A new dawn for annuities?

Has the Bank of England’s steady march of interest rate hikes this year provided a new lease of life for annuities, the Cinderellas of the pension freedoms age? As of this July, it was possible for a 65-year-old with a £100,000 pension pot to buy a level income for life worth over £6,000 a year; those annuity rates are likely to rise further if interest rates continue to increase in the coming months.

This uptick has already taken annuity rates to their highest level since 2014, before the introduction of pension freedoms in April 2015. Prior to that date, most people with defined contribution pensions were required to buy an annuity with their pension pot when they retired. But the changes introduced by then chancellor George Osborne hugely broadened the options at retirement, and retirees embraced their newfound freedoms enthusiastically. 

Many took the chance to cash in pensions (often smaller ones) entirely; the latest FCA data shows that 56 per cent of policies accessed for the first time between April 2018 and March 2020 were fully cashed in. A further 29 per cent were put into income drawdown, which enables retirees to leave their pensions invested while receiving a regular income from them.

This growth came at the expense of annuities: just 16 per cent of policies were used to buy an annuity in 2015-2018, and that fell further to 11 per cent over the following two years.

With rates for a level income for life at age 65 hitting an all-time low of less than 4.7 per cent in August 2016, according to sharingpensions.co.uk, they were widely regarded as dull, poor value and inflexible. At the same time, global stock markets were enjoying a prolonged bull run and income drawdown seemed like an obvious choice for most younger retirees.

How times change

Rising annuity rates have coincided with dramatically deteriorating stock markets this year, and the upshot is that annuities are looking more attractive. That is in part because interest rates are higher – for example, Canada Life’s benchmark rates have risen by around 29 per cent since the start of 2022 – but also because the alternatives look much less alluring.

As Billy Burrows, a financial adviser and founder of the Retirement Planning Project, explains: “An annuity rate where as well as the return of your original capital you’re getting underlying interest of say 3 or 4 per cent, plus peace of mind, plus insurance against longevity, becomes quite difficult for drawdown to beat in the current environment. Where could you get a drawdown investment that pays a secure income of 3 or 4 per cent after charges?”

According to Nick Flynn, retirement income director at Canada Life, a leading annuity provider, the combination of economic uncertainty, volatile stock markets and improving rates is having some effect on take-up. “We’ve witnessed renewed interest in annuities from all age groups,” he says. Canada Life annuity quote volumes are up 20 per cent this year to date compared to the second half of 2021.

However, a sticky bias against annuities persists. At retirement adviser Intelligent Pensions, managing director Andrew Pennie reports: “Generally, our clients tend to be anti-annuity. That may be down to negative coverage of annuities in recent years, a long period of historically low rates, or the fact that under pension freedoms clients have easier access to alternatives to the financial ‘gamble’ that is an annuity – live long and you win; die early, which most people believe will be the case for them, and you typically lose.”

But to look at annuities purely in financial terms is to miss the essence of their attraction, argues Stephen Lowe, director at retirement specialist Just Group.

“Many people who have negative perceptions of annuities do like the idea of a guaranteed lifetime income, which is why the industry thinks ‘guaranteed income for life’ or GifL is a better understood description,” he says. “It’s important to look at a GifL solution not as an investment but as insurance. An annuity isn’t designed to make you rich, but it can stop you becoming poor at a vulnerable time of life.”

Lowe says that the concept of ‘capacity for loss’ is useful in this context. This assesses how much an individual can afford to lose from their portfolio before it meaningfully impacts living standards.

“Wealthier people can usually absorb these shocks more readily than those with more modest assets, where income security is likely to be more important,” he adds. In other words, an annuity could be particularly valuable as the core of a retirement income for those with fewer assets.

But the bottom line, experts agree, is that some element of secure income in retirement, in addition to the state pension, is a really valuable thing for most people. It may be provided by a final salary pension, but for the many households entirely reliant on defined contribution pension pots, an element of annuity-based income can make a lot of sense as rates rise.

Says Flynn: “Everyone should have some guaranteed income in retirement; it’s really just a matter of how much is required and where that income is sourced. It shouldn’t be seen as a binary choice between annuity or drawdown. Both have a role to play, and often a blend of the two can provide a better retirement outcome.”

One argument that has weighed against annuities since 2015 is the fact that – unlike pensions in drawdown – they cannot be passed on to the next generation as part of an estate. However, Pennie makes the point that by using part of a fund to purchase an annuity providing a regular income, death benefits can actually be increased over the longer term, because the remaining fund can be invested on a longer investment horizon without having to worry about market timing for income payments.

Age is another factor to build into the equation. “When a saver first retires in their late 50s or early 60s, pension drawdown probably has the edge on annuities because of the flexibility; but as they get older, annuities become a better proposition,” says Burrows. “By 65 or 70 they ought to have some annuities under their belt, and certainly by 75 there is a strong case for having quite a lot in annuities. But how they get there depends on individual circumstances.”

There are several reasons for moving into annuities with increasing age. Most obviously, rates improve markedly, so for instance the current top rate on a £100,000 level annuity with a five-year guarantee rises from £5,270 at age 60 to £8,010 at age 75, according to data from williamburrows.com.

Additionally, older retirees often place a higher price on a simple, reliable income. As Pennie explains, they have more certainty around their essential expenditure but also: “in the trade-off between flexibility and security, they have perhaps shifted more towards security, having cut down on variable expenditure for holidays, hobbies and home improvements”.

Older people may also develop medical conditions that mean a further enhancement in annuity rates, so it’s important to factor in health and lifestyle considerations.

Current pressures

A further factor very much at play at the moment is inflation. The state pension is index-linked, and there is also the option of inflation-linked annuities – but these are expensive. Burrows says most people choose level annuities – which pay the same nominal amount of income every year – because the starting rate for index-linked alternatives is as much as 30 or 40 per cent lower.

For example, the current best rate for a £100,000 single level annuity with a five-year guarantee at age 65 is £6,081. For the retail price index (RPI) linked alternative the best starting rate is just £3,477.

Burrows argues that for those dependent primarily on the state pension, it makes sense to opt for a level annuity that starts on a more generous rate but doesn’t rise, because the bulk of their income is index-linked anyway. For those with more money and keen to protect the real value of a greater part of their income over the years, he suggests that an annuity with a fixed annual escalation (of say 3 per cent) is a more reliable and better-value option. Based on the above parameters, a 3 per cent escalation annuity pays £4,190 in the starting year.

“When I last looked at inflation-linked annuities a few weeks ago, the implied rate of uplift was between 4 and 5 per cent a year, so you’d receive the same starting income with a fixed annual escalation of 4-5 per cent,” he says. The difficulty is that inflation rises and falls, so you’ll be paying for a 4 or 5 per cent annual rise that that you won’t necessarily get.

However, as Flynn points out, we have no idea how long the current period of high inflation will continue. “The predicted inflation peak, when it comes later this year, is only half the story," says Flynn. "How long inflation remains high will determine all of our living standards for years to come - factoring in the cost of living is just one of the decisions retirees face when setting out their plans.”

Continuing increases in inflation are likely to result in further interest rate rises by the Bank of England in the coming months – and therefore further rises in annuity rates as gilt yields go up. So there is a potential argument for holding on in the expectation of better rates to come.

However, Burrows points out that the benefits could be cancelled out if the waiting pension pot is hit by more market volatility in the meantime and there’s less capital available when rates do rise. You’re also missing out on that assured income for as long as you defer. “Getting the timing right is really difficult, so it should be driven more by income requirements than speculation on interest rates,” he advises.

And shop around to get the best annuity rate. Says Lowe: “Recently the best rates have been 25 per cent higher than the worst for a 60-year-old, but our research has shown about two-thirds of retirees are eligible for even higher ‘enhanced’ rates.” Even a modest uplift can add up to significant sums over the course of a long retirement.