Retirement Income Dilemma: Certainty vs Flexibility in Annuities

Alpesh Patel
Sep 30
5 min read

Working out whether an annuity is “worth it” involves comparing what you give up (the lump sum used to buy the annuity) with what you get back (the guaranteed income and/or death benefits). Here’s how to think about it:

1. Compare cost vs income stream

In the example, at age 62, someone in average health would need to pay around £463,225 to secure an income of £35,000 per year (with value protection).
That’s a payout of roughly 7.6% of the initial premium per year (£35,000 ÷ £463,225).
To judge if it’s “worth it”, ask: How long would I need to live to “break even”?
- £463,225 ÷ £35,000 ≈ 13.2 years.
- So if you live beyond age 75, you start to get more out than you put in.

2. Health status matters

The quotes show lower purchase costs for poor health (£432k) and higher for good health (£493k).
This reflects insurers’ assessment of life expectancy: they’ll charge more if they think you’ll live longer.
If you’re in poor health but live longer than expected, you “win” on the deal; if you’re in excellent health but die early, you “lose”.

3. Value protection vs no protection

With protection: if you die early, your estate gets some money back.
Without protection: higher income efficiency but nothing is left for heirs.
This boils down to personal preference: security for family vs maximum lifetime income.

4. Compare with drawdown/fund growth

If instead you invested £463k in a diversified portfolio and drew £35k per year:
- You’d need ~7.5% annual return just to preserve capital (not realistic without risk).
- At 4–5% withdrawals, you’d run out of money in ~15–20 years unless markets outperform.
The annuity removes investment risk and longevity risk: the insurer guarantees income no matter what markets or lifespan do.

5. Inflation

Is the £35,000 fixed or inflation-linked?
- Fixed income erodes in value over time: £35,000 today could feel like £20,000 in 20 years.
- Inflation-linked annuities cost more upfront but preserve purchasing power.

6. Tax treatment

Annuity income is taxable as ordinary income.
If bought inside a pension, it’s subject to your marginal income tax.
The breakeven calculation should therefore use after-tax income.

7. Peace of mind vs flexibility

An annuity is illiquid: once you hand over the lump sum, it’s gone.
In return, you get peace of mind: no market timing, no fear of outliving your money.
The question is whether the certainty is worth the opportunity cost of locking up capital.

✅ Rule of thumb:

If you’re risk-averse, in average/good health, and want certainty of income, an annuity can be valuable.
If you have other income streams (state pension, rental income) or want flexibility and potential inheritance, drawdown might suit better.
A hybrid approach often works: annuitise enough to cover core living costs, keep the rest invested for growth and legacy.

Image from https://pqt.annuityquote.standardlife.co.uk/Fidelity

Headline findings

Annuity “cash-on-cash” breakeven: £463,225 ÷ £35,000 ≈ 13.2 years. Live past ~75 (starting at 62) and you’re ahead in simple payback terms.
Drawdown preservation hurdle: With a 0.30% fee, you need a net return of roughly 7.6% just to replace the £35k you withdraw, i.e., to keep capital intact. That’s the same maths as the annuity’s payout rate. Sustaining that net return without big drawdowns is the hard part.
Longevity and sequence risk: The annuity removes both. Drawdown looks fine at higher returns in a spreadsheet; it looks less clever in a 2000/2001 or 2022 sequence. Guarantees cost money because they insure the exact risks investors fear most.

What it shows

At 0–2% gross, capital erodes quickly. You’re trading flexibility for a rising probability of running short of money in your late 70s/80s.
At 4% gross, you often still see eventual depletion – not great if you’re healthy.
At 6–8% gross, the pot can last decades, sometimes beyond 40 years, but that relies on sustained market performance and tolerating volatility. No free lunch.

How to decide

Cover essentials with certainty: If your core spending (net of State Pension and any DB income) is ~£35k, annuitising that floor is rational insurance against living a long time or bad markets.
Keep upside elsewhere: Put the remainder in a diversified, low-cost portfolio for growth, liquidity and legacy. That hybrid approach typically dominates “all-in” either way.
Inflation check: Your quote looks like a level annuity. At 2–3% inflation, £35k loses bite over time. If you can afford it, cost an RPI-linked version and compare. Index-linking lowers starting income but protects purchasing power.
After-tax reality: Compare on a net-of-tax basis: annuity income is taxable like pension drawdown. If you plan to straddle tax bands or use personal allowance/marriage allowance, model net cash flows.
Bequest preference: Value Protection returns money if you die early but reduces income efficiency. If leaving capital is important, tilt toward drawdown or a smaller, protected annuity.
Shop around and split: Open Market Option, impaired-life underwriting, and splitting purchases over time (rate-averaging) can materially improve value.

Sensible assumptions and sources

I’ve used a 0.30% all-in fee for drawdown to represent a low-cost, diversified portfolio (reasonable for broad index funds; see typical OCFs: Vanguard LifeStrategy/FTSE Global All Cap ranges). Vanguard fund OCFs: https://www.vanguardinvestor.co.uk/investments/ongoing-charges
UK life expectancy context for a 62-year-old helps frame longevity risk (ONS cohort life tables): https://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages/lifeexpectancies
Inflation erosion matters for fixed annuities; UK CPI data for context: https://www.ons.gov.uk/economy/inflationandpriceindices

What the numbers say

Annuity, after tax, real terms: If you’re a basic-rate payer, net income is £28,000 in year 1. With 2.5% CPI, that buys only ~£16–17k of today’s goods by year 30; by year 40 it’s closer to £13–14k in today’s money. Same erosion at 40% tax, just starting lower. That’s the cost of a level annuity. If you care about purchasing power, price an RPI-linked annuity; it will start much lower but won’t wither.
UK CPI context: https://www.ons.gov.uk/economy/inflationandpriceindices
Deterministic drawdown (no volatility, just to anchor intuition):
With a 0.30% fee and withdrawals indexed to CPI to keep £35k net in real terms:
- At 2% gross, capital depletes well before 30 years.
- At 4% gross, it often still depletes within the 40-year horizon.
- At 6% gross, it can survive 40 years in the spreadsheet – but that assumes no nasty markets. Fee baseline: typical low-cost broad index funds have OCFs around 0.06–0.25% (e.g., Vanguard ranges): https://www.vanguardinvestor.co.uk/investments/ongoing-charges
Monte Carlo (the real world, with bad sequences):
Using two brackets:
- Balanced: 5% expected return, 12% volatility
- Growth: 7% expected return, 18% volatility
  
  (Both net a 0.30% fee; withdrawals rise with 2.5% CPI to deliver £35k net, 20% and 40% tax cases.)

Conclusion

If you must maintain £35k net in real terms, markets need to play ball for decades. That’s asking a lot.
A level annuity gives certainty but inflation eats it.
The rational compromise is boring and effective: annuitise the floor (enough - perhaps inflation-linked - to cover essentials) and invest the remainder for growth, flexibility and legacy. That neutralises the two risks that ruin retirements: living longer than the spreadsheet and bad early markets.

Disclaimer: This article is for information and education only. It does not constitute financial advice or a personal recommendation. Annuity rates, drawdown outcomes and tax treatments depend on individual circumstances and may change in the future. Before making any retirement or investment decision, please seek regulated financial advice.

Alpesh Patel OBE www.campaignforamillion.com