The Annuity Renaissance

According to a recent FT article, “annuity sales soared to their highest level in a decade in 2024, as high rates and economic uncertainty drove people towards the products and their guaranteed income streams”. According to the Association of British Insurers, insurers sold £7 billion in annuities last year, up 34% from 2023.[1]

In this week's blog, I'll explore the driving forces behind this resurgence and consider some smart planning opportunities using annuities.

A Quick Refresher on Annuities

Annuities provide a guaranteed income for life, and are typically purchased using a lump-sum from your pension.

Here’s a simple example:

• James is 65 years old and has a pension worth £300,000
• He decides to take his 25% tax-free cash (£75,000)
• He uses the remaining £225,000 to buy an annuity, on a level basis and with a 50% spouse pension (more on this shortly)
• On current rates, this provides him with an income of approximately £15,000 a year, guaranteed for life (equivalent to a 6.7% rate)
• This income is taxable at his marginal rate of income tax.

Customisation

Annuities can customised in several ways to match your personal situation:

1. Level annuities: These give you more money to start with, but the amount stays the same forever. While this means more cash in your pocket initially, remember that inflation will gradually reduce its purchasing power over time.
2. Escalating annuities: These start with smaller payments but grow over time. You can choose either fixed increases (typically 3% or 5% each year), or inflation-linked increases that rise with the Retail Price Index. This option helps protect your income against rising prices, though you'll have less to spend in the early years.
3. Joint-life annuities: These continue paying income to your spouse or partner after you die. Typically, they'll receive about half of what you were getting. This option provides financial security for your loved one but reduces your initial payments.
4. Guaranteed period annuities: These ensure payments continue for a minimum period (often 10 years), even if you die sooner. This feature provides peace of mind that your annuity will pay out for a certain time regardless of what happens to you.

Each option involves trade-offs between higher initial income and added protection features, so it's important to think about what matters most for your retirement plans.

A pension is a long-term investment and funds are not normally accessible until 55 (rising to 57 from April 2028). When investing via a pension, your capital is at risk. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.

Why are Annuities Making a Comeback?

Annuities fell out of favour after the so-called 'pension freedoms' introduced in 2015, which gave retirees more flexibility in how they access their pension savings. This decline was compounded by near-zero interest rates, which directly fed through to lower annuity rates, making them appear poor value for money.

However, annuities are now seeing renewed interest for three key reasons:

1. Annuity Rates Have Improved

Rising interest rates have significantly boosted annuity rates. These rates are closely tied to government bond yields, which have increased substantially since central banks began hiking interest rates to combat inflation. As a result, annuity providers can now offer much more attractive income levels than they could just a few years ago.

2. Market Volatility

The sharp market swings we’ve experienced since 2020 have highlighted the vulnerability of drawing down from investments during periods of poor performance (known as ‘sequencing risk’ - see my previous blog on this [2]). This has renewed appreciation for the certainty that annuities provide.

3. New Pension Tax Rules from 2027

There's been a noticeable increase in annuity interest ahead of the upcoming pension rule changes in April 2027. Under these new rules, pension savings will be included in your estate for inheritance tax (IHT) purposes - a significant change from the current system where pensions sit outside your estate.

This creates the potential for a 'Double Death Tax' scenario:

• First, inheritance tax (40%) could be applied to the pension on death
• Then, when beneficiaries withdraw the inherited pension, they'll pay income tax at their marginal rate (potentially 20%, 40% or 45%)

This combination could result in an effective tax rate as high as 67% on inherited pension funds!

Given this tax landscape, many retirees are reconsidering how they use their pension savings. An annuity offers a straightforward solution - by converting pension savings into guaranteed lifetime income, you effectively spend down the pension during your lifetime, leaving less to be caught by the new IHT rules.

Smart Planning with Annuities

Here are some practical ways I’m helping clients use annuities in their retirement plans:

1. The ‘Income Floor’ Approach

Perhaps the most compelling strategy is to use annuities to create an ‘income floor’ - guaranteed monthly income that covers all your basic needs plus some extras, paid for as long as you live.

This follows a three-layered approach:

1. Essential spending (plus a little extra): Make sure your ‘must-have’ expenses are covered by guaranteed income sources (State Pensions, defined benefit pensions, and annuities). The key benefit is peace of mind that you’ll always have enough for your basic needs, regardless of how markets perform or how long you live.
2. Lifestyle spending: For the more aspirational spending goals, e.g. travel, we use flexible investments and pension drawdown. Since these expenses could be reduced in tough times, we can afford to take more investment risk with this money, potentially driving better returns over time.
3. Legacy assets: Any excess can be preserved for inheritance purposes.

Consider the following example:

• Ben and Ana are both 65 and have recently retired. They’ve assessed their retirement spending needs as follows:
  
  • Essential expenses (housing, utilities, food, healthcare): £2,500 a month
  • Lifestyle spending (eating out, hobbies and memberships): £1,500 a month
  • Aspirational spending (holidays & gifts): £20,000-40,000 a year
• They have combined pension pots worth £1 million, plus £500,000 in ISAs and other investments, and are both entitled to full State Pensions, providing £1,000 a month (each), from age 66
• They calculate their ‘income gap’ at £2,000 a month (essential plus lifestyle spending less State Pension income)
• To secure this, they decide to ‘crystallise’ £480,000 of their pension savings:
  
  • They draw £120,000 in tax-free cash and put these monies towards aspirational spending for the next few years,
  • And use the remaining £360,000 to buy an annuity that pays £2,000 a month / £24,000 a year (level, 50% spouse pension, 10-year guarantee period).

The result is that they now have guaranteed income of approximately £4,000 a month, covering all essential spending needs and some modest lifestyle costs. They retain £520,000 in their pensions, plus the £500,000 in ISAs and other investments, to fund more aspirational goals.

They’ve therefore eliminated the risk of not being able to afford their basic lifestyle and can adjust discretionary spending based on investment performance and life events.

Blending Level and Increasing Annuities

As a side note here, when thinking about annuities, you don’t have to choose just one type. Many retirees are now combining level and increasing annuities to get the best of both worlds - a strong initial income with some protection against the long-term impact of rising living costs (inflation).

Revisiting the previous example:

• Ben and Ana might opt to crystallise a slightly higher amount - £520,000:
• They draw £130,000 (25%) as tax-free cash
• They then split the remaining £390,000 into two parts:
  
  • £260,000 goes into a level annuity that pays a fixed £1,500 monthly (£18,000 yearly). This gives them a higher starting income (6.9% of their investment).
  • £130,000 goes into an inflation-linked annuity that starts at £500 monthly (£6,000 yearly) but will increase each year with inflation. This provides a lower initial return (4.6%) but grows over time.

This balanced strategy ensures some of your money maintains its value throughout your retirement years.

2. Phased Annuity Purchase

Rather than converting your entire pension to an annuity at once, consider buying annuities gradually over time. This approach offers several advantages:

• Better rates as you age: Annuity rates increase with age, so delaying some purchases can secure higher income
• Spreading interest rate risk: Buying in phases helps avoid locking in all your money at a potentially unfavorable time, for example, ahead of a rise in interest rates, which would feed through to higher annuity income
• Maintaining flexibility: Keeping some of your pension in drawdown preserves options for changing circumstances

3. Temporary Annuities for the ‘Retirement Gap’

For those retiring before State Pension age, temporary annuities can provide a bridge. These pay out for a fixed period rather than for life, typically until your State Pension starts.

For example, someone retiring at 62 could use a portion of their pension to buy a 5-year temporary annuity that ends when their State Pension begins at 67, helping to maintain a consistent income throughout.

4. Gifting out of Surplus (Annuity) Income

For those with sizable pension pots, particularly with the new pension rules coming in April 2027, there's a strategic opportunity worth exploring - using annuities to create "surplus income" that can be gifted tax-efficiently.

Creating a Gift-Ready Income Stream

The concept is simple: convert some of your pension savings into a guaranteed annuity income, then use this regular income for inheritance tax (IHT) planning. This approach becomes especially valuable once the new rules bring pensions into the scope of IHT.

There are two particularly effective ways to deploy this annuity income:

1. Direct Gifts to Loved Ones: Using your annuity income to make regular gifts to children, grandchildren or other loved ones can be completely exempt from inheritance tax under the 'Normal Expenditure out of Income' exemption (see previous blog on this [3])
2. Funding a Whole of Life Insurance Policy: Alternatively, you could use the annuity income to pay premiums on a whole of life insurance policy. This creates a tax-free lump sum payable to your beneficiaries or into a trust upon your death, which can then be used to settle some or all of your potential inheritance tax bill.

I'll be exploring these annuity-based IHT strategies in much greater detail in an upcoming blog.

Potential Downsides to Consider

Annuities aren't right for everyone. Key considerations include:

• Irreversibility: Once purchased, you generally cannot change your mind
• Inflation risk: Unless you choose an inflation-linked option, your purchasing power will erode over time
• Early death: If you die soon after purchase, the value may be poor (though guaranteed periods can mitigate this)
• Limited legacy: Unlike drawdown, most annuities offer limited inheritance options

If you'd like to explore whether an annuity might be appropriate for your retirement plan, please get in touch.

Happy Thursday!

Kind regards,
George

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