Buying an annuity may once again be an appealing option for retirees, and it may be one that you can pursue even if you are already in pension drawdown. Here, Charles Calkin, financial planner at James Hambro & Partners, explains some key considerations.
For a long time, many people approaching or in retirement have barely considered swapping their savings for an annuity, but this may be changing. Annuity rates have increased substantially in the past year.
The reason for this is simple – annuity providers invest heavily in low-risk government debt, known as gilts. Providers can be more generous when gilt yields rise. At the beginning of 2022 gilt yields were a little over 1%. During the Truss/Kwarteng saga they breached 4%. Today they are still over 3%.
The result is that a 65-year-old converting £500,000 into a single-life, level annuity with a five-year guarantee can now buy themselves an annual income of around £33,000. This is nearly £5,000 a year more than they would have achieved 12 months ago – quite a difference
The result is that a 65-year-old converting £500,000 into a single-life, level annuity with a five-year guarantee can now buy themselves an annual income of around £33,000. This is nearly £5,000 a year more than they would have achieved 12 months ago – quite a difference.
An annuity is essentially an insurance product. It is usually provided by a life insurance company. You exchange a lump sum — typically your pension savings — for a guaranteed regular income for the rest of your life. Annuities have a long history, as novelist Jane Austen will attest. In 1811 Fanny Dashwood in Sense and Sensibility exclaimed: “An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it.”
That is annuities’ appeal – a degree of surety about your income. Yet in another respect there is still some uncertainty – few of us know when we will die.
This means that when you take out a lifetime annuity you are taking a bet on your life expectancy. If you live a long time afterwards you will be up on the deal. But nothing in life is guaranteed. Were you to die soon after your purchase then your loved ones might regret your decision. The annuity provider would have paid out only a small portion of your pot and banked the profits, to help meet its commitments to those who live beyond their life expectancy and reward its shareholders.
This means that when you take out a lifetime annuity you are taking a bet on your life expectancy. If you live a long time afterwards you will be up on the deal. But nothing in life is guaranteed
Historically, you had no choice but to buy an annuity with your pension savings. That influenced the way you ran your investments up to retirement. You took risk off the table as you approached the big day, because you did not want suddenly plummeting markets to undermine your savings pot just at the wrong time.
Today you have an alternative, known as “drawdown”. Here you leave your pension savings invested – perhaps with more risk than you might previously have done. You draw from them as needed and pass on to loved ones anything left when you die. With annuity rates so low for so long, drawdown became pretty much the default option. The Financial Conduct Authority estimates that fewer than 10% of plans accessed for the first time in 2020 were used for an annuity. Better rates may lift this number.
Things to consider
Even if your pension is in drawdown, you can still buy an annuity. Whatever you do, shop around. Do not take the offer made by a pension provider without testing it in the open market.
Take time to understand the different types of annuities. Do not just go for the one that pays most – you (or your loved ones) may regret it later. “Single life” annuities may offer the most attractive pay-outs, but when you die your spouse or civil partner will get nothing. A “joint life” policy delivers less while you are alive but will leave your partner with an income – perhaps two thirds of your annuity – for the rest of their life if you should die first.
Some annuities may mitigate the risk of you dying early. A five-year guarantee will mean that payouts will be at least equivalent to five years’ worth of income. With the hit on payments for this protection relatively cheap, this is worth taking into consideration.
“Single life” annuities may offer the most attractive pay-outs, but when you die your spouse or civil partner will get nothing. A “joint life” policy delivers less while you are alive but will leave your partner with an income – perhaps two thirds of your annuity – for the rest of their life if you should die first
As well as dying early, you should consider living late! And that means factoring in inflation, which can erode the real value of your pay each year surprisingly quickly. A “level annuity” pays the same sum every year. Let’s assume inflation does not come down as quickly as we hope and remains as high as it is currently. It would mean a 65-year-old buying a level annuity today could find their income halved in real terms before they have reached their mid-70s.
You can buy an annuity that rises in line with the retail price index each year or by a flat amount, such as 3%. This inflation protection costs, of course, resulting in a lower annual pay-out.
Health, wealth and looking carefully at terms
When it comes to annuities, having ill health can actually be helpful. If you can prove your life expectancy is impaired, you could get better rates. Make providers aware of health issues like high blood pressure or diabetes when you are looking for quotes. And certainly let them know if you are a smoker. Someone who gets through a packet of cigarettes each day may get substantially more each year than a typical non-smoker. (And for those tempted to ask, sadly, you cannot take up smoking temporarily a few days before buying the annuity to get the better terms. Your habit has to be ingrained!)
Finally, a word of warning on pension savings products taken out in the 1970s and 1980s, when annuity rates were somewhere between 10% and 16%. Some of these old products come with high guaranteed rates for annuity purchase. I saw one recently that was offering one of my clients level pension payments at 12% (more than twice what she might get in the market today). Some of these products also have generous promises underwriting the investment returns prior to you buying an annuity.
When it comes to annuities, having ill health can actually be helpful. If you can prove your life expectancy is impaired, you could get better rates. Make providers aware of health issues like high blood pressure or diabetes when you are looking for quotes
Look carefully at the terms, especially if you have an old policy. You might not ordinarily be tempted to take out an annuity, but guarantees like this can be so generous that it is hard to turn them down.
Generally, I am still not a big fan of annuities. Drawdown offers more attractive tax benefits on death and so much more flexibility. But I understand their appeal and why some people are considering a hybrid approach where they take out an annuity but also leave some money in drawdown. This is one of those situations where it pays to take advice.
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