What is an annuity?

An annuity converts your savings or pension pot into a low risk guaranteed income for your retirement. See how annuities work, and if it could be right for you.

Published: 14 May 2024

Imagine your life in retirement, with free time to travel, pursue hobbies, or just relax doing what you love. A guaranteed income could help you focus on the things that truly bring you joy.

Read on to learn how an annuity could help turn your golden years into a haven of financial stability.

So, what is a pension annuity?

You can use your pension pot to purchase an annuity once you're 55 (this will rise to 57 from 2028 unless you have a protected pension age). If you suffer from a serious health condition, you may be eligible for an annuity earlier. Find out how changes to the normal minimum pension age affect you.

You can choose between a single life or a joint life annuity. A single annuity pays you for the rest of your life. A joint annuity pays you for life, and when you die it pays a chosen percentage of your income to your beneficiary. This is usually your spouse, but it could also be a dependent child under 23 years old. If you choose a joint life annuity, the income you receive will be lower than with a single life annuity.

In the first quarter of 2023, over 16,000 people bought annuities, spending £1.2 billion, the most since 2015. It could be due to rising interest rates and inflation, which can make annuities more appealing.

With this article, we'll delve into the annuity space and present you with a wealth of knowledge and viewpoints to help you decide whether an annuity fits into your retirement strategy.

What’s involved in the annuity buying process?

The foundation is built around an agreement between you and an annuity provider
You can buy one through your pension provider or shop around for a better annuity rate
In most cases, you can choose how frequently to receive your taxable income (monthly, quarterly or annually) and whether to be paid in advance (at the beginning of the payment period) or in arrears (at the end of the payment period). You can usually specify the regular payment date
Before purchasing an annuity, you can take up to 25% of your pension pot as a tax-free lump sum. However, this will reduce the amount available to buy your annuity and result in a smaller guaranteed income
For free and impartial help and support that’s backed by the UK Government, you can use Pension Wise

Looking at what each type of annuity offers can help you make a more informed decision about your retirement.

Lifetime annuity

This well-known type of annuity guarantees you a taxable income for the rest of your life. The annuity provider will calculate how much income they'll pay you (known as the annuity rate) based on factors such as your age, your health and your lifestyle. Annuity rates vary between providers, so shopping around could help you find a better deal.

The level of income you receive will also be affected by the options you choose, such as:

how frequently you’re paid
whether you’re paid in advance or in arrears
whether you choose a level income or one that can increase over time
if you want your annuity to pay out for a minimum number of years, even if you die before that time
if you want your annuity to pay an income to your dependents after you pass away

Pros

The income is guaranteed for the rest of your life, so:
- depending on how long you live, you may receive more money as income than you paid for the annuity
- knowing what you’ll receive and when could make retirement planning easier.

Cons

An annuity may provide poor value if you die in the early years and haven't arranged for it to be paid for a minimum length of time
Once an annuity is set up, it cannot be cashed in or changed in any way, even if your circumstances change.
Your annuity will be set up in line with the rates at the time, so you won't benefit from any future improvements in annuity rates.
If you choose a level income, inflation will reduce its spending power in the future.

To learn how our lifetime pension annuity can guarantee an income for life, there's plenty of information on our dedicated page.

For a simple way to get an idea of the income, you might receive from our pension annuity, try our annuity quick quote calculator.

Enhanced annuity

If you're considering a lifetime annuity, and have any health conditions or a lifestyle which could reduce your life expectancy, then you may be entitled to a higher income from an enhanced annuity.

There are over 1,000 different medical conditions and lifestyle choices that might make you eligible. For example, if you live with:

high blood pressure or cholesterol
cancer
heart disease
diabetes
asthma
kidney failure
are a heavy smoker or heavy drinker

Fixed term annuity

You're paid a regular taxable income for a certain length of time (usually five to ten years). At the end of the term, when all the income has been taken, any money left over (the maturity amount), which may include investment profit, can be taken as cash, moved to drawdown or used to buy another annuity.

Pros

You can reconsider how to use your remaining pension pot when the annuity ends.
You may qualify for a better rate if you buy a new annuity as you’ll be older and your circumstances may have changed.

Cons

Your income might be hit by inflation, and a low Bank of England base rate could damage your money’s purchasing power.
Falling annuity rates during the term could reduce your maturity payout.
The maturity value and the income are linked. So the more income you take, the lower the maturity value.
If you delay purchasing a lifetime annuity using a fixed-term annuity and annuity rates fall, the income from your lifetime annuity may not be as high as it would have been if you had purchased it right away.

Investment-linked annuity

This type of annuity provides you with a varying retirement income based on the performance of investments linked to the annuity. Good investment conditions may produce an increasing income, whilst poor investment returns are likely to have a negative effect on the level of future income.

Like other annuities, you can choose what happens to your money after you pass away.

Pros

Gives you a more flexible retirement income, as your can choose how much to receive from a set range. This can include how much you get when the annuity begins.
There’s potential to reduce how much income tax you pay. For example, to avoid paying higher rates of tax, you could reduce your income. You can also take unplanned income payments.

Cons

Regular financial management and advice are required, both of which can be expensive.
As your income is based on the performance of the underlying investment, you may lose out on income if these investments don't perform as well as expected. You may get back less than has been paid in.

What happens to your annuity when you die?

This really depends on your annuity type.

With a single life annuity some providers offer value protection which means you can guarantee an amount that you wish for the annuity to pay out (up to 100% of the purchase price). If you die before you receive this amount, a lump sum equal to the shortfall will be paid to your chosen beneficiaries.

A joint life annuity will continue to pay to the surviving partner, receiving either partial or full payments for the rest of their life.

Guarantee period

If the person who receives the annuity payment (the annuitant) dies before the end of a guaranteed period, the annuity will either

continue to pay an income to their estate
pay out a lump sum to the annuitant's estate

Learn more about what happens to your annuity after you die.

Non-pension annuities

Purchased life annuity

A tax-efficient way to top-up existing pension income using any cash outside of a pension pot. It could be from a property sale or inheritance.

It can run for a set period or for life, though your income will end when you die unless you choose a death benefit, such as passing it on to your spouse or other family.

Pros

Part of the income will usually be treated as a return of your money, so you won't pay tax on all of it.
You can purchase one at any age, whereas pension annuities have age restrictions.
You can buy it using funds from savings, inheritance, or tax-free cash from a maturing pension scheme.

Cons

Once it is set up, it cannot be cashed in or changed in any way, even if your circumstances change.

Options we offer to protect your annuity

Value protection

You can add value protection, which guarantees an amount that you wish for the annuity contract to pay out (up to 100% of the purchase price).

If you die before you’ve received this amount, we’ll pay a lump sum equalling the value to your chosen beneficiaries.

We’ve answered a few more frequently asked questions here.

Choosing how to fund your retirement is a big decision, so make sure you consider all the different options available to you. If you’re at all unsure of what will be best for you, we strongly recommend that you speak to a financial adviser. They may charge for their advice, but you will receive a recommendation based on your personal circumstances and you may be able to pay for advice directly from your pension pot. If you don't have an adviser, you can find one in your area using Unbiased.

Pension annuity calculator

Learn more about the sort of income you might receive from an annuity with our calculator. It's free, quick and easy-to-use.

Looking for a pension annuity?

Learn more about the sort of income you might receive from an annuity with our calculator. It's free, quick and easy-to-use.

Calculate your income

Get in touch

Have a chat with one of our annuity experts. They’ll answer all your questions and queries and help you find out how much your annuity income could be.

They’ll clear up any questions you have and talk you through what comes next.

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What is an annuity?

So, what is a pension annuity?