up better than expected this year but with the rate cut and the bond market turmoil we have seen since Friday, they will probably fall, and those considering an annuity might want to act fairly swiftly.

‘But those who decide to buy an annuity still have a number of questions to address around what sort of product they want – for instance, whether to seek protection again inflation, which will eat into a fixed income over time. Opting for an income that increases annually to compensate for inflation will substantially reduce the starting income available at the same purchase price.’

Annuities explained

Ms Grimston says: ‘When you purchase an annuity you exchange some of your pension fund, after releasing your tax-free cash lump sum, for an insurance product that guarantees an income for the rest of your life. So whether you end up getting value of the product will depend in large part on how long you live for, something none of us can say for sure.

‘At the best income mentioned above of £7,263, you would have to live for nearly fourteen years to break even on the product, which for a 65-year-old these days is well within average life expectancy at that age of 18 to 20 years. If you lived for 20 years you would receive £145,260 from the £100,000 annuity – but that sum would be diminished in real terms by inflation.

‘Basic, level annuities pay the highest incomes but that do not include any benefits or inflation protection.

‘For a start, the annuity would end on your death, which is a chance many savers are unwilling to take, particularly when funds left in a defined contribution pension pot can not only be passed on but are also exempt from inheritance tax.’

To alleviate this jeopardy, protections can be added to an annuity. In principal they will make it more expensive – or reduce the income on offer for the same purchase value, but some protections are less costly than others to build in:

·       Guaranteed period: You can select the period that the annuity must be paid for even if you don’t survive this period – but the longer the guaranteed period the lower the annuity rate available.

·       Value protection: The annuity provider will guarantee to pay back a percentage of the fund used to purchase the annuity, less any income paid to the retiree during their lifetime.

·       Spouse / partner protection: For those who have a financial dependent, it is possible to include a spouse / partner option, and this will ensure that any surviving spouse will continue to receive an annuity should you pre-decease them.

The inflation issue

Ms Grimston says: ‘The above annuity rates assume that the income remains level in payment throughout the period of payment and future inflation would reduce the ‘real’ purchasing power of this income. For those with funds in drawdown, they will hope that investment gains will more than compensate for the effects of inflation, and even the state pension is currently well protected from the rising cost of living by the triple lock.

‘But if you buy an annuity then you must pay for an escalation option to try and protect it from inflation.

‘You can choose a percentage rate at which the income increases – or escalates – each year, with a higher rate obviously being more expensive, but it will reduce the initial income you receive for the same sum. You can alternatively link the product to the official inflation rate and how much that reduces the initial income will depend on the outlook for inflation.

‘The decision of whether or not to include an escalation option is a difficult one for those who are approaching retirement, as often the level option will seem to offer more value due to the higher initial income offered. If you have a low life expectancy or you are in ill-health, then including an escalation option might not be optimum – and in any case a saver in poor health might be entitled to an “enhanced” annuity with a higher rate.

‘‘The issue with purchasing an annuity for life is that you need to set the options from the outset and these can’t be altered part way through.’

Why might you opt for an annuity?

Ms Grimston says: ‘This inflexibility of annuities together with the idea of handing over a big lump sum for an income that can seem unattractive when protections and guarantees are added, means the majority of pension savers have abandoned annuities since 2015.

‘However, some savers do value having a guaranteed income over and above the state pension, and it is important to remember that just a portion of a pension pot can be used to buy an annuity with the rest kept invested in drawdown.

‘Finally, remember that pension annuity income, just like drawdown income, is taxable and must be added to the state pension and any other income for the purposes of income tax liability.’

‘Evaluating when and if an annuity might be a good idea is where advice from a good financial planner can prove invaluable. They can help you to get the most out of your pension savings, whether that is putting the whole pot in drawdown – and helping you to manage those investments – or using some of it to buy an annuity.

‘Advice can also be beneficial in choosing the annuity itself as there is a myriad of confusing options available.’

Ms Grimston suggests a few factors to consider when deciding whether an annuity is for you.

1. How much do you value the security of a guaranteed income?

Some savers opt for an annuity because they don’t like the risk and effort involved in managing an invested drawdown pot, and put a higher value on the certainty and security of a guaranteed income.

Ms Grimston says: ‘Someone who is less confident about managing a drawdown pot might devote a larger portion of their pot – or even all of it (minus the TFLS) – to an annuity. But even some confident investors have reconsidered annuities at the improved rates of the last couple of years.

‘They might for instance use an annuity to add to the state pension in order to provide a desired guaranteed annual income level, which they are then happy to supplement with drawdown income, or savings in ISAs for instance.’

2. There could be a ‘good age’ to buy one.

One strategy is to ‘flex first and fix later’.

Ms Grimston says: ‘The disadvantage of purchasing an annuity early in the retirement phase is that a chunk is taken out of a pension pot that could go on to earn investment returns. Moreover, as a retiree gets older, they may be less inclined to manage the complexities and risks of drawdown and will give more value to the security of a guaranteed income.

‘With this in mind, the plan could be to take an income from drawdown until a certain age (which will vary widely according to individual circumstances), at which point the pot is liquidated for an annuity.’

3. A ‘surrogate state pension’?

‘Yet another option for those who have built up larger pots with a view to retiring early is to buy an annuity to furnish a guaranteed income until the state pension arrives. Someone at age 57 could use part of their pot to buy a 10-year fixed term annuity to provide a guaranteed income to take them up to state pension age.’

4. An annuity does not trigger the money purchase annual allowance.

‘Just like the 25% tax free lump sum, purchasing a lifetime annuity does not trigger the money purchase annual allowance. This means that you can continue to contribute the annual allowance of £60,000 to a pension and benefit from tax relief – rather than have to submit to the £10,000 MPAA.’

5. Passing on of wealth.

‘It should be noted that funds held in a defined contribution pension pot currently benefit from being exempt from inheritance tax. This for some savers means that it might be preferable to keep the pot in drawdown rather than using a lump sum to buy an annuity.’

 

 

 

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