Pension annuities - 10th April 2025

Introduction

The purchase of an annuity has become less common, given the pension flexibilities first introduced on 6 April 2015. Although the number of annuities now purchased is now significantly less than prior to 6 April 2015, the average size of the annuity investment now is much higher.    

It remains the case that no other option at retirement offers a level of income that is guaranteed to be paid however long the individual lives for and thus, annuities still have their place. Indeed, they can be used as part of a holistic solution rather than a single solution, for example alongside drawdown to provide a certain level of income or used in later life when managing a drawdown is no longer viable. A fixed term annuity can also be used within the drawdown solution but is not covered here.

Here, we consider the advantages and disadvantages of the various lifetime annuity options.

Conventional Annuities

This is the tried and tested method of providing an income in retirement. After any pension commencement lump sum (PCLS) is taken, some or all of the balance of an individual's retirement fund can be used to purchase an annuity at the then available rates.

There are a number of factors which will affect the amount of an annuity an individual can secure with their retirement fund. These include:

(i) The type of annuity selected

There are many ways in which annuity income can be paid and choices will need to be made as to whether:

• The annuity should be in respect of the member only, or whether it should be set up on a joint life basis, so that an income continues to the member's spouse, civil partner, dependent or another individual in the event of the member's death. Naturally, where a joint life annuity is elected this will result in a lower income being provided for the member than if the annuity was payable in respect of their own life only.

• The annuity should be payable for the member's lifetime only or whether it should be guaranteed to be paid for a minimum period (e.g. five or ten years). Lifetime annuities purchased on or after 6 April 2015 can include a guarantee period of any length – the old ten-year maximum guarantee period no longer applies.

• The income should remain fixed in payment or whether it should increase each year by a fixed percentage or in line with changes in the Retail Prices Index.

If the member has elected a level, rather than an increasing income, the initial level of income will be greater. For example, if an individual in their early 60s were to elect a level income rather than an income increasing in line with inflation, their starting income could be 30-40% more than the inflation linked income.

Since 6 April 2015, lifetime annuity payments may also decrease. This could mean that an annuity can be tailored more closely to an individual's circumstances. For example, it could be paid at a higher initial level and then reduce at the individual's State Pension Age to take account of the individual's state pension benefits. Regulations specify what decreases are allowable:

• The annuity should be paid monthly, quarterly, half-yearly or yearly and whether the payments should be at the beginning or end of the chosen period.

If an individual chose to have the annuity paid monthly with the first payment being made immediately this would be less than where the payments were made annually with the first payment being delayed until 364 days after the purchase of the annuity.

(ii) Interest rates

The amount of annuity will be affected by the prevailing interest rate on long-term gilts, corporate bonds and returns on other assets used by annuity provider including commercial mortgages and infrastructure investments. The lower the rate of interest at the time of annuity purchase the lower the pension that can be secured.

(iii) Age of annuitant

The older an individual is when purchasing an annuity the higher the income they will receive, as the income will be paid for a shorter period.

(iv) Life expectancy of pensioners

If life expectancy of pensioners increases further, annuities will become more expensive.

(v) Personal circumstance

Since implementation of the Test-Achats European Court ruling on 21 December 2012, providers cannot differentiate between annuitants on the grounds of gender. However, other factors are increasingly taken into account in setting rates, with the most common being the postcode of the individual's home. Providers may also take into account things like occupation and whether the individual is a heavy smoker. The shorter the assessed life expectancy, the better the annuity rate available.

(vi) Health

Increasingly, providers take an individual's health into account in setting annuity rates, and this can lead to substantially enhanced rates. For example, the annuity comparison service on the Money Helper website now asks questions relating to weight, blood pressure and high cholesterol which can affect the annuities quoted. Those who have serious health issues, such as cancer, heart conditions and strokes, could get significantly enhanced rates if they are fully underwritten by a provider.

It is important to establish whether an individual qualifies for such enhanced annuity rates as these can often provide a significant increase in retirement income when compared with standard annuity rates.

(vii) Taking advantage of the open market option

A member of a defined contribution (DC) scheme has the right to select the provider of their lifetime annuity. This can be a very valuable option, and the ABI has previously estimated that by changing providers at this time, some members can enhance their annuity income by up to 30% - particularly when an annuity can be purchased in the wider market taking account of health conditions.

It is important to check the original pension provider's rate with the open-market rates. It is not always appropriate to switch if the original pension provider's rates are competitive, either generally or because of the operation of an annuity guarantee. In addition, account will need to be taken of any charges made by the scheme where an open-market annuity is undertaken.

Even when shopping around Annuity Ready data revealed in the summer of 2023 that there was a 9.1% difference in top and bottom annuity rates available on the market at that time. 

Advantages of a conventional annuity

The advantages of a conventional annuity include:

• A secure and certain income once the annuity has been purchased. The annuity is effectively an insurance against the annuitant living too long and running out of funds.
  

• Simplicity. Once the basis of the annuity has been selected the annuitant no longer has to make any further decisions about what to do with their retirement income.
  

• Mortality effect. If an annuitant is in good health and anticipates living longer than average for someone of their age they will benefit by purchasing an annuity.
  

• Suitability. Where the available annuity purchase price is very low, an annuity may be the only alternative to taking the whole fund as a lump sum at retirement.

Disadvantages of a conventional annuity

The disadvantages of a conventional annuity include:

• Inflexibility. Once the annuity has been secured its terms cannot subsequently be changed even if the annuitant's circumstances have.
  

• Unattractive death benefit. The death benefit is often considered unattractive where an annuitant dies shortly after an annuity has been purchased. This is, however, now less true for those who opt for annuity protection.
  

Investment Linked Annuities

Background

Investment-linked annuities grew in popularity in the late 1990s because, unlike conventional annuities, they were not affected by the substantial falls in long-term fixed interest rates. By 2000 they represented almost 20% of the annuity market in volume terms, but their popularity waned subsequently.

What is an investment-linked annuity?

An investment-linked annuity can be set up on a with-profits or unit-linked basis. In each case, the member's retirement income is linked to the value of the with-profits or unit-linked investment fund(s) in which the annuity is invested.

Because they can rise as well as fall, investment-linked annuities can only be set up as 'lifetime annuities' under the new pensions tax regime. They cannot be set up as a 'scheme pension' benefit because the legislation will not normally permit it to be reduced.

Investment-linked annuities share most of the characteristics of a conventional annuity. In particular the initial income level will still reflect the pensioner's expectation of life. The difference is that the guaranteed income of a conventional annuity is replaced by an income that varies according to the performance of the underlying funds in which it is invested.

With-profits annuity

The with-profits annuity is typically made up of two parts:

• a guaranteed minimum income;
  

• bonuses that are normally declared once or twice a year and added to the guaranteed minimum income.
  
  These bonuses often take two forms: a reversionary bonus that boosts the basic income level for future years and a one-off terminal bonus. Unlike other terminal bonuses, in this case, the terminal bonus is usually added each year. It will, however, represent a one-off payment and will not form part of the benefit on which future reversionary bonuses are made.

The starting level of income from a with-profits annuity is usually based on an assumed bonus rate, selected by the annuitant, of between 0% and 5%. Once this bonus rate has been selected it cannot normally be changed, although some providers are now prepared to allow this to be varied subsequently.

The higher the assumed level of bonus rate selected, the higher will be the starting income. The income in future years will depend upon the bonuses declared in those years. If the actual bonus declared exceeds the assumed rate, the income will rise, but if it is less than the assumed rate the income will fall.

Because of the fall in conventional annuity rates, it is now possible to get a starting income from a with-profit annuity that matches that of a conventional annuity. For example, to achieve a comparable initial income to that available from a level conventional annuity, an assumed bonus rate of around 3.5% would need to be selected by the with-profit annuitant.

The underlying with-profit fund's aim is to smooth investment returns by holding back money when investments perform well in order to pay out more than would otherwise be justified when investments perform badly. How the smoothing process operates in practice is not transparent and is generally at the discretion of the provider. 

Unit-linked annuity

A unit-linked annuity works in a very similar way to a with-profits annuity, except that the annuitant's starting income is based on an assumed rate of growth in the underlying unit- linked fund(s), rather than an assumed bonus rate. This generally makes a unit-linked annuity more transparent than a with-profits annuity.

The annuity income rises or falls in future years, depending on the actual performance of the unit-linked fund(s) in relation to the assumed rate of growth.

The income from a unit-linked annuity is likely to be more volatile than from a with-profits annuity because there is no smoothing, and usually no guaranteed minimum income.

Advantages of an investment-linked annuity

• Investment-linked annuities incorporate an allowance for mortality, just as with a conventional annuity, but unlike income withdrawal. This they can provide a degree of protection against an annuitant 'living too long'.

• The annuitant can continue to benefit from investments linked to real assets offering the prospect of a higher income if the underlying investments perform well.

 Disadvantages of an investment-linked annuity

• The income is not guaranteed, and might fall as well as rise, as it is dependent on the growth of the underlying investments when compared to the assumed growth rate.

• The available death benefits are no better than those in respect of a conventional annuity.

• Investment-linked annuities are still relatively inflexible compared to other retirement benefit options (e.g. income withdrawal), although providers are beginning to offer more flexibility.

• There is a relatively restricted choice of providers.

Annuity death benefits

There are three main types of death benefit that can be built into an annuity:

• Value protection, where on death an amount is paid out which is equal to the purchase price minus the total of any payment already made.

• Continuation of annuity for the balance of a guaranteed period. This could be five or ten years, but from 6 April 2015 there is no limit. If the total of future payments due is less than £30,000, they may be paid out as a lump sum.

• Payment of an annuity to a spouse, partner, dependent or anyone else chosen by the member. Before 6 April 2015 there had to be financial dependency or inter-dependency, but that is no longer the case.

As with other retirement options, any annuity death benefits first paid out on or after 6 April 2015 are free of income tax if the scheme member was under age 75 on death. This does not extend to spouse's/partner's/dependent's annuity already in payment before that date.

Similarly, if an individual in uncrystallised pension or drawdown dies and an annuity is purchased with the remaining pension fund on or after 6 April 2015, annuity payments will be free of income tax if the member was under age 75 at the date of death.

Where the member is over age 75 at the date of death, any annuity payments are subject to tax as income for the recipient.

Source: Technical connections 10.4.2025