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What is an annuity?

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Written by Dom James, Financial Content Writer

2 June 2020

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.

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.

What is it?

It is an income you buy with your pension fund when you retire.

If you do not want to use your 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 withdraw your pension fund and buy an annuity.

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

Your pension company may offer you an annuity rate, but do not settle for this until you have shopped around and compared rates from other companies first.

How does it work?

You sell your pension fund to an annuity company who offer you an income, for example:

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

  2. You use the money to buy an annuity

  3. An annuity company offers you an income worth 3% of your £100,000 each year

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

*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 or have bad habits such as smoking you could get a better rate with an enhanced annuity.

Annuity companies offer you a better income when they calculate your life expectancy to be lower than a healthy person.

This means you could get a higher rate because annuity companies take the risk that you will only need an income for a shorter time compared to a longer living healthy person.

What happens when you die?

When you die, there is no way to get the money you used to buy an annuity back. This could leave you short changed, for example:

If you buy an annuity for £100,000 and die 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.

What types of annuity could you choose?

  • Pension annuity gives you a guaranteed income for life in exchange for your pension fund, and does not require any form of reinvestment.

  • Purchased life annuity gives you an income for life with no risk, but you buy it with your own cash rather than your pension fund.

  • With profits pension annuity gives you an income but reinvests your pension fund, meaning it is not guaranteed for life as the value of your fund could go up or down.

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

What extras could you get?

Some annuity companies let you add features to your annuity, but they can lower the income you get:

  • Guaranteed period: This lets you pass your annuity income to a dependent when you die, up until the maximum term of your annuity.

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

Find out more information on annuities here

Annuity FAQs

No, you can only take the income offered to you by your annuity company, any other withdrawals are not allowed.

No, you are unable to add more money after you have bought your annuity.

Yes, but you could face large tax charges for doing so. Here is how these rules are changing in 2017 and what this could mean for your annuity.

Yes, all income you receive is subject to income tax at your normal rate. You can find out more information on income tax in our guide.

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.

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