- July 17, 2023
- Posted by: Rob
- Categories: Pension, Uncategorized
Higher interest rates may mean its time to take a second look at a guaranteed income in retirement.
Monday 17th July 2023 Author: Owen Foulkes
The significant rise in interest rates we have seen in the last 18 months is putting huge pressure on businesses and the mortgage market, but it’s an ill wind that blows no-one any good, and there are some people who will be quids in from the Bank of England tightening monetary policy. Cash savers are clear winners, but a less obvious beneficiary is anyone who is buying an annuity with their pension pot.
Annuities are a guaranteed income stream provided by insurers to savers in exchange for their pension pots.
WHAT DETERMINES HOW MUCH YOU GET FROM AN ANNUITY?
The rate you get is determined by bond yields, which in turn depend heavily on current interest rates. The rate you get is also determined by your age and health, but as an example, a 65-year-old can now get a £7,000 guaranteed income for life in exchange for a £100,000 pension pot. That compares to around £5,000 before the pandemic. When you consider this is paid as an annual income, that’s a considerable upswing in value.
Of course, because an annuity pays out each year until you die, the total income provided by an annuity is determined by one very big uncertainty- how long you live for.
Based on currently observed life expectancy, a 65-year-old man can on average expect to live until age 84 and a 65-year-old woman until age 86.
So, based on a £7,000 annual annuity income, that would add up to total payments of £133,000 for a man and £147,000 for a woman, in return for a £100,000 pension pot. That is of course on average, if you live longer, you will receive more, and conversely if you die younger, you will receive less.
One of the problems with accepting a guaranteed flat income for life is a beast we have all come to hear a lot more about in the last year or so: inflation. Even if inflation runs on target at 2% each year, after 20 years a £7,000 income stream will have the buying power of £4,700.
INFLATION PROTECTION AT A COST
If we get bouts of inflation like we’ve seen in the last year, it doesn’t take much imagination to figure out how that would impact a flat annual income. You can protect yourself from price rises by buying an annuity that rises in line with inflation, but the catch is this will start at a much lower level. For instance, our 65-year-old with a £100,000 pot could currently get an inflation-linked annuity starting at somewhere in the region of £4,500 per annum, so considerably lower.
There are other protections you can build into an annuity, such as a spouse’s pension after you die, or a guaranteed payment period, but again these will tend to reduce the rate you are offered. On the flip side, if you are a smoker or have any health issues, you might qualify for an enhanced annuity, which will boost the rate you receive.
However, that’s because on average these issues will mean you have a lower life expectancy, so the insurance company is banking on paying out for a shorter period.
Annuities offer a secure income which is guaranteed, but the long-standing problem has been that rates have been risible, because of loose monetary policy. But now all that has changed. In the first three months of the year there was a 22% increase in the number of people buying an annuity, according to the Association of British Insurers. Since the pension freedoms were introduced in 2015 though, only around 10% of retiring pension savers now buy an annuity.
That’s partly because of low rates, but also because annuities aren’t very flexible. Once you’ve bought them one there’s no going back, you can’t typically cash in and move your money elsewhere. You’re locked in for life, for better or worse. People also don’t tend to like the idea of gambling on their own life expectancy, seeing their pension savings disappear into the insurance company coffers if they get hit by a bus the day after buying an annuity.
THE MORE FLEXIBLE OPTION
Retirees can now instead keep their pension invested and draw it flexibly as cash, in tune with their needs and their tax situation. This is a riskier approach because the capital value of your investments, and the income they produce, can fall with the market. It can grow and offer some robust protection against inflation too.
But pension savers can tap into the best of both worlds if they want by buying an annuity to secure a certain level of income and investing the rest. This mix and match approach offers a balance of security and flexibility. Deciding how to draw your pension can be an intricate process, and there is usually a large sum riding on it, so if you’re in any doubt you should seek the services of a professional financial adviser.