Pension planning: annuities back on the table

Cliff Veitch will stop working full time at the end of February, just before he turns 58 in March. The lawyer from Newcastle upon Tyne plans to live off cash savings and a small investment income until he’s 60, when he is looking at buying an annuity, a guaranteed income for life.  

He says: “I’m attracted to the certainty that an annuity offers. I’m assuming I’ll get a better deal if I wait two years before dealing with my pension and purchasing an annuity.”

But he would like to know whether annuity rates are likely to change. “Would I do better to purchase an annuity now rather than wait until I’m 60?”

Annuities are back on the table for retirement. Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, says: “After years in the doldrums, annuities have enjoyed a dramatic turnaround in fortunes over the past couple of years.”

If you’re of retirement age, you may wonder whether to nail down annuity rates now. Time may be of the essence as inflation is expected to come down, meaning today’s good rates may not be around indefinitely. But it’s a demanding question involving fine judgments about your appetite for risk and whether the stock market will deliver a better return than the annuity you can buy.

Revived by high rates

The long-standing pros of annuities are certainty, simplicity and security — a known income for life. The cons are that your family can’t inherit, and they are inflexible — you cannot reverse decisions that later turn out to be wrong or inappropriate in years to come. What has changed are the rates paid out.

At the start of 2022, insurer Canada Life’s benchmark annuity on a £100,000 purchase value paid £4,540 a year to someone aged 65 with no health or lifestyle conditions to declare. Roll the clock forward two years, that same “level” annuity (meaning it does not increase each year) with a 10-year guarantee pays £6,450 a year — a 42 per cent surge driven by rising interest rates and the returns available on gilts. 

The leap in annuity rates has fuelled demand. Big annuity brokers such as Hargreaves Lansdown, alongside insurers that sell annuities, reported record sales for 2023. Hargreaves saw a 36 per cent increase in annuity quotes. The Association of British Insurers says more money was put into annuities in the first nine months of 2023 than the whole of 2022.

Rising rates have driven more annuity hunters to change provider in search of the best deals, rather than buying from their current pension provider. For the first nine months of 2023, 69 per cent of money put into annuities was on the open market, vs 50 per cent back in 2020, the ABI said.

Nevertheless, Veitch has missed the peak annuity rates seen in the aftermath of the “mini” Budget of September 2022. In October of that year, a 65-year-old using £100,000 to buy an annuity could have found deals paying £7,586, compared with £6,781 today, according to Hargreaves Lansdown. However, that is significantly higher than the £4,626 they could get in January 2021.

Meanwhile, the bond outlook is volatile, making it difficult for people like Veitch to decide whether to buy now or wait. Annuity rate changes are closely linked to 15-year gilt yields and so when these rise you tend to see higher annuity rates, although it often takes the providers time to introduce these changes.

So timing the purchase of an annuity is very hard to judge. Tideway Wealth, a financial planner, says the 30-year payout from an age-60 annuity bought for £100,000 would have varied from £125,000 in July 2021, to £204,000 in October 2022. It then fell to £180,000 in April 2023 before reaching £199,000 in September 2023. 

What is more, there is little consensus among financial advisers over current value. Some suggest clients buy now before rates fall further, while others point out that rates have risen from an exceptionally low starting point, but are not yet hugely attractive.

Assuming gilt yields are going to normalise at around the long term trend, James Baxter, Tideway Wealth founder, believes “rates actually may improve again as 2024 progresses”.

Eventually, some think rates could trend downwards. William Burrows, director of the Annuity Project, a free educational website, says: “As inflation is tamed, I expect annuity rates to drift downwards but I don’t expect this will happen suddenly. At the moment, the yield on 15 year gilts is about 4.4 per cent, which means the effective interest rate for annuities is over 4 per cent.”

Simplicity and security

The paradox is that if annuities are such a good idea, why don’t more people buy them? We asked Financial Times readers for their views and found it’s not all about the rates.

Some who witnessed their parents ageing recognise a benefit in having simple pension arrangements that someone else (perhaps with a power of attorney) can assist you with later in life. Some have no desire to manage drawdown investments into old age. One says: “Frankly, if I ever get to 80 I think I’ll be more worried about bowel movements rather than market movements.”

Gordon Lynes, 74, has no regrets about buying an annuity. He says: “My main reason for buying a pension annuity was security for my wife (a) in potential widowhood if, as age and sex indicate likely, I predecease her; and (b) if, during our joint lifetimes, I choose drawdown and my investment decisions prove to be suboptimal.”

Some readers argue that if you believe the state pension will continue to be index-linked a level annuity will be fine alongside it. Others are comfortable in drawdown, while being acutely aware that a level annuity (the most popular type bought) does not keep pace with inflation.

FT Money reader Caroline Peters had a “serious flirtation” with annuities in autumn 2022, but has decided to stick with her drawdown plan.

She says: “I noticed during 2022 that rates were on a ramp. In the early autumn I sought quotes for about one-third of my pension pot. The rates were tantalising.

“But an annuity is only worth the bet if one lives to a ripe old age. And then an increasing annuity is the only sensible option. The increasing annuity figures didn’t look nearly so alluring as the level ones. Having purchased two small level annuities at age 60 on account of guaranteed annuity rates, I was already wishing I had gone for increasing annuities.

“I realised that I would hate to spend my final years, months or weeks kicking myself for losing a bet with my pension provider.”

Several readers rejected annuities outright because they don’t create inheritable assets. If you don’t have any stipulations in place — some death benefits can be bought as “add-ons” to an annuity — your pension funds return to your provider upon your death.

And a particular set of confident investors are eschewing annuities in favour of buying index-linked gilts of differing maturities within a self-invested pension plan (Sipp) drawdown. One reader in his 60s says: “I was finding that RPI-linked annuities would be more expensive than if I just bought a pool of various index-linked gilts of differing maturities over the next 30 years.”

What do the experts advise?

Buying at a later age can lead to better rates, particularly if you have health issues that qualify you for enhanced rates. However you miss out on income in the intervening years.

Pete Cowell, head of annuity products at Standard Life, says 65 is the average age of purchase. “There’s not a huge trend to later life annuitisation but it is creeping up.”

The optimum time to buy may be 70 to 75, says Burrows. Once you get into your 80s, it’s more difficult to get a good rate as insurers find it harder to anticipate your life expectancy.  

Meanwhile, inflation protection is a point of debate. Burrows prefers 3 per cent escalation to inflation-linked annuities, which are more expensive.

Hargreaves Lansdown says a 65-year-old with a £100,000 pension would get a starting income of £4,316 from an RPI-linked annuity compared with £6,781 from a level one. The likelihood is it would take you at least a decade before your income hit the starting amount you would get from a flat annuity, never mind the income lost in the intervening years.

So some advisers recommend avoiding escalating annuities unless you are very certain about your health and longevity. Tideway Wealth calculates only those living beyond 95 will end up with a better return from a 3 per cent escalating annuity than a level one. 

To deal with inflation, you could keep some retirement funds in reserve to buy an additional level annuity in later life, or use drawdown to supplement your annuity.

Annuitising in slices throughout your retirement is a good way of dealing with price volatility. You may also find that if your health deteriorates, you qualify for an enhanced annuity, which could give you a significantly higher income.

Many advisers favour buying the annuity to cover minimum outgoings such as rent, rates and basic foodstuffs. A basic guaranteed income can enable higher risk tolerance with your other investments and reduce anxiety, which in turn helps protect you from making poor investment decisions. 

Plus, if you are solely reliant on your drawdown pot for an income, you are subject to “sequencing risk”. This means that if your drawdown pot falls in value and you sell assets to withdraw cash as pension income, you are pulling money out of your future investment growth to meet your present needs.

For those with the means, diversification may be the answer. Anna Rogers, senior partner at Arc Pensions Law, recommends “splitting one’s pension pot between annuity now and annuity later, and also between inflation proofed and flat rate”. 

However, Ian Millward, director of Candid Financial Advice, says he would still be tempted to defer an annuity purchase. “Most investment portfolios have flattered to deceive for at least the last two or three years. You can never promise future returns, but it is fair to say that they are long overdue and the more overdue they are, the more likely they are to happen . . . Assuming annuity rates stay the same, if your starting pot jumps 10 or 20 per cent in value then that equates directly to a 10 or 20 per cent increase in income each month for the rest of your life.”

But there are no guarantees. If you wait for the perfect moment, when pension fund values are high and annuity rates are peaking, it may never happen.

Burrows says: “In the end, the best time to purchase an annuity is when you need to secure guaranteed income. Emotionally, ask yourself — when do I want more peace of mind and security with my retirement income?”