Would an annuity work for you?

After years in the retirement planning wilderness, annuities — guaranteed incomes for life — are back in the limelight, due to rising interest rates.

With £100,000 from their pension pot, a healthy 65-year-old could now buy an annual income worth £7,465, compared with just £4,950 three years ago — up over 50 per cent, based on data from annuity broker Retirement Line.

But how far should we be swayed by current generous rates? A secure 7.5 per cent yield from your pension capital sounds appealing, especially at a time of uncertain stock markets. 

But that headline rate is not inflation-linked, so the real value will dwindle over time. Index-linked annuities pay much less initially — in the example above an inflation-linked annuity (based on the retail price index) would pay £4,725 a year. Also, annuities are irreversible, inflexible and cannot be freely passed on when you die.

Much depends on your circumstances. Age, health, other income sources and family situation can shape how well an annuity works for you. (Gender is not a factor since the European Court of Justice implemented gender neutral pricing in 2012.) 

The following examples offer pointers as to what might work for you.

1. Someone aged 60 who wants to retire and access their defined contribution pension 
Whether to buy an annuity when retiring at 60 depends on whether you are keen to arrange a secure income at this age, even if it means less flexibility, says Ian Cook, chartered financial planner at Quilter.

“While it is possible to buy an annuity with pension tax-free cash to bridge the gap (see example 3) until you receive a state pension, ordinarily you would want to use the ‘taxable’ portion of the pension,” says Cook. Using tax-free cash makes sense only if you have no other income, so the taxable annuity income could be offset against your personal allowance.

He adds that if security is important, it makes more sense to put the tax-free element of your pension into a cash Isa and buy an annuity with the taxable portion of the pension.

2. Someone in their mid-70s in income drawdown, who wants to lock in an income with part of their fund
Retirees with defined contribution (investment-based) pensions who initially drew an income from their drawdown fund can switch some (or all) of it into an annuity.

Mark Ormston, director of propositions at Retirement Line, observes: “As people age, the appetite for investment uncertainty tends to decrease and a desire to make fewer financial decisions starts to creep in. Annuity rates improve with age, making an annuity purchase look all the more appealing.” 

How much difference does delaying a purchase make? With £100,0000 of pension a 60-year-old could currently buy a level (unchanging) income with a five-year guarantee worth about £6,500 a year. Someone aged 75 would receive almost £9,500. 

Ormston adds that if a spouse or partner is also reliant on this annuity income, it may make sense to buy a joint life annuity that pays out until both people die (though this will reduce income received). 

3. Someone who receives a £100,000 cash windfall
Henrietta Grimston, associate director in financial planning at Evelyn Partners, says that although conventional annuities are designed to be bought with pension capital, it’s possible to buy a purchased life annuity (PLA) using a cash lump sum. 

There are advantages to a PLA. It is treated as a “capital purchase”, so not all the income paid out is considered taxable. The exact amount liable to income tax will be calculated by the annuity provider.

However, rates on PLAs can be lower than those on pension annuities.

Grimston says any level annuity will lose purchasing power so people still earning could instead “use part of the windfall to make extra pension contributions within their allowances, to increase their retirement savings”. 

4. Someone still working and saving into a pension, but wanting to lock a chunk of tax-free pension cash into an annuity now
Annuity rates may be high, but experts warn against buying an annuity early due to inflation and because rates improve with age. 

An annuity purchased using tax-free pension cash would be a PLA, so part of the income flow would be subject to income tax. 

Cook says that if you’re still working the additional taxable income could push you into a higher tax bracket. You’ll also lose that chunk of pension if you die. As a low-risk alternative, he suggests using money market or gilt funds within your pension.

5. Someone at retirement age with diabetes and a heart condition, who is wondering whether to go for an annuity or drawdown
Many conditions, even relatively common ones such as high cholesterol, qualify for a medically underwritten or “enhanced” annuity which provides higher annuity income.

For example, a healthy person aged 67 can expect £7,715 (level payments) from £100,000 of pension. With type two diabetes and a heart condition, the yearly income increases to £9,000.

But Cook says the best choice will depend mainly on a person’s need for income and whether they need to provide for a spouse or children after they die. 

“While you can receive a much higher annuity income with underlying health conditions, once additional benefits are added, such as spouse’s provision and inflation linking, you can find the income is dramatically reduced,” he warns. 

He suggests going into drawdown but using a low-risk, near cash-style portfolio so potential beneficiaries retain control of the pot after your death.

Annuities work well where a reliable income is needed, and higher rates are available (as in late retirement). But their inflexibility and complex pension rules means they must be treated with care. Expert advice makes sense.