Annuities versus gilts for retirement income – which is best?

The rise in interest rates, from 0.1% in 2021 to 5.25% today, means that bonds and annuities are relevant once again for savers looking to secure an income in retirement.

An annuity is a guaranteed income for life, with numerous options available that can link income to inflation, a guarantee if death occurs within a certain period, or pay for a care home. When interest rates rise, so do annuity rates. However, many add-ons reduce the value of the income paid.

In contrast, bonds are issued by companies and governments. They offer investors coupon payments paid twice a year, and the return of the bond’s face value when it matures, so long as the issuer has not fallen into financial difficulties.

A downside of annuities is that you generally don’t get a payout when you die, so the buyer may not be leaving much behind for family members, such as a spouse. Gilt investments meanwhile would stay part of an estate.

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So which is the best option for investors looking to secure an income stream in retirement? We look at the key opportunities and risks of annuities and bonds.

How much do annuities and bonds pay?

Annuity rates are typically greater than gilt yields, as investors pay a lump sum and generally do not receive their money back at the end of their annuity policy. Annuity rates are higher for older buyers and lower for younger buyers, as the length of the term will likely be longer.  

A standard single life, no-guarantee annuity rate for a 65-year old is now around 7.13%, or £7,130 a year per every £100,000 saved, according to Sharing Pensions, an annuity comparison site.  

This means that a £500,000 lump sum would deliver an income of £35,650 a year until death, with no link to inflation. Annuity rates will vary depending on the provider, the age of the customer, and changes in interest rates.  

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In contrast, a gilt maturing in 20 years – which would be a typical annuity length for someone retiring at 65 and living until 85, yields 4.5%. This means £500,000 invested in a bond issued by the UK government, trading at its par value, would deliver an equivalent income of £22,500 a year. But at the end of the 20-year term the owner would also receive their £500,000 back. The total profit delivered by the gilt would be £450,000 (£22,500 multiplied by 20).

On the other hand, the annuity would have paid out £713,000, but minus the £500,000 cost of the plan, this would only be a profit of £213,000 - that's an equivalent annual yield of about 2.15%.

Buying a gilt therefore could offer a substantially better return, with the advantage that it can be sold at any point in the term, which may be triggered by an early death. Annuities don’t come with the same advantage, and deliver a worse return for a typical life span.  

Sterling investment grade corporate bonds yield 5.5% on average. That's a £27,500 annual income – and your money back at the end of the term. However, buying corporate bonds directly is trickier for retail investors than buying gilts, and they come with more risk. 

Alice Guy, head of pensions and savings at interactive investor, says: “Annuities rates have risen steeply in the last few years, but they still remain unpopular because most pension savers choose flexibility over a guaranteed income.

“Those who do buy annuities often choose a level annuity, which doesn’t rise with inflation. You get a much better deal in the short term but will see your income eroded by inflation as you get older.”

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The simplicity premium

While the maths may not always make sense for buying an annuity compared with a gilt, Frazer Wilson, a senior wealth adviser at Canaccord Genuity Wealth Management, says you are paying for simplicity with an annuity, which will appeal to many approaching retirement.

“Once you buy annuity, the deal is done and you know what your income is going to be in retirement. It is much more simple than using bond or stock markets to fund a retirement. It removes any complexities of the bond market, such as what happens when interest rates change, or what happens when a bond matures,” he said.

He adds that while choosing the right annuity can be complex, as savers need to find a custom solution that fits their own needs, once the deal is struck then there is not much to worry about.

Annuities can be adjusted for various things, such as inflation linkage or a capital payout when the annuity ends if you choose a fixed-term annuity, but this reduces the rate on offer. On the other hand, if someone has health issues then they could get an “impaired life annuity”, which offers higher interest rates.

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A 3% escalation term is common. This adjusts the income upwards annually by 3% to counter the effects on inflation, but it reduces the rate given to savers. A 65-year old with a 3% escalation term would only get £5,196 per £100,000 saved.

On annuities generally not providing a payout upon death, Wilson says someone may not have any family members to leave money to. He adds: “Sometimes retirees don't have family members and just want to look after themselves.”

One way of looking at annuities is that they are a bet against the actuaries on how long you will live versus how long you are forecast to live. 

Taking a standard annuity with no capital payout on death, if someone lives five years when the annuity is priced for a typical life span of 20 years, then they are getting a poor deal. On the other hand, living longer than what an actuary expects means that you could be getting a better deal. Actuaries know that some people will live far longer and far shorter than the average, and price deals accordingly. However, the house generally wins, Wilson remarks.

Alice Guy, head of retirement and savings at interactive investor, says that the biggest benefit of annuities is to insure against longevity risk - the risk you live until 100 which means you need a huge pension pot.

“One option is to buy an annuity a lot later at say 80 when they're a lot cheaper, where rates currently exceed 9%.

"If we had a crystal ball then the decision about whether to buy an annuity would be easier. Live until you’re 100 and it could be a great deal but survive only 10 years and you’ll probably lose out, plus you’ll have nothing to pass on. The decision to buy an annuity is irreversible and the terms you choose at the outset are fixed for life. There’s no margin for error,” she said.

How to earn an income with gilts

For investors happy to manage their own money in retirement, bonds can be used to secure an income in a similar way to an annuity.

The gilt market is a good place to start, as the UK government has never defaulted on its debt. This makes it highly unlikely to ever do so, so investors can sleep well at night knowing that the government will honour its interest payments.

However, gilts come in many shapes and sizes, and investors must understand the mechanics of how they deliver a return.

Part of the return comes from the coupon of the bond, split into two payments a year. The income yield the bond offers is a calculation based on the price of the bond and its coupon. It is calculated by dividing the coupon by the price of the bond, and multiplying by 100.

For example a bond paying a £5 coupon costing £100 produces a yield of 5%, but if the bond were to trade at £50, the yield would have doubled to 10%.

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The other component of a gilt’s total return is the return of the £100 principal when it matures. If the bond trades at under £100, then this would lead to a positive contribution to the total return, but if it is bought at above £100 then it will have a negative impact.

Taken together, these produce the “yield-to-maturity” of a bond.

Understanding how and when a gilt will pay you is not always straightforward. The income yield paid by a gilt and its yield-to-maturity can vary significantly, such as if the gilt is trading at a large discount to its £100 par value. Gilt prices will also fluctuate, linked to factors like interest rates, economic growth and inflation.

This means that investors must understand how bonds work before using them to fund a retirement. On the other hand, buying an annuity takes out a lot of the complexity, which for some will be worth paying up for.

A list of gilts available on the ii platform can be found here.

Bond funds are a different proposition entirely. Because they are constantly buying and selling bonds, the portfolio never matures like an individual bond might. This means that movements in bond prices play an important role in total returns, and there is no way of guaranteeing an income by holding bonds to maturity.

Are gilts good value today?

There is currently an inversion in the yield curve, meaning that gilts maturing soon yield more than those maturing over some longer periods. This may not play into the hands of investors looking to lock in a long-term return from bonds.

However, the yield curve steepens for gilts maturing in more than 10 years, so investors looking past that term length see better value from yields.

Another consideration is what will happen to gilt yields. If they are set to fall, then while this will lead to an increase in prices, new investors looking for income from bonds will get a lower return. On the other hand, if yields rise, then there may be a case for waiting before buying a gilt as returns will be greater.

With the Bank of England expected to cut interest rates in August, this may signal a period of falling yields as interest rates fall.

Alexandra Ivanova, fixed income portfolio manager at Invesco, believes that the Bank of England will cut interest rates earlier than the market expects, and could even cut two three times this year. She says that the biggest risk to gilt markets is that inflation proves stickier than expected across the globe.

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Combine different strategies

Planning for retirement does not have to involve one binary decision. In fact, annuities can be successfully combined with other investments.

Wilson says that clients often use an annuity to cover their essential spending, alongside what they get from the state pension. Then they could use other assets, like stocks and bonds, to grow and protect a portfolio.

Gilts could be used extra income alongside an annuity. Guy says: “Fortunately, it doesn’t have to be all or nothing, so you can do a bit of both, getting a small annuity and investing the rest to get a better return.

“Or another option is to buy an annuity when you’re older as you get much more for your money. There are also other alternatives that offer more flexibility while still reducing your investing risk, like long-dated bonds and gilts.”