What is an annuity?

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When you retire and get your hands on your pension, it is difficult to know how to use your money. Here is how an annuity can turn your pension funds into a guaranteed income for life.
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Pensions are long term investments. You may get back less than you originally paid in because your capital is not guaranteed and charges may apply.

When you retire and get your hands on your pension savings, it is difficult to know how to get the most out of that money. Here is how using it to buy an annuity can turn your pension fund into a guaranteed income for life.

When you retire, you can choose to take up to 25% of your pension pot tax-free. You can then decide how to use the rest of the pot (which will be taxed as income) to fund your retirement. 

Make the most of your tax-free ISA.

What is an annuity?

An annuity is an insurance product you can buy with some or all of your pension pot. In return for this lump sum, the insurance company promises to pay you a guaranteed regular income for the rest of your life (or for a fixed term). 

While we can’t predict how long we will live, increasing life expectancy indicates that many of us will live well into our eighties and beyond. This is a long time for a pension pot to have to last, so having a guaranteed income from an annuity can provide peace of mind. 

You don’t have to use a pension fund to buy an annuity; you could use other money from an inheritance or property sale to buy a purchased life annuity instead.

When can you get an annuity?

When you turn 55, you can access your pension fund and buy an annuity (this minimum pension age is due to rise to 57 on 6 April 2028).

You can only buy an annuity once, so it is important to find the best possible rate.

How does it work?

As you near retirement age, your pension company will send you information regarding how much you have in your pension pot and the options available to access the money (such as annuities). 

If you choose to buy an annuity, you sell some or all of your pension fund to an insurance (annuity) company that offers you an annuity rate. For example:

  • You retire with a pension fund worth £100,000*

  • You decide to use some or all of the money to buy an annuity

  • An annuity company offers you an annuity rate of 3%. This means it will pay you an income worth 3% of your £100,000 each year

  • This gives you an annual income of £3,000 for life (3% of £100,000 = £3,000)

Of course, there can be large variations in the rates that different annuity companies offer, which can make a big difference in the income you receive. For this reason, it is important not to simply accept the rate offered by your pension company but to take some time to shop around and compare rates from other companies first.

*After tax deductions and 25% lump sum cash withdrawal.

How are annuity rates set?

Annuity companies set their rates by estimating how long they will need to pay you an income.

If you suffer from medical conditions, have worked in a job doing manual labour or have unhealthy habits such as smoking, you should declare them as you may be offered a better rate with an enhanced annuity.

What happens when you die?

When you die, there is no way for your estate to get the money you used to buy an annuity back. 

So if you bought a single life, lifetime annuity aged 65 for £100,000 and died within the first three years, you may have only received an income worth £9,000 (£3,000 a year), resulting in a loss of £91,000.

Conversely, live to be 100, and you could be quids in, having received £195,000 for your £100,000 pot.

With a single life annuity, when you die, the annuity payments stop, and your annuity is lost.

However, if you choose a joint-life annuity, it could go on to pay a percentage of that income to your spouse, civil partner or chosen beneficiary for the rest of their life after you die. It is also possible to take out a nominee annuity, which will pay a percentage to anyone nominated by you.

What types of annuities are available?

Lifetime annuity/Pension annuity

This type of annuity gives you a guaranteed income for life in exchange for your pension fund and does not require any form of reinvestment. It is also possible to buy a lifetime annuity that increases each year, which will protect you from inflation. But be warned, once you purchase a lifetime annuity, you can’t change your mind later.

Fixed-term annuity

This type of annuity will pay you a guaranteed income for a set period. This can be between 1 to 40 years, with 5-10 year terms being typical. The annuity provider invests the money you pay for the annuity and may pay you a “maturity” sum at the end of the term. This is what is left of your lump sum plus any investment growth it has made. However, as your money is invested, the value of your fund can go down as well as up.

Investment-linked annuity 

Investment-linked annuities typically invest your money in Unit Linked or With Profits investment funds. While investment-linked annuities are similar to lifetime annuities in that they promise to pay you an income for life, as your money has been invested, the income you receive each year is not guaranteed.

Purchased life annuity (PLA) 

This gives you an income for life, but you buy it with your own cash rather than your pension fund. Alternatively, you can use the 25% portion of your pension pot that you can take tax-free to buy one. This type of annuity also invests your money but is taxed differently to the other types of annuities as you only pay tax on the interest portion (not the capital) received.

You will also need to decide whether you want a single- or joint-life annuity, 

Speak to an independent financial adviser if you are unsure which type you should get.

What extras could you get?

In addition, some companies let you add features to your annuity, although they can lower the income you receive:

  • Guaranteed period: This protects your annuity for an agreed number of years. If you should die during this period, your annuity payments will continue to be paid to your spouse/ dependant until the term is up.

  • Value protection: This pays out a lump sum to a dependant outside of your estate if should you die within a set time after buying your annuity, such as 90 days.

Find out how to choose an annuity

You can find out more about annuities at the government’s MoneyHelper and Pension Wise websites.

Annuity FAQs

You can help ensure you have the retirement you want by finding the best personal pension plan to make your money work as hard as it can.