Using your pension pot to buy an annuity is one way of securing an income in retirement. And it’s becoming a more popular option thanks to improved annuity rates.

Retirement means different things to different people. It might begin at 55 and comprise foreign travel or expensive hobbies, or you might choose to keep working, leaving your pension invested. When you do eventually stop working, you’ll need a reliable income that will see you through your retirement years.

Annuity rates have jumped by 50% since 2022, which has prompted a 13% increase in sales

What is an annuity?

Annuities are insurance products that let you exchange your pension pot (minus your tax-free cash) for a guaranteed, regular income for the rest of your life or a set period of time. Buying an annuity used to be the only option available to most people taking their pension. But the introduction of so-called ‘pension freedoms’ in 2015 opened up more choice to consumers, thereby reducing their popularity.

However, in recent months the landscape has shifted again, and annuity rates have jumped by 50% since 2022. According to the Financial Conduct Authority, this has prompted a 13% increase in annuity sales, marking a 13-year high.

As well as improved rates, market volatility could also be a contributing factor to this renewed interest in annuities. After all, annuitants enjoy a guaranteed income – unlike pension drawdown.

If you’re considering whether an annuity is right for you, there are several important factors to take into account before making any decisions.

How are the rates calculated?

Annuity rates are calculated in a similar way to life insurance underwriting. The annuity provider will take into account factors like your age, health, lifestyle and where you live. They will also estimate the amount of time they will potentially need to pay you. If you’re retiring early and have a relatively long life expectancy, your annuity rate will be lower than that of someone retiring later with a shorter life expectancy.

Drawdown vs annuity

Another important decision is whether drawdown would be a better option for you, or perhaps a combination. Drawdown allows you to keep your pension savings invested and draw an income from them as and when you need it. This can be a more flexible option, as it allows you to adjust your income to suit your changing needs over time. However, it is subject to market volatility – and if the stock markets fall, so will the value of your investment and the income you get from it.

Your attitude to risk is also an important consideration when deciding whether to invest in a pension annuity. If you crave security and stability in your retirement income, an annuity may be the best option for you. However, if you’re comfortable, and can afford, to take more risk with your money, drawdown or other investment options may provide the potential for a higher return.

An annuity can provide the security of a guaranteed income for life. It can also help to mitigate the risk of outliving your savings, which can be a concern for many retirees. It may be worth considering a mix of the two, to benefit from the flexibility of drawdown while also having the security of an annuity.

It’s also important to note that when you buy an annuity, your pension savings will be used to provide an income for you for life, but your children won’t inherit any remaining capital when you die. This means that if estate planning is a priority for you, an annuity may not be the best option.

It's crucial to shop around and compare rates from different providers - you could boost your retirement income by up to 20%

Types of annuity

There are several different types of annuity to choose from, each with its own benefits and drawbacks:

Lifetime vs Fixed term annuities

  • Lifetime (permanent) annuities provide a fixed income for the rest of your life, regardless of how long you live. This type of annuity is suitable if you who want the security of a guaranteed income, but, depending on how long you live, you might receive less than you paid in. Plus your annuity will die with you, unless you choose to include an income or lump sum for a dependent.
  • Fixed-term (temporary) annuities provide an income for a set period of time. Unlike permanent annuities, the payout isn’t based on your life expectancy, but the length of the payout period. At the end of the term, you’ll receive a ‘maturity amount’, which will be the lump sum you bought the annuity for in the first place and the investment growth, less the amount you received in income.

Level vs Escalating income annuities

  • Level income annuities provide a fixed level of income each year. You’re likely to get a higher initial income than with an escalating annuity but, over time, even low-levels of inflation will diminish the value of your income.
  • Escalating income annuities are more expensive than a level income annuity, however, you will have more protection against the eroding effects of inflation. An escalating annuity will increase year-on-year in line with inflation, or a pre-agreed percentage, so your standard of living should remain the same.

It’s essential to carefully consider which type of annuity is right for you based on your individual circumstances and priorities.

For each type described above, you can also consider single or joint life annuities, depending on your circumstances.

Shop around and seek professional advice

Pension annuities can be a good option for those seeking security and stability in their retirement income. However, once you’ve bought an annuity, there’s no flexibility to change your mind.

It’s crucial to shop around and compare rates from different providers. Rates can differ dramatically, so it’s important to take the time to find the best option for you. A Which? report in 2019 found that shopping around could boost your retirement income by up to 20%.

Before you decide how to invest your pension pot, you should seek professional advice before making any commitments. Factors such as life expectancy, age, estate planning, attitude to risk, and the type of annuity that’s right for you all need to be taken into account. Your adviser will explain the pros and cons of different annuity options and help you find the best one for your retirement.

Get in touch

To speak to us about your retirement planning, or to arrange an appointment, call 0800 915 0000, or alternatively use our contact form here.