Annuities are back in the news. Firstly, annuity costs have fallen substantially since 2021. Annuity prices are not driven by base interest rates as commonly misquoted but by long dated government bond yields such as a 20-year gilt.
Annuity payout rates and Gilt yields are highly correlated
As yields on UK gilts have risen from around 1% p.a. in 2021 to close to 5% p.a. today, the amount of level annuity income a 65-year-old can buy with £100,000 has also risen from around £4,800 p.a. in 2021 to around £7,200 p.a. today.
That’s a 50% increase. Pity anyone who bought an annuity in 2021. Simply by putting their pension fund on deposit for three years and deferring the annuity purchase, they could buy 50% more income for life today than three years ago.
Secondly, we have now had the first Labour budget in 14 years and with it the news that unused pension funds will be part of our estates for inheritance tax (IHT) from April 2027. The incentive to leave funds to the next generation in a pension account is significantly diminished, but of course an annuity makes sure this never happens.
Insurance companies selling annuities, annuity brokers, and some financial advisers have been quick to put the two things together and suggest the demand for annuities will continue to increase.
There is some evidence demand for annuities has already risen. According to statistics from the Financial Conduct Authority the number of annuity purchases jumped by 40% in the year 2023/24 compared to the previous year, standing at around 80,000.
So, should we all be buying annuities? My personal opinion is, in the majority of cases, no. And here’s why.
Annuities and lifespan
“But if you observe, people always live for ever when there is an annuity to be paid them.”
Jane Austen, Sense and Sensibility
Looking more closely at the investment return offered by an annuity, it’s clear they offer better returns if you live longer, as the annuity pays out more.
The Jane Austen quote was around someone paying an annuity to a ‘stout, healthy and hearty’ 40-year-old woman and speculating as to how long she might live. In 1800, the average life expectancy was just under 40!
Average life expectancy has more than doubled in the last 200 years, so how long do you have to live now to get good value out of an annuity, and what sort of return on your purchase capital can you expect? In short, the answers are ‘a long time’ and ‘not very much’.
These days no matter how long we live annuity returns are relatively low
The chart below shows the returns (as in total income received) from a range of annuities over different lifespans. The return is expressed as the annual percentage return ultimately earned on the income received, which can only be calculated after you have died. For comparison, these have been mapped against the current interest rate payable on a 20-year gilt.
We can see from this data that regardless of which type of annuity we buy, and at what age we buy it, the-long term return is much the same. As you reach around 86, the return lines begin to merge on top of one another. Actuaries who price these products are very good at creating a return profile for an annuity which does not leave the insurance company out of pocket.
Therefore, you will need to live beyond 95 to get a better return from an annuity than simply buying a gilt. Even then, it’s only going to get about 1% p.a. more than a gilt return. We often call gilts the “risk-free” return1, as returns on gilts are backed by UK taxpayers and are very secure. We can invest in them within our pension funds, or indeed invest into corporate bond funds which, managed well, offer similar but somewhat higher returns at very modest risk levels.
1 All investments carry an amount of risk. This nickname refers to the fact that, comparatively, gilts are very secure and carry a low amount of risk.
Annuities carry a risk of offering a very poor return
If we want to see how long we might live and the chances of living beyond age 95, the Office of National Statistics (ONS) provides a nice calculator, the output of which is shown below for a 60-year-old woman. Life expectancy for men is lower. For couples around the same age, it will be very similar to a woman’s.
An average life expectancy of 87 would give returns of 4.1% p.a. on a level annuity and 3.6% p.a. for an escalating annuity bought at age 60.
This data shows only a 1-in-4 chance of reaching 94 – the age you need to reach to get a return equivalent to the 20-year gilt yield. Analysing the data from the life expectancy chart and the table showing annuities vs 20-year gilt returns, we can see that there is also a 1-in-4 chance of getting absolutely no return from the annuity if you were to die in your early 80s, even though the insurance company would have enjoyed the use of your money for 15 years.
It shows, unsurprisingly, that no one is a big winner from annuities other than the insurance companies who sell them. Some unlucky families will be big losers, with family members dying early leaving a windfall to the annuity provider.
This may not concern you if you live alone and have no one else interested in the legacy value of your estate. But for families who want to collaborate to preserve and increase family wealth, an annuity purchase with your pension funds is still an expensive, poor value approach to generating income in retirement, despite recent price drops.
What about buying later in life?
Age 75 is currently the latest point at which you can buy an annuity with your pension fund; some commentators are suggesting this might be a good idea. By this age, you may have a better picture of your health, life expectancy, and later life expenses, which will allow you to better assess its overall value for you.
By contrast, the chart below shows how a drawdown account balance, starting at £100,000 value at age 75, would last over time if it paid out the same amount as a level annuity bought at the same age. We’ve mapped three different investment strategies onto it:
- Gilts, the very lowest risk option;
- Fixed income, where you invest in corporate bonds with a fixed level of income and maturities;
- Mixed Asset approach of fixed income and some equities, based on a cautious portfolio.
In each case, we have taken a conservative estimate at future returns after all fees.
These results show that, even with a low-risk approach to investing, using drawdown to match the income from a level annuity bought at age 75 should still result in a surplus of income beyond the age of 90. In the mixed asset approach, there is still surplus in your late 90s. In this sense, you could match the income you might access from an annuity and still have some left over to pass on or gift.
Note the ONS calculator for a 75-year-old woman still only shows a 1-in-4 chance of living to 94, and 1-in-10 of beyond 98, so the chances of doing very well out of an annuity are still quite slim.
Bearing in mind that these are ages where regular living costs might be significantly lower (care costs notwithstanding), I still don’t see much value in giving up
- access to your capital in your late 70s and 80s, and
- the ability to gift surplus funds tax efficiently to the next generation
just to be sure of some income you might not need just in case you make it to 95.
An annuity purchase at age 75 may make sense if your regular income needs seem like they will exceed your state pension income in later life, and if you have good genes when it comes to longevity… I don’t!
Annuities are inflexible
Another reason to think twice before buying an annuity to avoid inheritance tax is to consider what financial security needs we will have if we do end up living beyond average life expectancy.
According to the Pensions and Lifetime Savings Association couples living in the UK will need:
- £22,400 per year for a minimum retirement (roughly equal to two state pensions);
- £43,100 per year for a moderate retirement
- £59,000 per year for a comfortable retirement.
We’ve spoken to many clients with parents who are approaching or living beyond normal life expectancy. Anecdotally, it appears that their expenditures tend to tail down towards the minimum retirement income shown here as their lifestyles become less and less active. The point at which this happens will, of course, be different for everybody, and some will manage to stay very active into their 80s. But it appears to be a truism that as life goes on beyond age 90, ultimately living expenses do drop significantly. Therefore, many of our clients report elderly parents living in their 90s with more income than they need and with excess income rolling up in their bank accounts.
This said, there are still lumpy expenses needed to look after them: home maintenance, care costs, and medical costs being among the most common, often needing management from the next generation. What we see is that financial security in very late life comes from access to liquid capital sums, not from having regular income over and above the state pension.
Conclusions
The lack of upside return, high probability of very poor returns or even loss of capital, and the inflexibility of annuities are the reasons why I would personally never buy an annuity.
This view does not change with higher annuity rates, as these are equally matched by higher bond yields which we can harness in our drawdown accounts. The change to make pensions form part of our estates for IHT does not change my mind either; after all it’s better to leave a percentage of something than nothing at all!
For some, annuities may suit their needs. Buying an annuity at age 75 with some of your pension funds might make sense, but only if you have good longevity genes!
