Thinking of purchasing an annuity ahead of retirement? Here’s what you should know

If you’re on the road to retirement, you might now be exploring your options with the aim of drawing a sustainable income that lasts a lifetime.

Although you have likely spent your career saving and investing diligently for the future, you may still worry about there being a shortfall in your retirement savings. In fact, nearly half of UK adults worry about outliving their money and facing financial hardship in later life, IFA Magazine reports.

If affordability and longevity are on your mind, you might have considered buying an annuity. An annuity is an agreement that provides a fixed income, which can be bought using some or all of your pension pot(s) when you reach pension age, which is 55 in the 2024/25 tax year. There are also Purchased Life Annuities, which are a form of fixed income you can purchase using other savings and investments, usually from the age of 35 or above.

In today’s unstable world, pension annuity sales went up by as much as 39% in the 2023/24 tax year, according to MoneyWeek, showing just how popular this form of retirement income can be. But this doesn’t mean that an annuity is necessarily the right choice for you and your family.

Here are some pros and cons of annuities and how we can help you decide the most appropriate vehicle for your retirement income.

Pro: Some annuities offer a fixed income for life

Some annuities, known as “lifetime annuities”, pay out a regular income that lasts your entire life. In certain cases, you could live into your 100s whilst still receiving exactly the same payments as you did in your 60s and 70s.

Whilst these annuities are normally slightly more expensive than fixed-term agreements, they could give you the ultimate peace of mind that your money won’t run out as you age.

Alternatively, fixed-term agreements give you a steady income up until a certain age, after which point you’ll need to use other savings and investments to cover your costs.

Pro: World events will not have an impact on your retirement income

When you reach retirement, you could choose to draw a flexible income from your private pension(s).

Whilst there’s nothing wrong with this route, remember that pensions are usually invested assets. World events, which affect share prices and can cause markets to fluctuate, will have a knock-on effect on the value of your investments. If there’s a downturn just before you take your pension benefits, you could end up being unable to draw as much as you wanted to, or depleting your funds faster than you intended.

Whereas, using some or all of these funds to purchase an annuity would remove this uncertainty. This form of stable income is set at the point of purchase, sometimes increasing year-on-year in line with inflation – but market volatility won’t affect how much you receive each year.

Pro: Contrary to popular belief, there’s a wide range of flexible annuity options

Whilst annuities are an irreversible purchase, there are several options available for retirees looking to enter a fixed-income agreement.

For example, you can:

• Decide how long you’d like your guaranteed income to last
• Work out how much of your pension wealth, savings, and other investments you would like to exchange for your annuities
• Explore annuities that rise in line with inflation, so the spending power of your income doesn’t decrease over time
• Consider whether a joint annuity with your partner, or a single annuity, is more appropriate for your needs
• Discuss your options with a Financial Planner.

There are certainly pros to annuities that are worth considering – but like all retirement income options, there are downsides to think about too.

Con: Falling interest rates could mean annuities are worth less

As of September 2024, the Office for National Statistics (ONS) reported that UK inflation had dropped to 1.7%, down from 2.2% in August.

As a result of falling inflation, the Bank of England (BoE) has begun to lower its base rate. Fixed at 5.25% between August 2023 and August 2024, the BoE dropped the rate to 5% in August, followed by another decrease to 4.75% in November.

However, the ONS reports that in October 2024, inflation rose again to 2.3%. This means that while interest rates have fallen recently, the BoE may not decrease the base rate again until inflation returns to its target rate of 2%.

Crucially, annuity rates are linked to interest rates. The higher the annuity rate at the point of purchase, the larger the sum you might receive as part of your guaranteed income.

As such, now that interest rates have dropped recently, it is likely that annuity rates could fall too, becoming less attractive to retirees in the coming year.

Con: Your beneficiaries might not inherit as much wealth

Some joint annuities enable your spouse or civil partner to continue receiving your payments, even if you pass away. However, using a large chunk of your retirement savings to purchase an annuity could leave your children and grandchildren with a smaller inheritance once you’re gone.

For instance, if the unthinkable happened and you passed away less than 10 years into retirement, your annuity payments may lapse altogether. This means that your pension wealth is essentially gone forever, irretrievable by your loved ones who could have benefited enormously from this wealth.

However, in light of recent Inheritance Tax (IHT) rule changes announced in the Budget, a non-inheritable annuity might help. In the Budget, the chancellor announced that from April 2027 onwards, pensions would form part of a person’s estate for IHT purposes – currently, they can be inherited IHT-free.

So, if you bought an annuity and payments lapsed after your death, this would reduce the value of your estate and potentially bring down your loved ones’ IHT bill. However, as you read above, it also means they’ll likely inherit less overall.

Con: Your pension won’t benefit from future investment returns

Whilst stability and peace of mind might be your priority, when you buy an annuity, you’ll lose out on potential gains that your pension could have seen if it remained invested.

There’s no crystal ball that tells us whether you would gain a better return on your investment by buying an annuity versus keeping your pension funds invested. So, discussing these options with your Financial Planner, who can use cashflow modelling software to help inform your choices, may be a wise move.

Get in touch to discuss retirement income options with an expert

There’s now a vast array of retirement income options at your fingertips. We can help you choose a tax-efficient route that gives you peace of mind and helps you plan a secure, comfortable retirement.

Talk to your existing Financial Planner today – or if you aren’t a client at PenLife, email us at enquiries@pen-life.co.uk or call 01904 661140 to start the conversation.

Please note

All information is correct at the time of writing and is subject to change in the future.

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate estate planning, cashflow planning, tax planning.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.

Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulation, which are subject to change in the future.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.