Why annuities are popular again

As a result, annuity rates have been on the low side in recent years – comparatively speaking when looking back 25-30 years ago.

However, in the past 12 months the interest rate on gilts has been rising, resulting in higher annuity rates.

In late September and early October there were some particularly sharp increases.

There is more awareness needed of the flexibility of fixed-term annuities and the benefits of enhanced annuities.Lorna Shah, Legal & General Retail

This can, in part, be attributed to financial markets having less confidence that the government at the time could be relied on to pay back the money they borrow, says Mark Ormston, director of propositions and corporate partnerships at Retirement Line.

Annuity providers back the annuities they sell by buying long-term gilts. As long-term gilt yields increase, so too do annuity rates.

The concern surrounding the UK’s ability to repay its debts and ensure the recovery of the economy – worsened by the "mini" Budget – contributed heavily towards the rise.

Ormston says: “This is why a risk premium is sometimes built into these interest rates – an extra cost to the government when borrowing money for the fear that risk was being taken with the public finances.”

But when Jeremy Hunt was made chancellor, gilt rates started to fall slightly, which also happened when Rishi Sunak became the prime minister. 

Ormston says: “The markets took the view that the grown-ups were now in charge. However, even with this taken into account, gilts are still much higher than they were at the start of the year.”

It is difficult to predict exactly when annuity rates will peak.David Gibb, Quilter

Lorna Shah, managing director of retail retirement at Legal & General Retail, says: “Despite annuities becoming more popular, I do think there is more awareness needed of the flexibility of fixed-term annuities and the benefits of enhanced annuities.

"People are still surprised at the payments that can be gained from a wide range of medical conditions, for example diabetes, or just from lifestyle choices like smoking and drinking."

It is difficult to predict exactly how long gilts will remain at this level. 

Interest rates

However one gauge, Ormston notes, might be for as long as the Bank of England keeps interest rates high as they attempt to tackle inflation. 

He says: “With this in mind, we may well see annuity rates maintain at or near their current level for a while yet. As a result, we may see many retirees looking to lock in some secure income via an annuity while rates are high and annuity providers compete in a busy market.”

David Gibb, chartered financial planner at Quilter, says: “It is difficult to predict exactly when annuity rates will peak. While it is unlikely they will continue to rise by much more, there is still a possibility that they could depending on the BoE’s actions moving forward and, more importantly, how the markets react to the Autumn Statement.”

Bond yields have been behaving strangely this year, and that is largely due to uncertainty.Vince Smith-Hughes, M&G Wealth

Agreeing in part, Vince Smith-Hughes, director of specialist business development at M&G Wealth, says it is possible rates could go higher, but there are many moving parts to how they are calculated and this is not guaranteed. 

Smith-Hughes says: “Bond yields have been behaving strangely this year, and that is largely due to uncertainty. That uncertainty is not over.”

Given the big increase in annuity rates, an annuity as part of retirement strategy alongside drawdown is looking increasingly attractive. 

Regulatory focus

Meanwhile, the Financial Conduct Authority is also turning its focus to the decumulation part of the customer journey; looking more closely at retirement income strategies over the next few years to better understand the market and the decision-making process behind such strategies.

Cecilia Furner, interim distribution director – retail annuities at Legal & General, says the regulator has specifically expressed concerns about the role drawdown has played since the introduction of pensions freedoms as it continues to gather evidence of outcomes in this area.

She adds: "While the FCA has not reported evidence of specific harms, the sheer size of the market and the relative complexity of the decision-making process means the regulator is keen to understand more, given the potential for consumer harm.”

I suspect guaranteed income will play a central role in any retirement income strategy laid out.Mark Ormston, Retirement Line

According to Ormston, the introduction of investment pathways is a likely insight into the FCA's thinking.

The pathways in their current form are solving one particular issue – ensuring that putting all of one's funds into cash is an active decision – but they could also lay the foundations for a short to mid-term retirement income strategy.

He says: "The communications and regulations that the FCA have put in place for DB transfers show just how highly the regulator views guaranteed income. With this in mind, I suspect guaranteed income will play a central role in any retirement income strategy laid out."

But Ormston offers a word of caution, saying he hopes the regulator does not “fall into the trap of looking solely for best outcomes”, as these will likely only be achieved through regular engagement and potentially personal holistic financial advice. 

He adds: “Instead, I hope the focus is on protecting against harm, which can typically be achieved by combining a drawdown plan for investment exposure and flexibility, with an annuity to provide security and longevity protection.”

Andrew Tully, technical director at Canada Life, says as well as customer outcomes the FCA would also be looking at how clear client communications are, and making sure clients are given transparent information around the choices they have, the risks they face for each choice, and whether a combination of options may present the best outcome. 

That allows people to guarantee a certain level of income each month, alongside state pensions and perhaps a DB income. But alongside that the client can have a flexible pot that can be used for one-off expenses and to pass on to the next generation if not required. 

Leaving part of the pension invested can be a hedge against inflation – a personal inflation pot that will hopefully grow over time.Andrew Tully, Canada Life

Tully explains further that buying annuities in phases through retirement also avoids locking into an income today when potentially a higher income may be available over the next few months or years, as annuity rates can be volatile. 

He adds: “The large majority of people buying an annuity buy a level annuity where income doesn’t increase. But with inflation currently running at 10 per cent or so, that level of income is falling in real terms, so will buy less next year than now. 

“Leaving part of the pension invested can be a hedge against inflation – a personal inflation pot that will hopefully grow over time. Additional income can be taken from that pot to top up the annuity in future years, or an additional annuity can be bought.”

Gibb says the FCA could potentially also require advisers to consider annuities and hybrid options to a greater degree, as well as require them to more rigorously stress test market downturns and sequential loss.

According to Smith-Hughes, a key area the FCA is likely to concentrate on is whether advisers have been paying appropriate consideration to the key risks of drawdown, for example, longevity risk, inflation risk, sequencing of return risk and the risk of running out of money. 

To back up his point he points to the FCA finalised guidance on DB transfers (FG21/3) where there are a lot of themes that also apply to income drawdown.

Ima Jackson-Obot is deputy features editor of FTAdviser