Are annuities a better deal in 2022?

In this article, we explain how annuities work, how they compare to other options (particularly income drawdown) in 2022 and ways that they can be integrated into a retirement plan.

Annuities - a type of financial product providing a stable retirement income - have been out of favour for some time now. In 2022, however, they surged in popularity, with incomes from new products soaring 44% in October (their highest rates since 2009). In this article, we explain how annuities work, how they compare to other options (particularly income drawdown) in 2022 and ways that they can be integrated into a retirement plan.

How do annuities work?

From the age of 55 (rising to 57 in 2028), a UK resident can typically start accessing his or her pension benefits from certain schemes. In particular, the funds in your pension “pots” (defined contribution pensions) could be used for different purposes. One option is to buy an annuity; a product providing a stable retirement income. Annuities are typically offered by insurance companies which pool pensioners’ money together to invest in “lower risk” assets, such as UK government bonds (gilts). The returns can then be used to fuel annuity incomes.

Annuities come in many varieties to try and suit a wide range of retirement goals and needs. A popular option is an “inflation-linked” annuity, which increases the product income each year in line with the cost of living (e.g. as defined by the Consumer Price Index). Alternatively, there is the “escalating” annuity which provides a rising annual income agreed on a set rate; or, a “level” annuity will provide the same income each year regardless of inflation. Some products can offer a higher income based on your health or life expectancy (“impaired” or “enhanced” annuities) and some will continue to provide an income to a surviving partner after your death (a “joint life” annuity). Finally, some annuities provide an indefinite lifetime income in retirement whilst others will pay out over a fixed period.

Why are annuities rising in popularity in 2022?

Insurance companies which offer annuities prefer to invest in “lower risk” assets like gilts (about 28% of UK debt is owned by UK insurance and pension funds). This means that annuities are, indirectly, influenced by interest rates. The higher interest rates are, the higher the interest rate offered by new bonds on the market. Insurance companies can then buy these investments and pass the higher returns down to customers via higher annuity rates (on new products).

Since the 2008 Financial Crisis, UK interest rates have been at historic lows (under 2%). This put downward pressure on the annuity market after 2015, when the Pension Freedoms allowed more people to use income drawdown with their pension funds. Now, in 2022, interest rates are going up as the Bank of England (BoE) battles surging UK inflation. Annuities are starting to get a “boost” from this turn of events. In October, a 65-year-old with a £100,000 pension pot could buy an annuity offering £7,191 per year - up from £4,989 twelve months ago.

Income drawdown vs. annuities in a retirement plan

One advantage that annuities have long had over income drawdown is the stability they offer in retirement. With income drawdown, your pension pot stays invested whilst you take an income to support your lifestyle. This means that the value of your pension can fluctuate as the market rises and falls. An annuity, however, provides the security and stability of regular payments over your retired life. Moreover, these payments can even rise over time if you choose a product that matches the cost of living (e.g. an inflation-linked annuity).

Annuities are certainly a better deal in 2022 compared to recent years. Yet are they now “worth it” compared to drawdown? Here, it is important to consider the wider picture of annuity rates. Whilst interest rates are now at 3% - the highest since 2008 (driving up annuity rates) - they are still low when viewed in light of the UK’s longer history. In November 2006, for instance, interest rates stood at 5% and in 1998 they even reached 7.50%. With UK inflation still high in 2022, it is difficult to say if annuities have “peaked”. Another factor to consider is average life expectancy. As this has gradually risen in the UK, it has driven down annuity rates as insurers must account for the risk that they must pay out incomes over longer periods. Whilst life expectancy did fall a small amount in 2020 (in England and Wales), it was up again the following year. Of course, it is certainly good news that people are living longer, but we must recognise it will likely continue for some time as a downward pressure force on annuities.

As things presently stand in 2022, better annuity rates mean that income drawdown is no longer the “go-to” choice for retirement planning. Indeed, for many people, a mixture of the two could be the ideal way forward. Here, annuities could help cover “essential costs” for households (with the help of State Pension income) whilst income drawdown could be used more for discretionary spending such as meals out, holidays and entertainment. The “break-even” point where you can potentially get back your pension from annuity income has fallen dramatically in the last nine months, from an average of 22 years to 15 years. As such, depending on your health and goals, buying an annuity could be a better option for many people.

The decision to buy an annuity is still a very personal one. Informing yourself about your options and then consulting with a financial planner can help you gain clarity about the best way forward for your specific goals and needs.

Get in touch with our financial planners for help with your tailored retirement plan, or visit Pension Potential to find out more about buying an annuity.