Are annuities an attractive option in 2022?
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Annuities have been out of favour for some time as a retirement income option. Yet, with interest rates rising in 2022, many are noticing the higher incomes these products are offering. Are they now a better option for retirement planning? How do annuities now compare to other options like income drawdown? In this article, our Grantham financial planners explain how annuities work, how they are changing in 2022 and whether they now offer a more compelling deal for those in (and approaching) retirement.
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How annuities work
An annuity is a type of financial product offering you a guaranteed lifetime income in retirement. It is typically offered by insurance companies and can be purchased using pension savings (e.g. from your workplace and/or private pensions). Annuities come in different forms, including:
- Inflation-linked annuities. The income from these annuities rises each year in line with a measure of inflation (e.g. the Consumer Price Index). This helps to protect the “real value” of your income over time.
- Escalating annuities. Here, your income goes up each year at a fixed rate rather than following an inflation measure.
- Level annuities. This provides the same level of income throughout the product’s lifetime. Such products often offer a higher initial income compared to escalating annuities, but they are likely to lose value over time due to inflation.
- Short-term annuities. Sometimes called “fixed annuities”, these products provide income for a limited period. This can be a good option if you do not want to fully commit your pension savings to an annuity (e.g. if you believe rates might rise in the future and could buy a better one).
Why annuity incomes are rising in 2022
The UK’s central interest rate (the “base rate”), set by the Bank of England, has been at very low levels since the 2008-9 Financial Crisis. In 2020, when the pandemic hit the UK economy, rates were set to 0.10% (an historic low) to try and protect the housing market and facilitate government borrowing. In 2022, however, rates have been rising steadily to fight rising inflation. Now, they stand at 2.25%; still low in historic terms, but leading to a sharp rise in mortgages.
Interest rates also have a knock-on effect on annuities. The insurance companies which offer annuities tend to invest the pension money they receive into “lower risk” investments to make a profit (e.g. UK government bonds, or gilts). When interest rates rise, this leads new gilts to offer a higher yield to investors – ultimately, boosting these insurance companies’ profits. These can then be passed down to customers in the form of higher incomes from new annuity products on the marketplace. This is why, at the time of writing, many customers are rushing to buy annuity products whilst yields are still high (following investors’ nervousness about the September 2022 Mini-Budget) and before the market potentially calms following Prime Minister Sunak’s arrival to the post of Prime Minister.
How annuities compare to drawdown
Annuities differ from income drawdown by offering a specified income from a product. By contrast, income drawdown involves keeping your pension money invested whilst gradually taking what you need for your lifestyle. This latter option involves greater exposure to market risk (e.g. the value of your pension may fall during a stock market crash), but also usually offers pensioners a higher retirement income if they are happy to tolerate the risks and adjust their income if/when needed. Income drawdown is also highly flexible. You are free to buy an annuity later if you want to, and you can move your money into one or more funds for a greater investment choice.
Annuities, of course, offer more stability and certainty. For many people, these are worth the cost of a lower retirement income. In November 2022, annuity rates have certainly improved. For instance, a 65-year-old with £100,000 could buy a product offering £6,515 per year (the best rate in 10 years). 12 months ago, by contrast, the same pot of money would likely have attained an annuity offering closer to £4,077. However, before rushing to buy an annuity, speak with your financial planner. Remember, once you have bought an annuity you cannot change your mind if you later regret your decision.
You need to be certain it is the right fit for your financial plan and not simply rush to try and get a “good deal”. Consider, for instance, how you want your pensions to be treated after you die. Pension pots can be passed down to beneficiaries without inheritance tax. Whether or not your annuity continues to pay out (and how much) depends on the type of product and its terms and conditions. A joint-life annuity, for instance, will continue paying out to a surviving spouse.
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