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Annuities back on the pensions radar as incomes hit a six-month high

Paloma Kubiak
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Paloma Kubiak

Annuity incomes have hit a six-month high but with further base rate hikes on the way, there’s every chance retirees could gain a higher allowance in the months to come.

Annuities provide a guaranteed income for life in return for a lump sum payment but over the last few years, they’ve sat on the sidelines of retirement planning following the dawn of pension freedoms.

This is because the freedoms – introduced in 2015 – give savers more flexibility when it comes to accessing retirement income, so you’re no longer required to take out an annuity, but can choose to do so.

According to Hargreaves Lansdown, annuity rate rises mean a 65-year-old is able to get more than £7,000 a year from a £100,000 pension pot.

While this is down on the highs seen in the aftermath of the mini Budget in September 2022 where the same person could lock in an annual income of £7,586, it’s much higher than the £4,979 achieved two years ago.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Annuities are once again taking centre stage and with more interest rate rises on the horizon there’s every chance we could see further income increases in the months to come.

“For those in need of some level of guaranteed income in retirement, annuities should always be a consideration. However, their reputation for being inflexible and offering poor value for money has made people hesitate. Their improved fortunes will certainly prompt more people to take a closer look.”

Why are annuity rates climbing?

Annuity rates – the amount of income per year you get for a certain lump sum – are linked to bond yields and interest rate expectations.

The ‘sticky’ inflation readings for the year to April – 8.7% headline and 6.8% core – resulted in investors suddenly betting that the Bank of England would keep rates higher for longer, according to Gary Smith, partner in financial planning at wealth manager Evelyn Partners.

Two-year bond yields rose above 4.5% for the first time since the tumultuous aftermath of the Truss and Kwarteng mini Budget in September 2022.

He said that if you look at this in another way, if a 65-year-old lives to the average life expectancy for a healthy person (86), then the annuity purchaser will get a total of £143,357 in income for their £100,000 outlay – rather than the £105,000 they would have got in January 2022. Alternatively, the 65-year-old would have to live for just over 14 years to recoup their annuity outlay.

However, Smith added: “While annuity rates are not experiencing the sudden surge they did last autumn, they are starting from higher levels maintained since then, and this could present an attractive buy-in point in the coming weeks and months for those who are seeking to secure income from their pension pot in the form of an annuity. If inflation ceases to surprise and does pull back as expected, these annuity rates could be short-lived.”

Locking in now as rates rise: Is an annuity a good idea?

For those concerned about locking into an annuity today and potentially missing out on increased income in future, Morrissey said individuals could consider annuitising their pension in tranches throughout retirement rather than in one transaction.

“This enables you to build guaranteed income as your needs increase while leaving the rest invested where it can hopefully grow further. Added to this you tend to get increased incomes as you age – for instance a 70-year-old with a £100,000 can currently get up to £7,838 per year compared to £7,017 for a 65-year-old. You may also qualify for an enhanced annuity as you age which will give your income a further boost.”

Smith shared five tips for savers to consider to help evaluate when and if an annuity might be a good idea:

1) How much do you value the security of a guaranteed income?

Annuities are in part a matter of preference: some people put a higher value on the guaranteed income they provide and are less keen on the possible fluctuations of a drawdown pot. For them, apportioning a larger portion of their pot to an annuity makes more sense, particularly at a time of favourable rates. They might for instance want to establish a required guaranteed annual income level, take away the state pension and any other income, and set the annuity to make up the difference.

Others will find annuities too restrictive, as a fixed one-off deal, and prefer the flexibility and control of drawdown – at least in early retirement.

2) There could be a ‘good age’ to buy one

Another strategy is to ‘flex first and fix later’. The disadvantage of purchasing an annuity early in the retirement phase is that a chunk is taken out of the pot that could go on to earn investment returns. Moreover, as a retiree gets older they may be less inclined to manage the complexities and risks of drawdown and will give more value to the security of a guaranteed income.

With this in mind, the plan would be to take an income from drawdown until a certain age (which will vary widely according to individual circumstances), at which point the pot is liquidated for an annuity.

3) A ‘surrogate state pension’?

Another option for those who have built up larger pots with a view to retiring early is to buy an annuity to furnish a guaranteed income until the state pension arrives. Someone at age 57 could use part of their pot to buy a 10-year fixed term annuity to provide a guaranteed income to take them up to state pension age, while drawing additional funds if needed from the remaining invested pot. As savers can purchase more than one annuity over their retirement this does not stop them from also buying one in the later phase.

Such considerations might become more commonplace if the higher annual and scrapped lifetime allowance measures announced in the last Budget remain in place.

4) An annuity does not trigger the money purchase annual allowance

Just like the 25% tax free lump sum, purchasing an annuity does not trigger the money purchase annual allowance. This means that you can continue to contribute the annual allowance of £60,000 to a pension and benefit from tax relief – rather than have to submit to the £10,000 MPAA.

5) Passing on of wealth

It should be noted that funds held in a defined contribution pension pot do benefit from being exempt from inheritance tax. This for some savers means that it might be preferable to keep the pot in drawdown rather than using a lump sum to buy an annuity. A standard annuity dies with the policy holder.

But it is possible to include options with an annuity that can protect your family on your death, although adding such benefits for the same purchase sum will reduce the level of starting annuity you can receive. These can include an income for spouse or partner, on your death, that could be 100% or 50% of the pension you receive. Any ongoing annuity received by a spouse or partner would be free of income tax if death occurs before age 75, but taxable if death occurs post age 75.

Where the annuitant wants to provide some protection for their children / grandchildren, they could include a guaranteed period, and this will ensure that the annuity is paid for a set period of time, regardless of whether or not they survive this period. If death occurs pre-75 this is typically paid free of tax, with tax paid on death post age 75.

I’ve locked into a lower annuity rate, is there anything I can do?

For those who bought an annuity in the last six months, you won’t have missed out on too much extra income, though if you bought an annuity around 18 months ago, you could get around 40% more today than back at the start of 2022.

Smith explained that the annuity you received at the time would have been based on the rates available at that time. Once you’ve bought a guaranteed annuity, unfortunately, you can’t close it and request a return of your capital to buy a new one simply because rates have changed.

When it comes to buying annuities, you aren’t required to take financial advice, though savers should seek advice to ensure you’re making the right decision for your circumstance and understand what you’re signing up to. As a starting point, Pension Wise offers free and impartial guidance which can help.

Related: Could you qualify for an enhanced annuity (and not know about it)?