Should you buy an annuity with your pension?

An annuity provides one of the most secure forms of income in retirement. Unlike a portfolio of investments, this insurance product comes with no performance risk allowing you to exchange a lump sum for guaranteed income every year for the rest of your life. 

At today’s rates, a 65-year-old with £100,000 can buy an annuity paying £7,430 a year, according to stockbrokers Hargreaves Lansdown, meaning it would take just over 13 years to recoup the cost of the outlay. 

How much annuities pay is largely based on the yield on British government bonds, or “gilts”, which the insurance companies that sell annuities must hold. In the years after the financial crisis, low interest rates meant they offered terrible value for money. 

But with significantly higher rates in the past two years, annuities are steadily rising in popularity again. Last year, 72,200 people bought annuities, a 34pc increase from 2022, according to the Association of British Insurers. 

With total sales at £5.2bn, the highest annual value since 2014, Telegraph Money takes a look at whether you should consider joining the tens of thousands of other retirees buying an annuity and how to make sure you get the highest annuity possible. This article will look at:

• Why choose an annuity?
• What are the drawbacks of an annuity?
• How to get the best annuity rates
• How to boost your annuity income

Why choose an annuity?

Annuities provide clarity and simplicity. Rather than investing your money in a “drawdown” account and paying platform fees or potentially even a portfolio manager to best manage your pension, you have the peace of mind and ability to plan knowing exactly how much income you will receive each year. 

This shields you from market fluctuations and while you might always rue the fact you could have grown your savings further if you had chosen to invest in the stock market, you avoid any market downturn or the risk that comes with picking a bad investment. 

You also don’t have the stress of worrying about how long your pension pot needs to last depending on how long you live.

You can buy an annuity when you gain access to your pension savings – at the moment that’s 55, due to rise to 57 by 2028.

What are the drawbacks of an annuity?

Yet there are several clear drawbacks. 

Firstly, generally the income from an annuity dies with you (or a partner if you bought a “joint life” annuity). Money left invested in drawdown, on the other hand, is free of inheritance tax and can pass down the generations potentially free of income tax, too. 

Another one of the drawbacks of an annuity is how inflation can eat into your annual income. 

Take, for example, the best rate on the market at the moment for a 65-year-old with £100,000. If you bought it today, you would receive an annual income of £7,430 per year. You may not notice how the value changes in the first few years, but what happens if you live for another 25 or 30 years? What will £7,430 be worth in 2054? That’s a question which nobody can answer but if inflation rises, your income will fall in real terms.

As to whether an annuity is good value depends on the rate (how quickly you’ll recoup your £100,000 investment) and how long you expect to live (how much “profit” you might make). In our example you’ll have made the money back before you’re 79 so even if inflation has eroded some of the spending power of the annuity, from that point onwards, it’s all growth on your original investment.

While the vast majority of annuities are “flat” contracts called level annuities, if you are worried about the effect of inflation, you can purchase inflation-linked annuities. These contracts, which rise in line with cost of living, will start out paying a far lower income, so many people decide not to buy them.

Annuities appeal to those who are risk-averse and one of the greatest risks of parting with such a significant lump sum would be passing away within a short period of having bought the annuity. These days, many annuities come with guarantee periods so your family would continue to receive the income if you die within a predetermined period, usually five years. 

You could also opt for a joint annuity which covers both you and your partner. It will continue to pay the surviving partner the annual income until their death. 

How to get the best rates: shopping around could make you £15,000 richer

There are huge differences between the rates offered by different annuity providers.

At the moment, Scottish Widows is offering a 60-year-old spending £100,000 a rate of 6.61pc. While Canada Life, a rival provider, is only offering 5.87pc. This means a difference in income of £737 a year which, over 20 years, would leave you almost £15,000 worse off.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, a stockbroker, explains why you need to think about the impact of these rates over such a long period of time. 

“Shopping around the market is vital when looking for an annuity. Once bought, they can’t be unwound so you risk real long-term consequences to your finances if you just take the rate offered by your pension provider,” she said.

The older you are, the bigger the difference between providers. A 70-year-old buying a £100,000 annuity from Legal & General would currently receive an annual income of £8,166. It will therefore take them 12 years and three months to recoup the cost of the annuity. But, Canada Life pays £791 less at £7,375 annually. This difference means it will take an extra 18 months before they have recouped the £100,000 outlay.

How to boost your annuity income: be upfront with your health

To get the highest annuity possible you need to fully disclose your medical history. Analysis by Aviva found one in four customers under-disclose their medical history and a separate study found 60pc of annuity customers have a health condition which would pay them a higher income. 

Health conditions that limit your life expectancy will allow you to qualify for an enhanced or “impaired life” annuity. Often customers assume they aren’t able to qualify because they believe better rates are reserved for only the most severe health problems, such as cancer or for those who have had a heart attack. 

The truth is that far more common conditions such as diabetes, high cholesterol and high blood pressure can add hundreds of pounds to your annual income which can quickly total thousands over a typical retirement.

The same goes for if you do or have previously smoked or are overweight. Disclosing your medical history can feel invasive and something you would rather keep quiet but when it comes to annuities, it will change your lifestyle in retirement because it has such a direct impact on your income.

Research by Which? found enhanced annuities can add a further 30pc extra to your annual income.

The consumer group said the following conditions could make you eligible for a higher rate:

• asthma
• diabetes
• high blood pressure
• heart disease
• cancer
• kidney failure

A 65-year-old man who discloses he is diabetic, as opposed to offering no health details, can earn an extra £344 per year, according to Hargreaves Lansdown. This means they will receive an extra £6,880 over a 20-year retirement. 

If they had previously suffered a stroke and had not told their provider when buying the annuity, they would lose out on £1,211 in additional income each year.

Ms Morrissey said: “You might be hesitant to disclose health conditions or habits such as smoking but it’s vital that you include them in any application as there is the potential to boost your income by much more. 

“The annuity pays out an income over the course of your entire lifetime and if you have suffered ill health or smoke then this could impact your life expectancy and so the annuity pays a higher income.

“If you are a smoker you can boost your income by several hundred pounds over the course of a year and if you have conditions such as diabetes or if you have suffered a stroke then you can see your income rise by substantially more.”