What is an annuity and how does it work?

7 minutes

Planning for the future is tricky, but necessary. If you’re concerned that your pension might not stretch far enough, an annuity could be right for you.

An annuity provides a guaranteed income using your pension savings

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 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.

A pension 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 a form of income. Think of it as being paid a salary while you're retired.

How does an annuity work?

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 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.

What is an Annuity? 
Pension piggy bank
An annuity offers pension holders a way to receive an income from their pension pot.
The Steps to Purchasing an Annuity
Advisers with speech bubble 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.

Document with some money
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. 
Man with medium amount of money
Piggybank next to a stack of coins with arrows projecting upwards 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. In addition, you can also use an annuity calculator first to get a rough idea of how much income you could get from your pension pot.

2. 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 for you.

3. 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 passed down to a beneficiary.

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 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.

  • Lifetime annuity

    Selecting this 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.

  • Fixed-term annuity

    Instead of paying out for life, you’ll receive a guaranteed income from a specified term of between one to 40 years dependent on the provider. At the end of the contract, it’s also possible to receive a maturity amount. This consists of money saved and the investment growth but subtracts the income already received.

  • Enhanced or lifestyle life annuity

    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, or a set percentage of them, are passed on to your chosen beneficiary after you die.

  • 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.

What are the benefits of an annuity?


  • Guaranteed fixed income over a set period of time.
  • Customised to suit your circumstances.
  • Offers financial stability during retirement years.
  • Controlled level of risk.
  • Long-term security for you and your beneficiary.

What are the disadvantages of an annuity?


  • Government changes to annuities could change the amount you receive.
  • It’s possible that other products could be a better investment opportunity.
  • You can only receive an annuity from a set date.
  • If you pass away just after your plan starts, you and your loved ones might not receive the full value.

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 gender
  • Amount you wish to deposit
  • Length of time you want to receive payments for
  • Any medical conditions
  • Additional options, such as joint annuities

These factors will determine the amount you receive through annuity payments. If you deposit more, you’re likely to get more back than someone who deposits less. 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.

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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.

Annuity rates are traditionally displayed as your projected annual income for every £100,000 paid in.

What is a guaranteed annuity rate?

A guaranteed annuity rate is pre-determined when you first take 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 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.

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. 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.