Would you swap £250,000 for £20,000 a year for life?

Annuities were once one of the least fashionable areas of retirement planning. For years, low interest rates meant the income available from an annuity appeared unattractive when compared with keeping a pension invested and drawing money from it gradually. Pension freedoms introduced in 2015 accelerated that trend. Retirees gained far greater control over their pension savings, and many understandably preferred flexibility rather than handing a large pension fund to an insurance company in return for a fixed income.

But the world has changed.

Higher interest rates and gilt yields have dramatically improved annuity rates, and suddenly a product many investors had written off deserves another look. Imagine, for example, that someone aged in their mid-60s could exchange £250,000 of pension savings for an income approaching £20,000 a year for the rest of their life.

Would you do it?

There is no universally correct answer. But it is a much more interesting question than it was several years ago.

What exactly is an annuity?

At its simplest, an annuity converts a pension fund into guaranteed income.You give an insurance company a lump sum and, in return, it promises to pay an agreed level of income for life.

The key attraction is contained in those final two words. For life.

Whether you live for another five years or another thirty, the income continues according to the terms selected at outset. That removes one of the most difficult questions in retirement planning: How long does my money need to last?

Why annuity rates have improved

Annuity pricing is heavily influenced by long-term interest rates and government bond yields. When yields were exceptionally low, insurers could generate relatively little income from the assets backing annuity promises. As yields increased, the amount insurers could afford to pay new annuity customers also rose. Age, health, lifestyle and the precise options selected will all affect the actual rate available, but the broad improvement has been significant enough to put annuities firmly back into retirement conversations.

Why guaranteed income for life has real psychological value

Retirement planning is not simply a mathematical exercise. Two retirees with identical wealth may feel completely differently about money. One may be perfectly comfortable owning an investment portfolio that rises and falls, knowing they have sufficient assets to withstand market volatility. Another may find every market decline deeply unsettling. A guaranteed income can therefore have considerable psychological value. Knowing that essential expenditure such as household bills, food and everyday living costs will be covered regardless of what financial markets are doing can make retirement much more comfortable.

State Pension income may provide the first layer of that security. An annuity can potentially provide another.

Annuity vs drawdown: what you give up when you buy an annuity

The principal disadvantage is equally important. Once an annuity is purchased, the decision is generally irreversible. The capital used to buy it is no longer sitting in your pension waiting to be withdrawn or invested. That matters if circumstances change. A drawdown pension offers flexibility. You can potentially change withdrawals, alter investments or leave remaining pension assets to beneficiaries. An annuity trades much of that flexibility for certainty. The choice is therefore not simply about which option might produce the highest theoretical financial return. 

It is a question of what you value more: certainty or flexibility.

Do annuities keep up with inflation? Level vs escalating income

A headline annuity rate can sometimes look extremely attractive because it relates to a level annuity. That means the income remains unchanged throughout retirement. £20,000 may feel substantial today. Twenty years of inflation could significantly reduce what that £20,000 buys.

Inflation-linked or escalating annuities are available, but they usually begin with a lower level of income. This makes comparisons particularly important. Someone comparing annuities should understand exactly what protection is included and whether income continues to a spouse or partner after death.

What is a partial annuity? Why the answer could be some, not all

Perhaps one of the most interesting uses of annuities today is partial annuitisation. Retirement planning does not need to involve choosing between putting an entire pension into an annuity or leaving all of it invested. A retiree might use part of a pension fund to secure enough guaranteed income to meet essential expenditure while leaving the remainder invested. Imagine someone requires £35,000 a year for their core retirement lifestyle. Their State Pension and other secure income might provide £15,000. They could potentially purchase sufficient annuity income to cover part or all of the remaining £20,000. The rest of their pension and investments remain available for holidays, gifts, unexpected expenditure and longer-term growth.

For some people, that combination may offer the best features of both approaches.

How longevity risk changes the annuity calculation

Annuities also protect what financial planners call longevity risk. Living a long and healthy retirement is obviously desirable. Financially, however, it means supporting perhaps thirty or even forty years without employment income. An individual attempting to fund that entirely from invested assets must decide how much can safely be withdrawn each year. An annuity transfers that longevity risk to an insurer.

For someone who lives considerably longer than average, that guarantee can become extremely valuable.

So, would you exchange £250,000 for £20,000 a year?

The answer depends on far more than the headline percentage. Your existing guaranteed income matters. Your health matters. Whether you want to leave money to children matters. Your attitude towards investment risk matters. Your wider assets, tax position and expenditure all matter. That is precisely why annuities should normally be considered as part of a broader retirement plan rather than purchased simply because the advertised rate looks attractive.

For years, the financial industry increasingly viewed annuities as yesterday’s retirement product. That may have been premature. At today’s significantly improved rates, they certainly deserve another conversation.