The Bank of England's decision to raise interest rates to 4% could lead to better annuity rates, but experts warn there is a catch that retirees need to consider.
Threadneedle Street announced the increase from 3.75% to 4% on Thursday, November 5 - the first rise since August 2023. The move came as the central bank sharply raised its inflation forecasts due to a recent jump in energy and fuel prices linked to the Iran war.
What the rate rise means for annuities
Annuities are financial products that can usually be bought with money from a pension pot. They provide a regular, guaranteed income when you retire, which can last for the rest of your life or for a fixed period.
The main drivers of the rates offered on annuities are interest rates and bond yields. When the Bank of England hikes interest rates, the returns on government bonds typically go up. This can allow annuity providers to offer better terms.
However, experts advise caution when deciding whether an annuity is the best option. Lily Megson-Harvey, policy director at My Pension Expert, said: "For people approaching retirement, the Bank of England's decision to raise interest rates to 4% presents both opportunities and challenges."
The inflation and tax pitfalls
Ms Megson-Harvey said higher interest rates may help support better annuity rates, which would be welcome news for those looking to secure a guaranteed income in retirement. She added: "But a better rate doesn't automatically mean annuities are the best route to retirement."
The policy chief explained that with inflation continuing to push up the cost of everyday essentials, people need to think about how far their money will stretch, not just today, but in 10 or 20 years' time. She said: "A guaranteed income can offer valuable peace of mind, but if it doesn't rise with inflation, it could buy less and less over time. That's why it's important to look beyond the headline rate and consider what different retirement income options actually mean for the years ahead."
Ms Megson-Harvey concluded there is no one-size-fits-all approach to retirement, which is why it is important for everyone to have access to clear information and affordable, regulated financial advice.
Tax impact and expert advice
Harvey Dhillon, chief executive of accountancy firm Zmartly, cautioned savers not to expect a jump in annuity rates from Thursday's rate rise, as they depend on longer-term interest rates which don't always move in step with the Bank of England's base rate. He added: "A better rate buys more income, but it doesn't automatically make an annuity the right route, because a lifetime annuity can't be undone once the window to cancel has passed."
Mr Dhillon explained that income from an annuity would also be taxed, usually via PAYE, on top of your State Pension. He said: "Someone whose only other income is the full new State Pension has used almost all of this year's £12,570 personal allowance, so a £5,000-a-year annuity leaves them about £4,000 after tax."
The current rate for the full New State Pension is £241.30 per week, which is equivalent to £12,547.60 per year. It will increase to £13,036 per year in April.
Mr Dhillon recommended booking a free Pension Wise appointment before deciding on the tax-free cash element before you buy, because up to 25% of the pot can usually come out tax-free. He advised savers to focus on comparing quotes on what will actually hit their bank account and not on the headline rate.
