What is a pension annuity and how does it work?

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What is a pension annuity?

An annuity is a way to receive income from your pension pot. Depending on the type of annuity you select, it guarantees that you will be paid a form of income for the rest of your life. Using the savings from your pension, an annuity converts your money into a regular, reliable income.

You can choose to receive an annuity income for a fixed period or the rest of your life once you retire and leave the world of work behind. There are a range of different options to explore, choosing a pension annuity is not a decision you can rush into. You'll need to consider whether a flat or escalating income would be better for your family over time; and if an 'enhanced' annuity might be available.

What is the difference between an annuity and a pension?

Annuities and pensions offer a form of income for pension holders. However, an annuity ensures a regular income for you when you retire. An annuity is considered an insurance contract, whereas a pension plan is a savings and investments product.

How does an annuity work?

An annuity offers a helping hand by regulating your savings and stopping you from running out of money. Rather than withdrawing all your cash in one go when you retire, these products allow you to convert your pension savings into guaranteed income. Think of it as being paid a salary while you're retired.

An annuity can be purchased by anyone over the age of 55 (unless you have a protected pension age) with at least £5,000 saved in a pension pot. Even if you’re not quite ready to purchase one, or are planning for the future, it’s important to know how an annuity could give you peace of mind and financial security during your retirement.

Annuities are generally designed for savers with defined contribution (DC) pension plans. Any money you save in a DC scheme is invested in things like stocks and bonds. It means the returns you make are based on investment performance, as well as the amount you put in during your working life.

Try our pension annuity calculator

Find out how much guaranteed income you could receive for the rest of your life using our quick pension annuity calculator.

All you need to do is enter a few simple details to estimate your potential annuity income and help you make a confident choice about your financial future.

What is an Annuity?
	An annuity offers pension holders a way to receive an income from their pension pot.
The Steps to Purchasing an Annuity
	1. Speak to a retirement specialist Based on a few questions, your retirement specialist can determine the right annuity product to meet your needs.
2. Make future plans for your annuity Create some financial security for your loved ones too through joint life annuities and value protection.
	3. Purchase the right annuity for you Your retirement specialist will help arrange the best annuity product for you. You’ll then transfer your pension funds to the provider who turns it into regular income.
4. Start receiving your income Once you’ve purchased your annuity, your regular payments will start. You can take up to 25% tax-free.
	5. Enjoy regular payments You’ll now enjoy a guaranteed income for as long as your annuity allows. Any regular payments will now be taxed as income.

1. Seek guidance or financial advice

Preparing for the future is important and so is understanding your pension. Based on a few questions, a retirement specialist or financial adviser can support you with selecting the right annuity product. Our annuity calculator is a sensible first step and can provide a rough idea of how much income you could get from your pension pot.

2. Make future plans for your annuity

Ensuring your family is looked after is important. That’s why your annuity can continue to support your loved ones after you’re gone. With value protection, guarantee periods and joint life annuities available, your estate can be transferred to a beneficiary if you pass away.

3. Purchase the right annuity

The best annuity product and rates will depend on your circumstances, including your pension savings and lifestyle choices. That’s why it’s important that your annuity works for you. When you speak to a retirement specialist or financial adviser, they’ll be able to find the right product to match your needs. They’ll shop around the market and find the best annuity deal, meaning you can sit back and relax as it’s all taken care of for you.

4. Start receiving your income

Just like a salary, you’ll receive regular income from your annuity pension. Before buying your annuity, you can take up to 25% of your pension as tax-free cash. Your circumstances will also determine the rate and amount you receive. For example, taking out an annuity later in life can offer a higher income.

5. Enjoy regular payments

Once you’ve accepted 25% tax-free cash, any payments after this will be taxed as income. You can now enjoy regular payments for as long as your annuity allows, or until you pass away.

What are the benefits of a pension annuity?

If you’re wondering how an annuity works, you may also be seeking guidance on the benefits of a pension annuity.

If you're aged 55 or over (rising to 57 from 6 April 2028 unless you have a protected pension age), you can use some – or all – of your pension to purchase an annuity. The benefits of a pension annuity include:

Flexible payment options

You can decide how you’d like to receive your annuity income. This could be a fixed income for the rest of your life, payments that increase at a fixed annual rate, or payments that rise in line with inflation (Retail Price Index).

Protect your family and loved ones

Annuities can be used to provide a partner, child under 23, or other financial dependents with a regular income. They could also receive up to 100% of your guaranteed income if you pass away. 

Set your annuity income terms

You get to choose the length of time you’d like your annuity to run for a minimum of between 1 and 30 years, even if you die early. You may benefit from 90 days of value protection from the start of your plan, although this can differ depending on the provider. If your provider does offer this and you pass away within this period, you’ll receive a lump-sum payout if no annuity payments are continuing to a dependent.

It’s important to remember that your options affect the income you receive. Once your annuity plan has been set up, you won’t be able to make changes or cash it in.

If you’re unsure what annuity options are best for your circumstances, speak to a qualified pensions and retirement adviser. 

What are the different types of annuities?

As everyone’s circumstances are different, a one-size-fits-all annuity is simply not possible. Instead, you can have more control over the type of annuity you need and can determine when your payments will stop. The different types of annuities include:

Lifetime annuity

Selecting a lifetime annuity will pay out a guaranteed income for the rest of your life. It’s normally a viable option for someone who prefers minimal risks with their investments. As a product, it always ensures money will be paid out, so you’ll never be without it. You have the option to take up to 25% of your pension as a tax-free sum when you’re first eligible to claim.

Enhanced or impaired life annuity

Enhanced annuities are available for those who have been diagnosed with a serious or life-limiting illness. If you’re in poorer health, you could receive a higher annuity rate compared to someone on a standard lifetime annuity.

Joint life annuity

Your annuity pays you a fixed income for the rest of your life. Why not ensure some financial security for a beneficiary too? The regular payments you receive from a joint life annuity, or a set percentage of them, are passed on to your chosen beneficiary after you die.

Fixed term annuities

A fixed-term annuity provides guaranteed payments for a set period of time. This can be anything between one and 40 years. You’ll have the option to add death benefits and also be able to keep any remaining pension invested, allowing it to keep growing. Of course, there’s always a risk that any investment rates could fall, meaning your money is worth less. In addition to a guaranteed retirement income, you’ll also receive a lump sum at the end of the agreed term, also known as a ‘maturity amount’. You’ll agree on the value of this when you take out the fixed-term annuity and you can use the lump sum anyway you choose at the end of the fixed term.

Investment-linked annuities

As long as you are educated on the potential risks, an investment-linked annuity could offer a greater return on investment. This one is a little trickier to predict as your rate and income will be determined by how the stocks and shares market is performing.

Please note, LV= do not offer this type of annuity.

What should you consider when purchasing an annuity?

The type of annuity you’re after will depend on several factors. For example, if you purchase a lifetime annuity at 57, you’re likely to receive a lower income than someone who buys it at 71. That’s because providers are likely to make fewer payments. When you discuss the prospect of an annuity, you’ll also need to disclose:

• Your age.
• Your postcode.
• Amount you wish to deposit.
• Length of time you want to receive payments for.
• Any medical conditions.
• Additional options, such as joint annuities.
• How much of your pension pot you want to use to buy an annuity, known as the annuity purchase price.

These factors will determine the amount you receive through annuity payments. Likewise, you could receive more on a lifetime annuity if you don’t add a beneficiary. It all depends on what is important for you and your family.

What is the difference between an annuity and income drawdown?

A pension annuity converts your retirement savings into an income, either for a fixed term or the rest of your life. In contrast, income drawdown allows you to keep your retirement pot invested, so it can carry on growing.

You draw an income directly from your fund. A key issue to remember with income drawdown products is that your investments could go down as well as up.

What is an annuity rate?

Ultimately, the annuity rate you're offered holds the key to how much income you'll receive during retirement.

Your product choice, pension pot and health can all be included in your annuity rate calculation. Interest rates and the performance of government bonds can also have an influence.

What is a guaranteed annuity rate?

A guaranteed annuity rate is pre-determined when you first took out your annuity policy. You’ll be told of this percentage when you come to purchase, and you can expect a guaranteed rate to stay the same from the date you took the policy out to the final payment date.

It could mean that rates offered today are higher or lower than previous rates offered. As interest rates are always fluctuating, this can affect annuity rates too.

Where can you find an annuity provider?

After discussing your plans with a retirement specialist or financial adviser, they’ll run through the right annuity product for your needs. They’ll offer guidance on information such as any interest and monthly income expected from your annuity.

How do you buy an annuity in the UK?

Your retirement specialist or financial adviser can support you and point you in the direction of reputable companies.

As you reach pensionable age, your current pension provider will contact you. They’ll send you the value of your pension pot and any options available to you.

Whilst it might be an easy option to accept an annuity agreement from your current pension provider, it’s not always the best option. You might even be advised to wait if interest rates aren’t in your favour.

Once you’ve purchased an annuity, you’ll have a cooling-off period where you can make changes or cancel your policy. It’s worth checking this with your provider first. If you’re happy with your deal, just sit back, relax, and wait for your payments to start.

What is an enhanced annuity?

An enhanced annuity can be beneficial for people who have a health condition, follow a certain lifestyle, and/or live in specific areas of the country. Essentially anything that could impact overall life expectancy. If you’ve been diagnosed with a terminal illness, have a higher BMI, are a smoker, live in a certain postcode, or are in poor health, you’ll want to ensure you’re financially secure. Fortunately, an enhanced annuity offers exactly that. As well as regular income, you’ll have peace of mind that everything is being taken care of.

Compared to a regular annuity, individuals receiving an enhanced annuity are likely to receive more from their payment due to their health condition.

What medical conditions qualify for an enhanced annuity?

Each provider might have a different list. Some annuity companies could offer support for more illnesses, whilst others might provide less.

How much income does an annuity generate?

The amount you’re paid depends on who you are, what your circumstances are, and how old you are when you purchase one.

A standard annuity gives you a guaranteed income for the rest of your life, no matter how long you live. You can choose to be paid monthly, quarterly, half-yearly or annually.
You can also get fixed-term or temporary annuities that pay out for a set period of time.

Your annuity income will depend on several factors:

• How much of your pension pot you decide to access.
  
• The options you select when you set up your plan.
  
• Your health and lifestyle, such as whether you smoke.

Additionally, you can set your annuity up so that payments continue to a spouse, partner or dependent if you pass away. That way, they’ll still be taken care of if you die before them. 

Try our annuity calculator

How do you calculate an annuity?

Calculating your annuity will help you determine if it’s best to receive regular payments or one lump sum.

An annuity is calculated through a formula that includes:

• The current value of your pension.
• Your overall health and wellness.
• Any guarantee periods.
• Your chosen payment frequency.

Using an online annuity calculator can help you determine how much you could receive from regular payments.

Can an annuity be sold or transferred?

Don’t worry, if you’re worried about your loved ones and their financial situation after you’re gone, an annuity can support you. Whilst an annuity can’t be sold, you can include a beneficiary through a joint-life annuity. You can also insure your estate with value protection. Additionally, guarantee periods mean that your beneficiaries will continue to receive your annuity payments for an agreed term even if you’ve passed away before your contract ends.

What happens to an annuity after death?

Ensuring security for your family is likely one of your top priorities. Although we wish for a long and prosperous life, we still want our families to be supported once we’re gone. The right annuity can do this for you.

With a lifetime annuity, your payments will stop upon your death unless you have taken out some form of guarantees, dependents pension or value protection. That’s why many choose to add a joint-life annuity, value protection or to set up a guarantee period. Both options mean a delegated beneficiary will receive your payments either for the rest of their lives or until the period runs out. This will depend on the agreement and policy you purchased.

Need support with arranging an annuity? We’re here to help

At LV=, we know just how important it is to feel secure when you hit retirement. That’s why we’re here to help you select the right annuity agreement. Our specialists are friendly and knowledgeable, meaning you’re always in safe hands. Get in touch today.

Pension annuity FAQs

You may have more queries about pension annuities. Here are some of the most frequently asked questions to help your decision-making.

Is a pension annuity taxed?

Yes, income from a pension annuity is taxed in the same way as earnings from employment are taxed through Pay As You Earn (PAYE). In other words, tax is automatically deducted before you receive your income payments.

What is a benefit crystallisation event?

These are checks to ensure you're taxed correctly when accessing your pension. These events can occur multiple times and are triggered by key events, such as taking an annuity or reaching age 75.

Can I sell a pension annuity?

No, once an annuity is set up, it can’t be changed, sold, or transferred. However, as mentioned, a joint-life annuity allows you to include a beneficiary who will continue receiving payments for a set time, even if you die before the term ends.

Can I change my mind about buying an annuity?

Yes, you generally have 30 days from the start of your annuity to cancel if you change your mind, although this can differ depending on the provider. After that, your annuity will continue to run for the rest of your life.