Is an annuity a good option? | Benefits vs Drawbacks

Is an annuity a good option?

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    A lifetime annuity is a retirement option that is often referred to as a ‘guaranteed income for life’. Essentially you ‘swap’ your Defined Contribution pension fund in return for a fixed monthly, quarterly or annual income.

    Whether an annuity is a good option depends on your goals, circumstances, risk tolerance and retirement plans. There are pros and cons, for example, annuities provide a reliable income stream but no flexibility or scope for investment growth.

    In this article, we’ll focus on the benefits and disadvantages of lifetime annuities and briefly touch on fixed-term annuities.

    Deciding on the right pension option for you can be complex and stressful. For professional pensions advice, get in contact the experts at Heritage Financial Planning.

    Benefits of pension annuities

    1. Low risk

    An annuity can be a good option for those who are uncomfortable with investment risk, as the income is guaranteed and paid for life. This is in contrast to drawdown, where the remaining pension fund is usually invested and, therefore, subject to risk and market volatility. There is a risk that if investment returns are lower than expected and/or you take too much income, you could run out of money.      

    Although stock markets have historically rewarded investors over the longer term, they can be very volatile in the short term. As you can see below, a portfolio with a 60:40* allocation has lost 20% or more 4 times since the millennium.

    portfolio with a 60:40 allocation

    Source: Portfolio Visualizer

    If you are uncomfortable with volatility and are likely to panic and sell your investments, this could have a catastrophic effect on your retirement plan. This is because by selling, you would crystalise what were only paper losses up until the point you sold your investments. 

    *60% invested in the US stock market, and 40% invested in the US bond market.

    2. Require no investment or pension knowledge

    Drawdown can be complex, and you are responsible for investment decisions and determining how much income you can take from your retirement savings.

    If you have little knowledge (or interest!) in investing, then a guaranteed income may be a good option for you. An annuity will simply pay you a guaranteed amount of income, just like a salary, with no other input required from you.

    This means you don’t have to worry about a whole raft of drawdown-related issues, such as your investment strategy, sequence of returns risk, determining a ‘safe’ withdrawal rate and worrying about having enough money to sustain you through retirement. 

    To illustrate the risks of drawdown, a study by the FCA in 2021 found that the average person in drawdown was withdrawing 8% of their pension a year! This is more than twice the amount of retirement income that is often considered a ‘Sustainable Withdrawal Rate’. If these figures are correct, then many retirees could run down their pensions very quickly and run out of money in retirement.

    You could have an independent financial adviser like us manage your pension on your behalf, but this would, of course, incur fees.     

    3. Annuity Rates have increased dramatically in recent years

    Annuity rates are intrinsically linked to gilt yields (UK government bonds) and interest rates. The annuity rate you receive is simply the annual annuity payment divided by the value of the pension used to purchase it. 

    UK interest rates from 2021 to November, 2023

    Interest rates were at rock bottom for much of the past decade following the banking crisis of 2007/2008, so the prevailing annuity rates were relatively low, as you can see in the chart below. 

    Interest rates increased dramatically post-COVID to combat soaring inflation, so the retirement income from annuities has increased substantially. This means that an annuity is currently a viable alternative to drawdown.

    annuity rates chart based on november 2023 figures


    What are the drawbacks of an annuity?

    1. Little to no flexibility

    One of the biggest disadvantages is that it’s usually not possible to change the income amount once the annuity is in payment.   

    This means it’s not possible to shape the income around your circumstances. People often prefer to take more income during their ‘active years’ whilst they have their health and will spend more on things like holidays, before reducing payments as they approach, what I like to call, ‘later retirement’.

    Also, people who retire before the state pension age (currently 66) may choose to withdraw more from their private pension and reduce it once the state pension kicks in. Unfortunately, an annuity doesn’t allow you to do this. 

    2. Less favourable death benefits

    In most annuity contracts, when you die, your annuity dies with you.

    Although it’s possible to add a survivor pension (which is usually a percentage of the annuity payment at the date of death, such as 50%), the initial annuity payment will usually be lower.

    In contrast to pension drawdown, with an annuity, your beneficiaries can usually inherit your remaining pension. If you die before age 75, your loved ones can potentially inherit the remaining pension tax-free. If you die after age 75, then the pension will be taxed at your beneficiary’s marginal rate of income tax.  If you have a family and wish to provide a legacy for your family after you have gone, this can have implications for you.

    3. Inflation Risk

    If you opt for an annuity that is ‘level in payment’ (i.e. where the annuity payment doesn’t increase), then inflation will erode the value of the income, and you will be comparably poorer.  

    It is possible to add protection by purchasing an ‘escalating’ annuity that increases with inflation or a set percentage. However, the starting income will be lower compared to an annuity that is level in payment.  

    4. Your pension won’t benefit from investment growth

    With an annuity, you essentially exchange your pension fund in return for a guaranteed retirement income from an insurance company. Therefore, you will no longer have a pension fund.

    With income drawdown, the remainder of the pension is usually invested, meaning it can potentially benefit from investment growth, which is not possible with an annuity. Death benefits from pension drawdown are also generally more favourable compared to an annuity.

    This can, however, be a double-edged sword. If investment returns are much worse than expected, with an annuity, you will not be affected.

    2. How much income can I get from an annuity?

    As we mentioned above, the prevailing interest rate can have a big impact on annuity rates and, in turn, the amount of income that you receive.

    It depends on the annuity that you choose from the outset. To illustrate how this can affect income, I will give two examples.

    Both examples are based on a £100,000 pension pot for a man aged 66 and in good health:

    • Annuity 1 – Single Life Annuity with Inflation Protection. 
    • Annuity 2 – Joint Life Annuity with a 50% survivor pension, which increases with inflation and has a 5-year guarantee.

    Looking at the table below, you can see how the extra ‘frills’ of joint life annuities and inflation protection can reduce the initial amount of retirement income.

    Type of AnnuityIncome PAAnnuity Rate
    Annuity 1- Single Life Annuity£4,543.324.54%
    Annuity 2- Joint Life Annuity£3,544.923.55%
    Source: Ires Exchange as of 12/12/2023

    A £100,000 pension could purchase an annuity income of £4,543 or £3,544 using the assumptions above. This is an annuity rate of 4.54% and 3.55%, respectively.   

    What affects the level of annuity income?

    The following factors can impact the level of annuity income:

    • Your retirement age -typically, the older you are, the higher income you can receive, as your life expectancy is shorter, so your pension funds don’t have to stretch as far.
    • Your health  – if you have any health concerns, you may be able to get an impaired annuity (or ‘enhanced’ annuity). Enhanced annuities offer a higher level of income to those with certain health conditions that may reduce life expectancy.
    • The value of your pension pot and retirement savings
    • Lifestyle – Your lifestyle choices and habits, such as smoking or high alcohol consumption, can impact annuity rates. Certain lifestyles may lead to a reduced life expectancy, influencing the level of annuity income.
    • Gender – Historically, gender has been a factor in annuity pricing, as women have a higher life expectancy than men.

    Do I have to take my tax-free lump sum before I buy an annuity?

    Typically, 25% of a defined contribution pension can be taken as a tax-free lump sum, although it can be more than this in rare circumstances. 

    There is no obligation to take your tax-free lump sum before you buy an annuity. However, most people take at least some of their tax-free cash before doing so. 

    If you do decide to take some or all of your retirement savings as a tax-free lump sum, then (all else being equal) it will reduce the amount available for annuity purchase, leading to a lower annuity income.

    How are annuities taxed?

    Annuity income payments are treated as taxable income.

    They are assessed along with any other taxable income you may have, such as your state pension, rental income and Defined Benefit pensions.

    If your income exceeds your personal allowance, which is £12,570 for the 2023/24 tax year, then you will pay income tax on the annuity payment:

    Band ThresholdTax Rate
    Personal AllowanceRemaining £12, 5700%
    Basic Rate Band£12, 571- £50, 27020%
    Higher Rate Band£50, 271- £125, 14040%
    Additional Rate BandOver £125, 14045%

    What is a fixed-term annuity?

    A fixed-term annuity is payable for a specific period of time, in contrast to a lifetime annuity that provides a guaranteed income for the rest of your life. Fixed-term annuities are often between 1 and 20 years.

    A fixed-term annuity can be useful if you are looking for a guaranteed income for a certain period of time, e.g. between retirement and state pension age.

    It’s possible to add a guaranteed maturity value at the end of the fixed term so that you be certain of your pension fund amount at the end of the term.

    Get annuities advice from the experts at Heritage Financial Planning

    It’s crucial to weigh the pros and cons of annuities in the context of your goals, risk tolerance, and personal circumstances. That’s why it’s important to seek financial advice from experts like Heritage Financial Planning.

    We can help you make informed decisions and determine the most suitable strategy for a comfortable retirement.

    Contact us today to enquire.

    The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. Past performance is not a reliable indicator of future performance and should not be relied upon.

    Annuity rates may change in the future, which could reduce the potential income. The figures in this article are based on various assumptions, which are impossible to control, such as life expectancy, growth rates and inflation. If the figures are much worse, this can affect the sustainability of your pension fund.

    Frequently asked questions about annuities

    What’s the difference between an immediate and deferred annuity?

    An immediate annuity provides income shortly after a lump sum investment, suitable for those nearing retirement. In contrast, a deferred annuity has an accumulation phase before income begins, offering flexibility on when payments start. Both serve distinct needs in retirement planning.

    What are the alternatives to an annuity?

    Alternatives to annuities for retirement include investing in a mutual fund or diversified portfolio of stocks and bonds, a withdrawal plan, considering guaranteed income solutions like bonds or certificates of deposit or exploring property investments. Each option has its risks and benefits, so it’s essential to seek advice from a financial professional to determine the most suitable strategy for your retirement.

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

    Contact Me Today

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