The return of annuities for retirement income

Annuities have been largely ignored since the pension freedom reforms of 2015. However, a near 30% rise in some annuity rates so far this year is turning heads. For many savers approaching retirement, an annuity now looks a more attractive way to convert pension fund cash into regular income than an income drawdown arrangement.

Annuities, which are sold by life insurers, offer a guaranteed income for the rest of your life. The plans are available with various bells and whistles – different levels of inflation proofing and dependants’ benefits, for example – but the underlying principle remains the same. You hand over your pension fund and the insurer promises to keep paying your pension for as long as you live.

With income drawdown plans, you must manage your savings with great care, balancing the need to generate growth against the risk of depleting your funds and working out how much you can withdraw without risking depleting the pot. Since the 2015 reforms, these have become the default option for savers reaching retirement, who have largely eschewed annuities.

One of the main reasons for the growing popularity of drawdown is that annuity rates have been stuck at all-time lows for much of the past five years. Rates are pegged to gilt yields, which move up and down in line with interest rates. Since interest rates have been close to zero for so long, annuity rates have been dismal. Rising life expectancies have also been a factor: insurers expecting to pay annuities for longer naturally reduce the amount they pay each year.

Rising rates turn the tide

Now the environment has changed. With five base rate rises in the past six months, gilt yields have climbed steadily. And as increases in average UK life expectancies have stalled, the rise in annuity rates has been even more dramatic. A 65-year-old man with a £100,000 pension fund can now buy an annuity income of around £5,940 a year, the highest amount since August 2014, and 28% higher than at the start of the year.

To put that into perspective, pension experts often suggest that if you want to be sure your pension fund will last, you shouldn’t take an income of more than 3%-4% a year from your savings using income drawdown (see MoneyWeek issue 1107). That would suggest an annual income of no more than £4,000 if your savings are worth £100,000.

This doesn’t mean annuities are right for everyone. Income drawdown plans offer other advantages – notably, greater flexibility about how you can pass on unused savings. Still, it is also possible to buy annuities with attractive death benefits, enabling family members to inherit either a regular income or a lump-sum payment.

However, the choice does not have to be one or the other. One option is to buy a series of annuities over time, rather than deploying your entire pension fund in one go. This can provide increased flexibility, particularly in the early years of retirement. It could also allow you to benefit from any further annuity rate rises to come.

Annuity rates were already higher for older savers, since insurers don’t expect to have to pay out for so long. But this end of the market has also seen rates rise in line with higher gilt yields. A 75-year-old man with a £100,000 pension fund can buy an annuity income of around £7,900 a year, 18% more than at the beginning of the year.

Retire later to boost income

Savers looking to generate extra pension income should consider delaying their retirement. New data from insurer Aegon shows a delay of just a single year could offer a boost of over 16%.

The figure is based on the example of a 60-year-old man with a £200,000 pension fund, who could today buy an annual annuity income of around £4,900 with these savings. Waiting a year to retire and continuing to contribute could mean the pension fund grows to £211,000, assuming investment growth of 4.25%, after charges. Factor in the higher annuity rate available to a slightly older saver, and this could provide an annual income of around £5,700 – a 16.3% increase.

The potential to secure higher pension income grows larger the longer you are prepared to defer claiming your money. Waiting three years could mean an increase of 41%, Aegon calculates, while waiting five years could net an extra 73%. Of course, everyone’s circumstances will be different, but the broad principle holds in most situations. Those who are able to delay retirement may be able to unlock a much larger increase in pension income than they might expect.

State pensions can also be boosted in this way. The government offers additional pension income to those who do not begin claiming their benefit at 66, the age at which the state pension usually becomes payable.