PERSONAL FINANCE Want a guaranteed income for life? It’s worth noting annuity rates are going up

Annuities won’t suit everyone in retirement but some will like what’s on offer

There was a time when 90% of retiring investors bought an annuity with their pension pot, but in 2015, that radically changed.

The pension freedoms swept away many restrictions and allowed retiring pension savers to access as much of their pension cash as they wanted. The result is that nowadays, only around 10% of people buy an annuity. The big question is whether that is about to change.

The pension freedoms clearly had a huge impact on annuity purchases, but they also coincided with a period when interest rates were exceptionally low. With rates now going up, it’s worth taking another look at the annuities space.

WHAT IS AN ANNUITY?

For the uninitiated, an annuity is an insurance product, where you swap a lump sum from your pension for an income for life.

Insurance companies base their annuity rates on bond yields, which have been hugely depressed for the last decade by loose monetary policy.

That is now changing, and the Bank of England is hiking interest rates aggressively. As a result, annuity rates have increased by around 20% this year. Based on a £100,000 pension pot, a 65-yearold can now get an income of £5,970 a year, or almost 6%, according to the MoneyHelper service.

A 6% income may sound attractive to many investors, who are perhaps used to a dividend yield from the stock market of around 3% to 4%. But there is a key difference between investment income and annuity income that means it’s not a like-for-like comparison.

If you receive dividends from shares or funds, you still also have your capital invested. By contrast, with an annuity you are swapping your capital for income, so you’ll no longer have a pension fund to speak of, just an income stream.

That means a 6% annuity rate includes your capital being fed back to you, for the rest of your life. And while we know death and taxes are certain, their timing is not.

IMPORTANT POINTS TO CONSIDER

If you live a long time, an annuity might be an extremely good choice. But if you die early, you may not have received much of your money back before death, and unlike keeping your pension invested, there is no lump sum left to pass on to beneficiaries.

You can build a spouse’s pension into an annuity, which continues to pay out to your spouse or civil partner after your death. A common option is a 50% spouse’s pension, which continues to pay out

half the income you were receiving. But depending on the age of your spouse, this could reduce the annuity rate you get by 5% to 10%, maybe more if they are significantly younger than you.

It may also be possible for retiring investors with certain health or lifestyle conditions to lock into a higher income too, because statistically speaking, insurers expect them to die at younger ages.

For instance, a regular smoker might be able to pick up a 10% uplift on standard annuity rates. If you’ve had a stroke or heart attack, you’ll likely get more.

WILL THE PAYMENT RATE CHANGE?

It’s important to note the 6% annuity rate on offer today also stays level for life, so it will be eroded by inflation over time.

At 2% inflation, an annual income of £5,970 would only be worth £4,900 in 10 years’ time, and £4,020 in 20 years’ time.

Periods of high inflation like we are seeing today will do even more damage. You can opt for an annuity that rises in line with inflation, but again, this reduces the initial income you get.

In our example of the 65-year-old with a £100,000 pension pot, they would initially get an annuity of just £3,220 a year, rising in line with RPI thereafter.

CAN WE EXPECT A BOOM IN ANNUITIES NOW?

It would be remarkable for the 20% rise we have seen in annuity rates this year to have absolutely no effect on their popularity. But the increase in pension savers attracted to annuities is still likely to be marginal.

Even when 90% of people bought an annuity, many of them did so begrudgingly. People really don’t like the fact that if you get hit by a bus the day after you buy your annuity, all the money you have saved up over the years might bite the dust too.

Keeping your money invested in your pension is risky, but it also has benefits, like hopefully seeing your money continue to grow, passing what’s left of your pension savings on to your family after you die, and managing your income to keep your tax bill in check.

Annuity rates are improving – they’ve gone up 20% this year alone

They offer you a fixed income for life Your annuity ends when you die so you cannot pass on wealth this way like a pension

UNDERAPPRECIATED ANNUITY BENEFIT

The one thing that people probably underestimate is the potential to live a very long life. More and more people are living into their nineties and even past their hundredth birthday.

Seen from this perspective, a guaranteed income for life can be a very valuable thing, if the rate on offer is a good one.

Most of us will get a guaranteed income in the form of the state pension, but at £185.15 a week, that’s not enough to live a particularly comfortable life.

Some people may also be lucky enough to have defined benefit pensions, which also give them a guaranteed income for life. But many won’t, and so an annuity should at least be a consideration, especially if rates rise further from here.

The good news is investors can split their pension fund if they want, using some of it to buy an annuity, and keeping the rest invested. That way they get a bit of income security, and a bit of growth and flexibility too. As annuity rates rise, more people might give this mix and match approach a proper look.

By Laith Khalaf AJ Bell Head of Investment Analysis

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