Changes unveiled in the 2024 Budget could boost the appeal of annuities, but if you’re considering using some – or all – of your pension to buy a guaranteed income, make sure you weigh up the pros and cons carefully first.
The Chancellor Rachel Reeves announced on October 30 that from 2027, unused defined contribution pension funds and death benefits payable from a pension will fall into a person’s estate for inheritance tax (IHT) purposes for the first time.
The move means that children who inherit their parents’ drawdown pension savings could face paying “death tax” of nearly 70%. That’s because if their parents are aged over 75 when they die, beneficiaries will not only have to pay Inheritance Tax on the whole fund, but also income tax at their marginal rate on the remainder (which could be as high as 45% if they’re an additional rate taxpayer). Learn more about the Budget changes in our guides Budget 2024 pension changes and 5 ways to beat pension Inheritance Tax Budget changes.
These changes mean that people may be less likely to view their pension as an inheritance tax planning vehicle, and will instead be focusing on the best ways to take a retirement income, including taking the annuity route.
Here, we explain how annuities work, and what the alternatives are, to help you decide which might be the best option for you.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
What is an annuity and how does it work?
The amount of income you’ll get for your money will depend on several different factors. These include your age, whether you want the income you get to increase each year in line with living costs, your health, and whether you want the annuity to continue to pay out to your partner or spouse when you die.
The guaranteed income that annuities offer can provide valuable peace of mind that you’ll know exactly how much income is coming in each month, which can be really useful if you have fixed expenses you need to cover. However, one of the biggest downsides of annuities is that once you’ve bought one, your provider will usually keep your pension fund when you die rather than you being able to pass your savings on.
However, there are ways to ensure your loved ones end up with something. For example, if you take out a joint life annuity with someone else, this will ensure that your spouse, partner, or other named beneficiary will receive the income from it when you die.
You can also opt to purchase what’s known as value protection, which will ensure that your chosen beneficiary will receive up to 100% of your remaining pot as a lump sum should you die. Some providers will include value protection as standard for the first 90 days after you’ve purchased your annuity. You can find out more about how the different types of annuity work in our guide Annuities explained.
Gary Smith, Financial Planning Partner and retirement specialist at wealth management firm Evelyn Partners, said: “Attaching death benefits to annuities can be expensive. Headline annuity rates might be quite attractive but as soon as you start to add on desirable features like death benefits and inflation-protection, the incomes on offer for the same sum tend to plunge. You end up having to accept either a much lower income – certainly to start off with – or you spend a bigger chunk of your pot to get a higher income.”
What’s the alternative to an annuity?
Most people currently take an income from their pensions using pension drawdown – often known as flexible drawdown or flexi-access drawdown – because it provides them with greater flexibility than an annuity.
With drawdown, as the name suggests, you draw down money from your pension when required, and the rest of your pension stays invested, either with your current pension provider or another provider. When you die, under current rules, any money that’s left in your pension pot, can be passed on to your loved ones tax-free if you’re aged under 75 when you die. If you die aged over 75, your beneficiaries must have to pay income tax on any income taken from it.
This will change from 2027 when pensions will be brought into the scope of inheritance tax. Helen Morrissey, head of retirement analysis at Hargreaves Lansdown said: “We’ll see many more people being dragged into paying inheritance tax because their defined contribution pension is now counted as part of their estate. It will mean people who were planning to leave money in their pension to give tax-efficiently to family after their death will need to revisit their finances.
“The likelihood is we will see people looking to spend down their pensions as retirement income rather than leave them untouched, a move which could keep the rest of someone’s estate below the IHT threshold. They might choose to give some of this money away to their family to help them with life’s milestones. We may also see an increased interest in annuities as people look to secure a guaranteed income while also keeping their estate below the inheritance tax threshold.”
Why might annuities become more popular?
Drawdown has traditionally been far more popular than annuities, because it’s up to you how much and when you take money from your pension, and your pension can be passed on free of inheritance tax when you die. However, when this changes in April 2027, the decision whether to go for an annuity or drawdown may be less clear cut.
Mr Smith of Evelyn Partners, said: “Annuities have made a modest comeback since rates improved from the beginning of 2022, when interest rates and bond yields really started to rise. But many savers are still put off by annuities’ inflexibility, in that once one is purchased there is no going back. Also the IHT benefits of unspent pension funds have meant that many savers also did not see the point of spending their pot on an annuity that would die with them.
‘While the death benefits on offer with annuities currently seem poor value compared to leaving an unspent pot free of IHT, that balance might change slightly in 2027, especially for older retirees who tend to be less keen on drawdown and value a guaranteed income more. A pot can be kept in drawdown in early retirement and then spent on an annuity later on, either using all or part of the pension fund, and age 75 may well become an important tipping point, where remaining pots are swapped for annuities – particularly the annuity incomes on offer tend to get better as age increases.”
What are current annuity rates like?
Annuity rates are affected by various factors, including the yields on government bonds, known as gilts, and interest rates. As interest rates rise, annuity rates also usually increase, pushing up the amount of income received from these products in retirement.
According to analysis by Hargreaves Lansdown, at current annuity rates, a 65-year-old with a £100,000 pension can get up to £7,499 per year – that’s based on a single life, annuity guaranteed for five years, based on an average postcode, paid monthly in advance and with no increase. This is close to the all-time high of £7,586 seen after the mini-Budget in October 2022.
However, following November’s interest rate cut annuity rates are likely to ease. Nick Flynn, Retirement Income Director at Canada Life said: “The Bank of England’s decision to cut the base rate means that it’s unlikely that annuity rates will improve further, at least in the short term. However, while interest rates may have reached their peak, annuities are still offering great returns and offer that all-important guaranteed income for life.
“Whilst there’s no need to panic if you’re considering purchasing an annuity, it is worth getting organised. Remember purchasing an annuity is a one-off, so it’s critical you weigh up your options before making any decisions.”
If you’re not sure how Budget changes affect you, or whether you should re-consider your retirement planning strategy, you may want to seek professional advice.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
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