Why it's a good time to buy an annuity

After a few years of relative insignificance, annuities have come back to the fore in the past two years, as rates have become increasingly attractive. Rates remain relatively enticing at the start of 2024, but that could change over the next few months.

Annuity rates are closely tied to interest rates because providers invest the money in fixed-income securities. The chart below underlines this – the spike in late 2022 was just after Liz Truss’s mini Budget and the corresponding increase in gilt yields.

In February 2021, a 65-year-old in good health with £100,000 to spend could buy a single-life level annuity with a five-year guarantee that would pay an income of £4,626 a year, according to Hargreaves Lansdown data. Three years later, the amount has risen to £7,117. After softening towards the end of 2023, annuity rates increased slightly again at the beginning of February, following the Bank of England’s decision on 1 February to hold interest rates.

The past year has again underlined that forecasting the future path of interest rates is no easy task. But while it is hard to say when base rate cuts might actually begin, further hikes do not appear very likely. Accordingly, Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, says annuity rates look as though they have already peaked. “We’ve seen rates fall back from their post 'mini' Budget highs and recent months have seen them settle down. The decision to keep rates on pause will add to this calmer atmosphere... the prospect of rate cuts in the coming months could act as an incentive as falling rates could put pressure on the incomes providers can offer,” she argues.

Good value for money

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Keep in mind that interest rates won’t be the only thing influencing the cost of your annuity, with experts stressing the importance of shopping around and taking any health conditions you may have into account. Research from annuity broker Just Group found that as of August 2023, the gap between the best and worst-paying annuity available to a healthy 65-year-old with £50,000 to employ amounted to £400 of income per year, increasing to £500 for a 70-year-old and to a considerable £650 for a 75-year-old. Being a smoker or having certain health conditions, including common ones such as diabetes and high blood pressure, means you might qualify for an enhanced annuity and could be able to obtain a better rate than with a standard annuity.

Blended approach

While annuities offer a guaranteed income, their total returns ultimately depend on your life expectancy. But higher rates have reduced the risk of getting back less than you initially put in. In February 2021, a 65-year-old in good health who bought the highest-paying single-life annuity with a five-year guarantee for £100,000 would have had to live past 86 just to get the initial lump sum back in income. In February 2024, the break-even age was a more reasonable 79.

The chart below shows how a £100,000 pot could behave if you instead opted to keep it invested, drawing down the same £7,117 a year from the age of 65. The pot could feasibly still have £38,700 left at age 90, but to do this you’d have needed to achieve a steady return of 6 per cent a year – plausible, but not certain.  

If you do opt to annuitise you can also purchase value protection, so that the original cost of the annuity (minus the income already received) is paid out to your beneficiaries if you die before receiving it yourself. This comes at a cost. For example, Just Group says that as of 3 January, a 65-year-old using a £50,000 pension pot to buy an annuity would have to sacrifice £235-worth of annual income in exchange for full value protection.

Additionally, annuities offer no flexibility once you’ve purchased them. In contrast to investing, you can’t tweak your withdrawals depending on personal circumstances, market conditions or inflation, for example. And while inflation-linked annuities can be a great option to secure a fixed real-terms income through your lifetime, they remain unpopular because of their hefty cost. An investment portfolio with an allocation to equities will typically be better for inflation protection purposes.

By using part of your pot to buy an annuity and keeping the rest invested, you can combine the two approaches. Claire Trott, divisional director of retirement and holistic planning at St James's Place, considers it “a real positive” that interest rates have prompted more people to opt for a blended approach to retirement. For instance, you could use an annuity to cover your basic bills and draw down any additional expenses from your investments.

You can even think of the annuity as an almost risk-free alternative to the fixed income portion of your portfolio and invest the rest more aggressively. In a recent paper, behavioural finance firm Oxford Risk looks at the benefits of a blended approach, which can be financial as well as psychological. Guaranteeing a portion of your income in retirement will protect you from sequencing risk because you are less likely to need to withdraw money from your investments when markets are down; because you can take more risk with the rest of the portfolio, your final returns can end up being higher – although this ultimately still depends on your life expectancy.

The IC guide to pensions 2023