One reason taxes are rising is that the government is paying more to borrow. But there could be a silver lining to this cloud for retirees. Annuity rates are up 40 per cent this year.
This is because annuity providers invest heavily in low-risk government debt, known as gilts. When gilt yields rise, they can be more generous.
So a 65-year-old converting £500,000 into a single-life, level annuity with a five-year guarantee (we’ll address these terms shortly) can now buy themselves an annual income of £36,140. A year ago it was just £25,670. Have annuities suddenly become attractive again?
An annuity is an insurance product. It allows you to swap a lump sum — your pension savings — for a guaranteed regular income for the rest of your life. They go back centuries: in 1811, Fanny Dashwood in Jane Austen’s novel Sense and Sensibility says: “An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it.”
Until, that is, you die. A lifetime annuity is essentially a bet on your life expectancy. Live long and you prosper. Die soon after your purchase and you probably lose on the deal. The annuity provider will have paid out a small portion of your pot and banked any money left to help pay those who live longer than expected.
Historically, we were required to buy annuities with our pension savings — tough if your retirement coincided with gilt rates being low. Today you have an alternative, known as “drawdown”.
You can leave your pension savings invested, drawing from them as needed and passing on anything left when you die to loved ones. With annuity rates so low in recent years, drawdown became the preferred option. Fewer than one in 10 pension plans accessed for the first time in 2020 were used to buy an annuity, according to the Financial Conduct Authority. Could improved rates change this?
Even if your pension is in drawdown, you can still buy an annuity. But shop around. The difference in rates offered by the best providers can mean thousands of pounds a year in extra income.
Make sure you understand the terminology. A “single life annuity” will pay more than a “joint life” one, but if you die first your spouse or civil partner will get nothing. A joint life annuity may leave them with perhaps two-thirds of your annuity for life.
Consider inflation protection. A “level annuity” pays the same sum every year. If inflation continues at 11 per cent that means your annuity income halving in real terms in under seven years. You can buy an annuity that rises in line with the retail price index each year or by a flat amount, such as three per cent. This inflation protection costs, of course.
Some annuities offer guarantees to mitigate the risk of you dying early. A five-year guarantee will mean that on your death your beneficiaries could receive a discounted lump sum equivalent to five years of payouts. A 10-year guarantee lays the risk off further. The drag on payments for this protection can be relatively cheap, so it is worth considering.
Being unhealthy can help the offer from the annuity provider. Prove that your life expectancy is impaired and you get better rates. A 10-a-day smoker will get substantially more each year than a non-smoker of average health. If you have health issues — say, for example, you have high blood pressure or diabetes or have suffered a stroke — make the provider quoting aware.
Some lucky savers will have pension savings products with high guaranteed rates for annuity purchase. Through the 1970s and 1980s annuity rates averaged between 10 and 16 per cent. One of my clients who bought a pension savings product in that era triggered the annuity recently. At age 65 they were guaranteed over 12 per cent for a level annuity — two-thirds more than today’s levels, even after the recent uplift.
This is much more than is currently available from safely investing. With such attractive rates, they opted to forgo the tax-free cash entitlement, too. Check your products carefully for such promises. I have met too many people who switched out of pensions with guaranteed annuities to enter drawdown, unaware of this hidden perk. There can also be guaranteed rates of investment return pre-annuity purchase.
If all this suggests I am becoming a convert to annuities, I am not. The tax benefits on death and flexibility that come with drawdown are too attractive for many to surrender. But a guaranteed income in retirement does bring security.
I have clients who took advantage of recent high rates to exchange some of their pension savings for an annuity. They have no dependants and are not worried about legacies.
This hybrid approach had obvious merits for them. It may for others. If inflation and interest rates fall they will have timed the deal well. If they live long enough it could prove a very smart transaction. But those are big ifs for a product designed to reduce risk and provide reassurance. Buying an annuity remains a serious gamble.
Charles Calkin is a financial planner at wealth manager James Hambro & Partners