Annuity rates have leapt 44% in the space of a year and are now at their highest levels since early 2009, according to recent figures from Hargreaves Lansdown.

So, what are annuities, and why is this recent news potentially important?

A guaranteed income

An annuity is a guaranteed income for life, provided by a life assurance company or other provider. In most cases, this is something you might buy at retirement with an accumulated pension fund.

Until 2015, everybody was legally obliged to use their pension fund to buy an annuity by age 75 at the absolute latest. Although you could take 25% of your fund as tax-free cash before doing this, the obligation to buy an annuity was very unpopular.

This was exacerbated by the fact that annuity rates – the amount of income that could be obtained per pound spent – had steadily worsened over the past decade.

The requirement to buy an annuity was finally scrapped by Chancellor George Osborne in 2015, as part of broader reforms to pensions rules. This meant that people were free to flexibly draw upon their pension funds as they saw fit, and to pass on any unspent funds to the next generation.

This saw annuity sales plunge 75% between 2013 and 2015, according to data from the Association of British Insurers.

Whilst the greater flexibility offered by pensions freedoms proved popular, removing the necessity to buy an annuity did leave the door open to the possibility that retirees could run out of money during their retirement.

This is because, unlike an annuity, there is no guarantee that a pension fund cannot be exhausted if its owner lives long enough or spends too much.

Annuities and pension drawdown therefore represent two very different options for retirement planning – annuities are secure but very inflexible, whereas drawdown is very flexible but offers little security.

Annuities and interest rates – two sides of the same coin

The fact that annuity rates and interest rates have both been very low over the last decade is no coincidence. This is because the income levels that annuities pay are determined by the interest rate payable on UK government bonds.

These bonds, known as gilts, have been paying progressively lower and lower rates of interest (known as the yield) since the 2008 financial crisis.

In addition to cutting interest rates close to zero, the Bank of England (much like other central banks around the world), had engaged extensively in a process known as quantitative easing. Put simply, this meant that the Bank uses freshly created money to purchase gilts, with the objective of pushing down gilt yields and keeping the cost of borrowing deliberately low.

One unfortunate side effect of this however, was that annuity rates were similarly suppressed. When providing annuities, life assurance companies would buy gilts to underwrite the income they were then obliged to provide. This is because gilts are extremely stable investments, being 100% backed by HM Treasury with effectively no risk to capital when bought at issue and held to maturity.

This long-term trend of falling interest rates and lacklustre annuity rates appears to have finally reversed itself in the last six months or so, with gilt prices falling and their yields surging.

Contrary to reports, this was not caused by the mini Budget, as gilt yields began to trend upwards from the summer of 2020, but the process was certainly accelerated by it.

The overall volume of UK debt is also a factor, as it is relatively high by peacetime standards, compared to the size of the UK economy. This has meant that it is more susceptible to changes in the cost of borrowing, and changes in interest rate expectations have a more dramatic effect than they would otherwise do.

These combined factors mean that for the first time in years, annuity rates are in some cases beginning to rise and look more attractive again. So, does this mean that annuities are due for a comeback?

Flexibility versus security

As is often the case, the answer is ‘it depends’. It is certainly true that annuity rates represent better value for money than they did six months ago. For people who have large pension funds relative to their needs and who are risk averse for example, buying an annuity now would provide a copper-bottomed income at a better level than we have seen for several years.

Not only that, but this income will continue to be paid for life, regardless of how long someone lives, so this could be a valuable guarantee they would want to take advantage of.

On the other hand, the level of income available does not change the fundamental nature of annuities. Someone must still spend their pension fund in order to buy one, compared to the greater choice offered by drawdown.

It is also the case that unless the annuity chosen factors in some degree of protection against inflation, the real terms value of the income provided will erode over time.

This is another one of the attractions of pension drawdown, since such funds are not merely accessible, but also have the potential for long-term growth above the rate of inflation, if appropriately invested.

Whilst it is true to say that annuities are better value than they used to be, it is still too early to confidently say that their place in financial planning has materially changed since the introduction of pension freedoms.

It will therefore be interesting to see how annuity rates develop over the coming year.

James Batchelor is a chartered financial planner at Progeny