Here’s a sentence you won’t read very often: the annuity market witnessed a significant boom in the last tax year.  Data from the FCA shows annuity sales rose by almost 40% in 2023/24, marking a sharp reversal in fortunes. Ever since pension freedoms were introduced in 2015, annuities have been shunned in favour of more flexible ways of drawing a pension.

But rising interest rates have led to a surge in popularity, though it must be said annuities still only account for 10% of pension withdrawals. Most people still prefer to keep their money invested in their pension via a drawdown plan, or simply take it as cash.

ANNUITIES USED TO DOMINATE

Before George Osborne waved his magic wand and did away with the rules governing pension withdrawals, 90% of retiring pension savers opted for an annuity. But they did so reluctantly, because other options were limited. There are plenty of reasons people don’t like annuities, but they might not appreciate the value they can add to a retirement strategy. For many years this was a moot point ─ because annuity rates were so low, annuities were deeply unattractive. Now rates have risen, they are worthy of consideration for those starting to take their pension income.

Many pension savers won’t have come across an annuity before they get close to retirement and get a pack explaining their choices from their pension provider. The basic premise of an annuity is that if you hand over your pension pot, or part of it, to an insurance company, they will provide you with an annual income for life in return.

One of the big gripes savers have with this arrangement is if you die soon after buying an annuity, all your money is gone (unless you build in some protections which reduce your income). This is a fair criticism, but it’s easy to ignore the flip side of this risk: if you live to 100, or beyond, an annuity keeps paying out, year after year.

SECURITY VERSUS FLEXIBILITY

Whether you choose to buy an annuity or not will often come down to how much you value the security of your pension income. Investment income is variable and so doesn’t provide the certainty an annuity does. But by the same token, annuity income isn’t flexible so you can’t adjust the income you withdraw from your pension each year if you want to manage your tax liabilities, or simply have changeable income needs. This is quite normal in retirement when the early years might be filled with extra expenditure as you make the most of your free time.

The rate you get also matters, of course, and this will vary depending on a number of factors, but most relevant is the age at which you take out the annuity. A 65-year-old can currently get a level annuity income of around £7,200 per year on a £100,000 pension pot. That may sound appealing compared to a dividend yield of around 3.5% from the UK stock market, but remember that with an annuity, your capital is also effectively being paid back to you. By contrast you can take the income yield from the stock market while leaving your capital untouched, or indeed roll the dividends up for future growth.

UNDERSTANDING INFLATION RISK

It’s very important to take into account inflation risk with an annuity. An annual income of £7,200 might sound attractive now, but it will gradually lose its buying power. After 20 years of 2% inflation that £7,200 would effectively be worth just £4,800. It’s possible to buy an annuity which rises each year in line with inflation, but they start at a much lower level. Currently this would be around £4,500 for a 65-year-old. This is a significant drop, but if you’re concerned about the security of your income, then protecting it from inflation will also likely be high on your list of priorities. There are other protections you can build into an annuity, such as a spouse’s pension, or a guaranteed payment period, but again these will reduce the starting value.

You may be able to get a boost to the annuity as a result of health or lifestyle conditions, such as diabetes, elevated cholesterol levels, or being a smoker. Of course, the higher income the insurance company is willing to pay in these circumstances is based on a higher statistical likelihood of an early death, so even here it’s worth considering the total value of all the payments that might be made.

Annuities are unlikely to recover their former glory, mainly because they look so inflexible compared to the other options now on offer. But retiring pension savers should at least consider the pros and cons. It’s also worth remembering you can take out an annuity with some of your pension while keeping the rest invested. This mix and match approach might help you hit the perfect blend of security, flexibility, and growth.

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