Do rising rates on annuities mean you should consider them as a retirement option?

Would you like a guaranteed income for life when you retire?

That might seem a strange question. Who wouldn’t want a guaranteed income in retirement?

Well annuities can provide guaranteed incomes for life. But, curiously, they fell out of favour (1).

An annuity is an insurance product in which you swap a lump sum (typically your pension savings or part of your pension savings) for a guaranteed regular income. You can usually choose to receive the income monthly, quarterly, half-yearly or annually.

This article focuses solely on defined contribution (DC) pensions, in which your retirement funds are dependent on how much you and your employer contributed and how these investments performed. With the other main type of pension, defined benefit (DB), you may never have to make a decision about buying an annuity. That’s because the trustees of the DB scheme will pay your pension directly or buy an annuity on your behalf.

The rates (income) annuities provide are linked to the yields (income) from government bonds. Annuity rates dwindled as government bond yields fell close to zero in the UK after the Global Financial Crisis of 2008. Meanwhile, pensions freedoms introduced in the UK in 2015 meant we were no longer compelled to buy annuities with our DC pension savings. Annuities consequently became an unpopular choice for retirement income.

Annuity rates have risen

Today, though, UK government bond (gilt) yields are at highs not seen so far this century (2) and annuity rates have risen as a result. A 65-year-old can now get £7,140 a year from an annuity purchased for £100,000. Around the start of 2021, a 65-year-old would only have received £4,800 a year (3).

This suggests annuities could be poised to make a return as a popular retirement income option and evidence shows this might already be happening. Annuity premiums (the amount paid into annuity products) surged by 22 percent between the final three months of 2022 and the first three months of 2023 (4).

Even so, the Financial Services Compensation Scheme (FSCS) recently revealed that only 28 percent of UK adults aged 50 or above either hold an annuity or are considering annuities (5). The FSCS believes this unpopularity is unwarranted. In a recent article, it highlighted the following potential benefits of annuities (5):

• They can provide a guaranteed income for life at what the FSCS considers to be relatively low risk.

• Annuity rates have increased significantly in recent months.

• They have a high degree of protection. Annuities from UK-regulated insurers are fully protected by the FSCS, so eligible annuity holders would be in line to receive full compensation should an annuity provider go bust.

If you are considering buying an annuity, then you will face a complex range of options. I outline some of these in this article, but you can get more informationfrom the Money Helper website. Money Helper is part of the Money and Pensions Service (MaPS), which, in turn, is sponsored by the government’s Department for Work and Pensions.

Annuity options

One option a single person might consider is a single life annuity, which would solely cover their own life and would cease upon their death. Alternatively, people who are married or in a civil partnership might well prefer a joint life annuity, which would provide an income until both of the couple died.

Unsurprisingly, a single life annuity typically offers a higher annual income than a joint life annuity for the same initial outlay. Someone choosing a joint life annuity might want to select a product in which the income falls by a certain percentage after the death of one of the couple to reflect an expectation of lower living costs.

Annuities can offer various income arrangements. A level annuity has an income that stays constant throughout the life of the product. But the income from an increasing annuity rises over time, for example, in line with inflation or by a pre-arranged percentage.

There is also an option to select an annuity for a limited period only (a fixed term annuity), after which the income ceases. This would typically offer a greater annual income than an annuity that remains in place for a product-holder’s lifetime (a lifetime annuity). Moreover, some annuities guarantee a payout to loved ones for a minimum set period (perhaps five years) should you pass away before the period ends.

There are, though, real risks with annuities. For example, the buying power of the income from a level annuity could dwindle significantly if there is high inflation.

Moreover, annuity incomes aren’t usually passed on to inheritors on the death of the annuity holder. So the risk exists that if an annuity holder was to die shortly after swapping their pensions savings for a regular income, none of those pension savings would go to loved ones unless some form of guarantee or protection was in place. This suggests an annuity may not always be a good option for you if you want to leave your pension assets or part of your pension assets as a legacy.

Benefits of shopping around

According to the Institute for Fiscal Studies (IFS), only 20 percent of retirees own annuities. Of these annuity holders, 70 percent bought their annuity from their pension savings provider and the remaining 30 percent used an alternative provider (6). This is concerning: a 2019 report from Which? (owned by not-for-profit organisation the Consumers’ Association) revealed that people who shop around for annuities can often obtain better rates than those offered by their pension savings provider.

The Money Helper website has an online calculator that shows the income you might receive from an annuity, based on your particular circumstances and requirements. It also shows how declaring any relevant health conditions could potentially lead to better (i.e. higher) annuity rates.

One key thing to note is some older pension savings policies offer very attractive built-in high guaranteed annuity rates. So you may want to check the details of your pension policy or policies very carefully before considering alternative arrangements for retirement income.

Whether you should buy an annuity for retirement income, and how it might dovetail into your overall financial planning needs, is a complex matter. You may, for example, prefer a hybrid or blended approach, in which a proportion of your pension savings goes into an annuity and the rest is invested elsewhere.

The FSCS recommends seeking financial advice on annuities. At Schroders Personal Wealth, one of our principles is to have regular reviews with advisers. This can help you deal with complex retirement issues and help ensure you’re on track to achieve your financial goals.

Sources:

(1) FCA, Retirement income market data: 2018/19 (25 September 2019); 2019/20 (29 September 2020); 2020/21 (9 December 2021).

(2) Financial Times (www.ft.com), ‘UK sells £4bn of debt at highest 2-year borrowing cost this century’, 5 July 2023.

(3) sharingpensions.co.uk, ‘Annuity Rates Chart’, 2 June 2023. Figures are for a fund of £100,000, for a male aged 65, with a single life, level annuity and no guaranteed period.

(4) Association of British Insurers (ABI; www.abi.org.uk), ‘Annuity sales surge after turbulent 2022’, 28 May 2023.

(5) Financial Services Compensation Scheme (www.fscs.org.uk), ‘Around 19 million people aged 50+ in the UK are not considering annuities, which provide a guaranteed regular retirement income’, June 2023.

(6) Institute for Fiscal Studies (IFS; ifs.org.uk), ‘How important are defined contribution pensions for financing retirement?’, 30 June 2023.