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Annuities have been largely “out of favour” as a retirement planning option since the 2015 Pension Freedoms. Yet, with interest rates steadily rising since late 2021, annuity rates and sales are on the rise. In this article, our financial planners in Padiham explain how annuities work, why they are becoming a more viable pension planning option in 2022 and how they can be used effectively in a retirement strategy. We hope this is useful and please get in touch if you’d like to discuss your own financial plan with us over a free, no-commitment consultation.
How do annuities work?
When you reach your normal minimum pension age (55 in 2022, but rising to 57 in 2028), you can typically start accessing certain pension benefits. Pension pots, for instance, can often be accessed to withdraw up to 25% of the value, tax-free. A popular option is to enter “income drawdown”, which involves making regular withdrawals from your pension fund (to provide an income in retirement) whilst keeping the rest invested. Another route is to use your funds to buy an annuity; a financial product providing a stable regular income in retirement.
Annuities are offered in many forms to try and cater to different retirement planning needs. For instance, a “level” annuity provides the same income across its lifetime (regardless of inflation) whilst an “inflation-linked” annuity will rise each year in line with a specific measure, such as the Consumer Price Index (CPI). Annuities can provide an income for a limited period (a fixed-term annuity) or indefinitely – the latter possibly even providing an income to a surviving spouse or other dependents after the policyholder’s death. Naturally, the more benefits (and income) you want from an annuity, the more costly it is likely to be. However, interest rates also play a role in determining how much income you can potentially get from annuities on the market.
Why are annuities more attractive in 2022?
To understand why annuity rates are rising in 2022, it is important to lay out how bonds affect annuities. Annuities are typically offered by insurance companies which gather pensioners’ money and invest it into “lower risk” assets (e.g. UK government bonds, or “gilts”). Investment returns are then partly used to provide income for their annuity products. Depending on the returns that can be generated, new annuity products may offer higher (or lower) incomes.
The UK’s main interest rate (the “base rate” set by the Bank of England) plays a crucial role in determining the interest rate on newly-issued UK government bonds. If the base rate is higher, then these bonds tend to become more attractive to investors as the interest rate they can gain also rises. A key group of investors in these bonds is insurance and pension companies, which own around 75% of UK public debt. This explains why annuity rates are rising in 2022, since the Bank of England has repeatedly raised the base rate from 0.10% in 2021 to 3% today. As a result, annuity rates (at the time of writing) now stand at a 14-year high.
Should I buy an annuity?
Buying an annuity is a very personal decision and has a big impact on your retirement plan. If you buy one, then you cannot change your mind – so discussing your options with a financial planner, beforehand, is often a good idea. One consideration is how much income fluctuation your want to deal with in retirement. Annuities offer a high degree of income predictability and stability, since this is clearly outlined in the product (before purchase) and the responsibility to provide this income falls on the insurance company. By contrast, income drawdown involves making withdrawals from your pension whilst keeping the rest of your money invested. If the market goes down, then so might the value of your pension. To keep your pension sustainable, you might need to reduce the value of your withdrawals during harsher economic conditions.
In recent years, annuity incomes have tended to fall short of what can be achieved from income drawdown – although this may be starting to change. At present, a 65-year-old with a £100,000 pension pot may find an annuity offering £7,191 a year compared to £4,989 in October 2021 (a 44% rise). However, in 2022 stock markets have not performed strongly; in the future, when markets should recover, income from drawdown is likely to beat that which can be gained from an annuity. Another factor to consider is time. Given your age, health and lifestyle, are you likely to live long enough to start getting your money back from an annuity? If you use £100,000 to buy an annuity providing £7,000 per year, for instance, then your “break-even” point would be in about 14 years’ time. After that, you start to make a “profit” from your investment. For some, this will make an annuity purchase automatically unviable. Yet for others (e.g. those earlier in their retirement), it could still be a potential option.
Invitation
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938
E: info@elmfieldfp.co.uk
