Spiralling government borrowing costs are once again dominating the news agenda, with 10-year gilt yields hitting their highest level since the 2007/08 financial crash.
While a prolonged period of higher interest rates could be a disaster for people with mortgages linked to the Bank of England base rate, cash savers, people buying annuities and companies with defined benefit (DB) schemes should benefit.
Tom Selby, director of public policy at AJ Bell, said: “The recent spike in government borrowing costs is in danger of turning into a political disaster for Rachel Reeves, who will no doubt be sweating over the risk that any wiggle room in public finances could evaporate. Anyone borrowing money, particularly those looking to get on the housing ladder or with a mortgage that is pegged to the Bank of England base rate, will also be watching nervously.
“However, there will have been plenty of people cheering as gilt yields jumped to highs not seen since the 2007/08 financial crash. Returns on cash investments should be bolstered if gilt yields remain elevated, meaning people’s rainy-day savings should grow by more than previously expected. Companies administering defined benefit (DB) pension schemes could also see the value of their accounting liabilities substantially reduced, potentially swinging from a deficit to a surplus as a result.
“Annuities languished in the doldrums throughout the 2010s, in part because gilt yields – which largely determine the rates offered by insurers – remained persistently low. The flexibility available for drawdown investors has also proven hugely popular since the pension freedoms were introduced in 2015.
“However, rising gilt yields in 2022 – particularly following the Truss-Kwarteng mini-Budget – saw rates improve dramatically, and the recent gilt yield resurgence should also filter through to improved annuity returns. This means annuities are likely to come on the radar for millions of retirees who previously might have dismissed them as poor value.
“It’s important when considering the merits of annuities and drawdown to appreciate that they have very different strengths and weaknesses. This is not a binary choice, however, and it can make sense to combine an annuity, perhaps to cover your fixed costs, with the flexibility and growth potential of drawdown in retirement.”
Drawdown – strengths and weaknesses
“Drawdown offers you the flexibility to alter withdrawals to suit your needs, so if your circumstances change you can adjust. Your fund remaining invested also means you will have the opportunity to benefit from long-term growth.
“The death benefits rules for drawdown are extremely attractive. If you die before age 75, you can pass on any unused funds to your nominated beneficiaries tax free. If you die after 75, any inherited funds will be taxed in the same way as income when your beneficiaries make a withdrawal. However, from April 2027 the government plans to bring pensions into the scope of inheritance tax (IHT), a move which will substantially reduce the appeal of passing on pensions for those whose assets exceed the IHT nil-rate band.
“This choice and flexibility comes with responsibility. You will need to make sure you manage your withdrawals sustainably and be prepared to reduce withdrawals if your investments hit the skids.
“This means that you’ll need to take a hands-on approach and review your strategy regularly – at least once a year. You’ll also need to accept investment risk, which in turn means the value of your fund could go down as well as up, particularly over the short term.”
Annuities – what are the options?
“If you’re using some of your pot to buy an annuity, you should make sure you buy a product that meets your needs.
“The rates commonly quoted are often single-life, flat-rate annuities, meaning your income will die with you and you will be exposed to the ravages of inflation over time. However, there are various annuity add-ons which will reduce your starting rate but provide you and your loved ones with extra protection.”
Annuities – strengths and weaknesses
“Rising annuity rates of course makes them a more attractive proposition to retirees, but it’s important when making a choice to consider all relevant factors.
“The main strengths of annuities are the security of income they provide and the fact they do not require any engagement once you have selected a product that suits your needs.
“On the downside, annuities are inflexible and once you lock into an income, there is no going back. This means if your circumstances change – for example, you fall into ill-health and need to pay for care – your income will not be able to adjust. This also means you will forgo the possibility of benefiting from long-term investment growth.
“It is absolutely essential when buying an annuity that you disclose any health or lifestyle factors that might decrease your life expectancy, as this could mean you get a better rate. You should also shop around providers to maximise your retirement income.”
Five questions you should consider when choosing an annuity or drawdown (or a combination):
• How much do you value flexibility over security? Those who prefer flexibility and are comfortable with investment risk are more likely to value drawdown. Conversely, those who don’t want any risk and prefer security might opt for an annuity. This is a spectrum, however, and many will want a bit of both.
• Are you willing to engage or would you prefer to take a hands-off approach? For those willing and able to engage with their pension pot, drawdown could be suitable. If you want to take a completely hands-off approach, an annuity might be more appropriate.
• Could your income needs change in the future? If you’re expecting your income needs to fluctuate then drawdown might be attractive. However, if you expect your spending to be relatively predictable then an annuity might be the best fit. This is exactly where an annuity for fixed costs and drawdown for other spending could be a good approach.
• Are you in good health? Your health and lifestyle are key, both when annuitising and taking a flexible income through drawdown. If you have limited life expectancy then you might be able to get a better ‘enhanced’ annuity rate. Similarly, in drawdown, if you have a shorter life expectancy you might be comfortable withdrawing more. However, you still need to be confident your pension pot will survive as long as you do.
• What are your priorities on death? Lots of retirees want to leave money to loved ones after they die. If this is the case for you, it is currently possible to pass money on tax free to your nominated beneficiaries through drawdown – although this perk is set to end from April 2027. You can also pass money on using annuity add-ons (see above).
