Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Today it’s hard to find anyone outside the public sector who can still pay into a final salary pension. 

Try asking around your wider friend group. I’ve found one, and even he is being transferred from ‘defined benefit’ to the far more common ‘defined contribution’ pension.

Like the rest of us, he will now be required to pay money into a pot, along with employer contributions, and hope it grows to a size that will cover his full retirement. The final salary pension already accrued will make that significantly easier.

Final salary pensions were treasured for many reasons. Firstly, you knew the retirement salary you’d get, as the name suggests. Secondly, that income would rise with inflation.

Final salary ‘lite’

Imagine if such a pension product was available today, and available to all. Well, there is. But it’s not loved. In fact, it’s very much unloved. I am talking, of course, about annuities.

You hand over money to an insurance company and they will pay you an agreed income each month or year. On an annuity rate of 6.5%, you’d pay £100,000 and get £6,500 a year. You can add inflation protection, so the income rises with inflation. But it will start at a far lower level. Like a final salary pension, you know what you’ll get throughout retirement and you know that it will rise with inflation.

Yet the pariah status of annuities remains alive and well. It was hit home at a recent panel discussion where I was talking about early retirement. My fellow panellist delivered a brutal valedictory on the wrongs of annuities, met by many audience nods.

History explains why. Before 2015, most of us were compelled to buy an annuity with our pensions. Hence the celebrations when compulsion was removed for all, enabling us to go out and “buy Lamborghinis”, if we so wanted (a dry comment from the pensions minster at the time, Steve Webb). We didn’t and haven’t. But we had the choice.

Meanwhile, the anti-annuity sentiment gathered pace. Annuity rates, which were already low at the time, fell even further. This is because annuity pricing is led by the government’s cost of borrowing. As this fell throughout the 2010s so did the income that an annuity could buy.

The renaissance of annuities

But fast forward to today and much is changing. It began when the Liz Truss’s mini budget of 2022 sent government borrowing rates soaring, and therefore annuity rates. The purchasing power of £100,000 for a 65-year-old, without inflation protection, suddenly surged from an annual income of around £5,000 to around £7,500. Some shrewd buyers picked up a bargain, buying certain income that might exceed uncertain returns of the stock market - a rare opportunity.

Industry figures point to a renaissance in the popularity of annuities as rates have improved. Sales rose 39% in the last financial year, according to figures recently published by the Financial Conduct Authority.

Rates may be about to rise further due to moves in gilt pricing. The crucial 15-year gilt yield, which influences annuity pricing, has risen from a whisker above 4% three weeks ago to around 4.5%. The chart below shows the longer history of the 15-year gilt yield.

Annuities vs income drawdown

Perhaps the Autumn Budget will further steer the debate on the merits of annuities. An alternative to buying an annuity is to stay invested and take an income from your investments. This can be done via regular ‘drawdown’ income payments or though lump-sums.

If all goes well, you get a decent income without diminishing the pot and it can, on your death, be bequeathed to your beneficiaries free of inheritance tax. And by keeping the pot intact, not sold for an annuity, you can dip into it for emergencies, such as private healthcare, and so on.

But the inheritance exemption that exists on pensions is said to be one of the Treasury’s targets in the Autumn Budget. If pensions were moved into the inheritance tax net, it would remove one of the perks of staying invested, at least for the wealthiest investors. Bear in mind that only 4% of estates are liable to inheritance tax today. The figure is expected to rise sharply but would rise faster if pensions were caught in the net.

Such a move would face fierce opposition, so we’ll have to wait and see what Rachel Reeves does on 30 October.

Even if the change is made, income drawdown will maintain its primary appeal given the flexibility it offers. Annuities, however, may play a greater role in retirement plans with the ‘bit of both approach’ gaining in popularity.

The plethora of annuity options are not always understood. You can buy an annuity for a fixed period rather than for life, for example. You can also include an income for your spouse after your death. You also get a better income if you declare certain health issues. And buying later, perhaps in your 70s or 80s, will achieve a far higher income - a £100,000 inflation-linked annuity at age 65 buys £5,161 a year, or £7,595 at age 75, according to data from the retirement specialist HUB Financial Solutions.1

For some - particularly those who overly worry about investment ups and downs - a hybrid route may have appeal. You could, for example, cover all basic expenses with an annuity while keeping a chunk invested to pay for discretionary spending.

How I might play it

The choices are numerous and can be daunting. The help of a financial adviser is crucial.

One of the common pitfalls is being drawn to a headline rate, evidenced in the FCA’s data. It showed 80% of annuity sales were level policies. Buyers were opting for higher income today but leaving themselves vulnerable to future inflation, something an adviser might warn against.

I, for one, expect to keep most of my pension invested. I’ll aim to take a sustainable rate of income, hopefully no more than 4%, and will consider an inflation-linked annuity for later in retirement.

Such a plan looks very different to my friend’s simple final-salary retirement but I will have at least created my own degree of final salary-style security.

The government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Fidelity’s Retirement Service also has a team of specialists who can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

This article was originally published in This is Money

Source:

1 Hub Financial Solutions, October 2024

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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