The past 17 months of bank base rate rises may have played havoc with mortgages, but they have been very good news for retirees contemplating a move to greater financial security by using some or all their pension pot to buy an annuity, a guaranteed income for life.
That’s because as interest rates have climbed, they have taken the yield on government bonds, known as gilts - in which annuities invest – to a 14-year high.
To put that into perspective, a healthy 65-year-old with £100,000 of pension could buy an annual income of around £7,500 in September 2023, compared with just under £5,000 three years ago, according to data from broker Retirement Line.
Advisers report an increasing focus on annuities among older retirees who started their retirement by moving their pension into drawdown (where it remains invested in the markets) and taking an income from it, but now want to capitalise on better annuity rates for a reliable core income, at least.
But what about younger people, those approaching retirement age who are still working but tempted to use some of their pension to lock into current alluring headline annuity rates before they drop back to less attractive levels? Should they take the plunge – or are there good reasons to think twice?
Ruth Tilly (not her real name), a 63-year-old self-employed part-time remedial fitness trainer and personal friend of mine, is a prime example. She earns around £50,000 a year and has no debt, mortgage or dependents, so she really doesn’t need the extra annuity income at this stage.
But Tilly is clearly a canny investor, and after eyeing top annuity rates of around 7.5% she wondered whether it would make financial sense to withdraw perhaps £100,000 of tax-free income from her £700,000 pension pot and use it to buy a secure income for life that would cover core outgoings such as food and household bills.
Her thinking was that if she only withdrew tax-free cash from the pension, she would not trigger the money purchase annual allowance (MPAA). Triggering the MPAA would limit her annual pension contributions to £10,000 going forward, rather than the current maximum of £60,000. She would therefore be able to use the additional income to boost her pension contributions until she retired.
Needless to say, however, when it comes to pensions nothing is as simple as it seems. Tilly, recognising this, took the idea to a financial adviser, who pointed out a number of reasons why she should not put her plan into action at this stage.
For a start, the extra income on top of her existing earnings would likely tip her into a higher tax bracket and therefore immediately undermine the benefits of the high annuity rate.
Moreover, if she holds off on her annuity purchase until she is older, the rates on offer will automatically be higher anyway (because the number of years she can expect to live and receive payouts will have reduced).
A further consideration is that headline rates apply to ‘level’ annuities without any built-in protection against inflation. Inflation-linked rates are much lower: a healthy 65-year-old would currently receive only around £4,780 a year from a £100,000 annuity on this basis.
That may not matter if – as Tilly does – you have other sources of income, for instance from equity investments, rental property or a final salary pension, which are index-linked or have the potential to increase over time so that your real purchasing power is not eroded by inflation.
But if you don’t, index-linking is an important question to consider. That’s especially the case if you’re buying an annuity at a relatively young age and could therefore be looking at a ‘level’ income that will dwindle in real terms potentially over several decades.
Importantly, as Henrietta Grimston, an associate director in financial planning at Evelyn Partners, points out, the rules around annuities mean that if Tilly wants to use cash (including the tax-free element of her pension) rather than taxable pension for annuity purchase, she will have to buy a special type called a purchased life annuity (PLA).
With a PLA, as Grimston explains, “part of the income flow would be subject to income tax, thus increasing her tax liability, while the remainder would be counted as ‘return of capital’ and therefore tax-free.”
But although she would pay less tax with a PLA than on a conventional annuity, it doesn’t make good financial sense for her to use tax-free pension cash to produce a taxable income.
Nor could she recycle that extra income back into her pension. “The annuity income itself would not be considered relevant earnings for pension contributions, and so she would need to have sufficient earnings elsewhere to be able to contribute,” Grimston adds.
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A final consideration revolves around inheritance: unlike pensions and drawdown funds, annuity contracts cannot be passed on to the next generation and are effectively lost if the annuitant dies early (though joint annuities pay out until both spouses die). However, this is arguably less of a big deal for Tilly as she does not have children.
All in all, it’s really not a great idea for Tilly to buy an annuity income that she does not actually need yet, because any purchase would be likely to come back and bite her finances.
However, her adviser believes that interest rates are likely to remain around this level for the next year or so at least. He suggests instead that she should revisit her personal work situation in 12 to 24 months.
If she is ready to stop working by then, she could arrange an annuity that would pay out around £10,000 a year, as part of a £25,000 secure ‘core’ income also including her state pension and a small final salary pension. At current rates, the annuity income would cost around £135,000.
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Mark Ormston, director of propositions at Retirement Line, adds: “Based on the latest Bank of England projections, we may potentially see further base rate increases. If this materialises, we may see annuity rates increase further before potentially hitting their peak at some point in the next six months.”
But he stresses that trying to time an annuity purchase to catch the highest rates is likely to be a false economy. “It is always very tricky to predict the future; and it can take eight to 12 weeks to set an annuity up, so if people are happy with the annuity rate being presented, it could be a bit of a gamble to hold out for any further rate increases,” he says.
“In any case, it’s not all about the rate: several factors are making up the annuity rate on offer, including health and lifestyle information.”
The bottom line is that these days there are many ways to make the transition from earned income to pension income; annuities may play a role in that transition, but it makes a lot of sense to get some input from a specialist retirement expert who can take a holistic perspective on your situation.
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