Exploring Annuities

Annuities were once the cornerstone of retirement planning. For anyone with a Defined Contribution pension (a pension that builds up an investment value), the usual approach at retirement was to take the 25% tax-free amount and use the remaining pension to purchase an annuity.

In recent years, annuities have fallen out of favour. However, as interest rates and annuity rates rise again, they are once more becoming an option worth considering.

What Is an Annuity?

An annuity is a product designed to provide you with a guaranteed income for life. You give some or all of your pension savings (after taking any tax-free cash) to an insurance company, and in return, they promise to pay you an income for the rest of your life.

You can tailor an annuity to your needs by including certain options, such as:

-            Inflation protection: so that your income increases each year to help keep pace with rising costs.

-            A spouse’s or partner’s pension: ensuring your income continues, wholly or partly, to your spouse or civil partner if you die first.

-            A guaranteed payment period or value: which ensures the annuity will pay out for a set number of years or a set total amount, even if you die sooner.

-            Shorter Time period: Whilst most are paid for your lifetime, there are some short-term annuities which may payout for a certain time frame such as 5 years.

These features can make an annuity more flexible and provide peace of mind, though they may reduce the initial level of income you receive.

What Happened to Annuities?

Annuities started to lose their appeal for two main reasons.

1. The Introduction of Drawdown

Pension Freedoms was introduced in 2015 and as part of this, a new option for retirement planning called drawdown was formed. This allowed people approaching or in retirement to take greater control of pension savings. Rather than being required to buy an annuity, it became possible to take the tax-free cash and leave the remaining pension invested. Individuals could then decide when and how much they required from their pension and take this from their pension when required.  

2. Falling Annuity Rates

Annuity rates determine how much income you’ll receive for your pension fund, and these have fallen significantly over the past 10 years, largely due to lower interest rates. As a result, the guaranteed incomes on offer seemed poor value, and many preferred to keep their money invested instead.

What about today?

After years of being overlooked, annuities now look much more attractive. The main driver behind this renewed interest is the significant rise in annuity rates over the past couple of years.

Rising Interest Rates

Annuity rates are closely linked to long-term interest rates and government bond yields. As these have increased, so to have the incomes available from annuities. In simple terms, your pension fund can now buy a higher guaranteed income than it could a few years ago. The chart below shows how annuity rates fell after 2014 and have since risen again. 

Data provided by Sharing Pensions

Desire for Certainty

The reassurance of a guaranteed, lifelong income can be very appealing. For some, knowing that essential expenses will always be covered, regardless of what happens to investment markets, can provide peace of mind.

Key Considerations

While the appeal of a guaranteed income for life is clear, there are some important considerations to bear in mind before choosing an annuity.

The main drawback is the lack of flexibility. As retirement progresses, income needs often change. For example, some people may need a higher income in the early years to support their lifestyle before the State Pension begins, with less required later on. Because annuities provide a fixed pattern of income, they cannot be adapted to these changing circumstances.

There is also the risk of dying early. Once your pension funds have been exchanged for an annuity, the capital belongs to the insurance company. Unless you have included additional options,  such as a guaranteed payment period or a spouse’s annuity, payments will stop on your death. This means the total income received could be less than the amount originally used to buy the annuity.

Unless you choose an annuity that increases each year, the income will remain level. Over time, this means your spending power will gradually reduce as the cost-of-living increases.

It’s also important to remember that annuities are a one-off purchase, once set up, they can’t be changed. This makes it especially important to take time to explore the right structure and options before committing.

With annuity rates having improved significantly, they are once again an important part of retirement planning conversations. While an annuity may not offer the same flexibility as accessing your pension through drawdown, it can provide a valuable foundation of guaranteed income alongside other sources.

For those already in, or approaching, retirement, annuities are something we will continue to review together as part of your regular financial planning meetings, ensuring your income strategy remains balanced and aligned with your long-term goals.