The bond market has got a nasty case of the jitters, thanks in part to Donald Trump launching an attack on the independence of the US central bank. The waves of concern from this unprecedented political interference in monetary policy can also be felt on this side of the Atlantic, as the UK’s long-term borrowing costs reached their highest level since 1998.

A rise in borrowing costs isn’t good for companies or individuals looking to take on debt. Or indeed the chancellor, who is in a tight spot when it comes to balancing the public finances. But it is pretty good news for those who are thinking about drawing on their pension, because annuity rates go up when bond yields do.

WHAT IS AN ANNUITY?

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. They do this by investing in bonds; hence the fact gilt yields have a big impact on annuity rates.

A £100,000 pension pot will now buy a 65-year-old a level annuity of around £7,600 a year, according to MoneyHelper. That compares with somewhere in the region of £5,000 five years ago. So, things are definitely looking a lot better for annuity buyers than they did for a long time in the era of ultra-low interest rates.

Given the big jump in annuity rates, we might well see more people buying an annuity instead of the risker option of keeping their pension invested and drawing an income from it (commonly known as drawdown). Indeed, we’ve already seen evidence of this happening, and that’s probably going to be exacerbated by the chancellor’s introduction of inheritance tax on pensions.

WHY DRAWDOWN MAY REMAIN POPULAR

Annuities are undoubtedly a great option for those who want a secure income for life, taking minimum risk. But I suspect that keeping your money invested in a pension will remain the more popular option for pension savers for a number of reasons.

First, most people will already be on course to receive annuities, albeit in a different guise. Both the State Pension and Defined Benefit schemes (better known as final salary schemes) provide pension savers with a secure income for life, just like an annuity.  Buying an annuity with a pension pot effectively doubles up on this strategy which may be appropriate for some, but by no means all.

Second, annuities aren’t flexible. They pay out an income year in, year out, irrespective of whether you need it or not. For many people this won’t fit their retirement income needs. For example, they may be stepping back from work gradually or have especially high expenditure in the first few years of retirement as they travel and make the most of their free time. The inflexibility of annuity income also means pension savers can’t manage their tax liabilities easily if they have income from other sources. There may be years they wish to minimise pension income to avoid being pushed up into a higher tax bracket. They can do this with a drawdown plan, but not with an annuity.

INFLATION PROTECTION COMES AT A COST

Third, protecting an annuity from inflation comes at a hefty cost. Understandably so over such a long time frame. Whereas £100,000 would buy you a level income (staying the same every year) of around £7,600 a year, if you wanted the income to rise in line with inflation, that would fall to a starting income of about £5,000, again according to MoneyHelper.

Given you can get a 4% yield on an equity income fund while also retaining control of your capital, and some inflation protection from stock market growth over the long term, the pendulum looks like it’s swinging back towards a drawdown plan, though of course, remaining invested comes with its own risks attached.

Fourthly, and this is a big one, people really don’t like annuities. Perhaps this is because some don’t understand them. Others might underestimate their chances of living to a ripe old age and still getting payments from their annuity provider, even at age 100. But mostly I think, people don’t like the idea that if they get run over by a bus, their income stops and all those years of saving into a pension were for nothing. There are of course protections you can build into an annuity, such as a guarantee period or a spouse’s pension, but these also reduce the starting income you get and hence soften the dazzle of the high rates available on the market at the moment.

A MIX AND MATCH APPROACH

There was a time 90% of pension savers bought an annuity with their pension. But that’s because the rules around drawdown were extremely restrictive, rather than because annuities were perceived to be appealing. Those rules were washed away by George Osborne’s pension freedoms, and as a result, annuities aren’t likely to see such glory days again, even if rates stay high.

Nonetheless they are still an important option for savers to have at retirement. It’s also worth keeping in mind that you don’t have to choose an annuity or drawdown, you can use some of your pension for each. This mix and match approach means you can secure the income you absolutely need from an annuity and also keep some invested for growth in a drawdown which provides a more variable, flexible income. In a way, this is the best of both worlds.

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