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, normally for the rest of your life. Using the savings from your personal 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.

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 (57 from April 2028) 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.

What is the difference between an annuity and a pension?

A pension is a savings vehicle to provide for your retirement. An annuity provides a way to use a pension to provide you with a regular income when you retire. An annuity is considered an insurance contract, whereas a pension plan is a savings vehicle.

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 5 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 Consider creating some financial security for your loved ones too by adding options for 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.

5 Steps to purchasing an annuity

If you’re considering a pension annuity, we’ve broken down the process of buying one into five easy steps.

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.

Once you’ve purchased an annuity, you’ll normally 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.

4. Start receiving your income

Just like a salary, you’ll receive regular income from your annuity. 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 received your 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

Depending on the options you choose, annuities can be used to provide your loved ones with a regular income and/or a lump sum after you die. A joint life annuity can ensure that some or all of your income can be paid to your chosen beneficiary for the remainder of their life if you pass away first.

Set your annuity income terms

You can guarantee the length of time you’d like your annuity to run for, even if you die early.

It’s important to remember that any death benefits you choose will affect the income you receive. Once your annuity plan has been set up, you won’t usually 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 usually have the option to take up to 25% of your pension as a tax-free sum when you purchase the annuity.

Enhanced or impaired life annuity

Enhanced annuities are lifetime annuities 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 income 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, a fixed-term annuity can be set up so that you 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. With an investment-linked annuity your pension retains some stocks and share exposure, with the income you receive each year changing, depending on how these investments perform.

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

What are the pros and cons of an annuity?

Here's a quick breakdown of the advantages and potential drawbacks of annuities:

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 you require, 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 death benefits. 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 a pre-determined rate agreed when you first took out your pension policy. Your existing pension provider will inform you if you have this feature as you approach retirement and before you access or transfer your pension. 

In most cases, a guaranteed annuity rate means that your existing provider will be required to offer you an annuity rate that pays a higher income than any annuity that you could normally buy today. This is because these policies were sold at a time when annuity rates were much higher than today. 

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 reduce overall life expectancy. You might qualify for an enhanced annuity 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. An enhanced annuity can usually offer a higher income than a standard lifetime annuity and with a 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 will offer enhanced income for more illnesses, whilst others might cover less conditions.

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.

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?

No, once an annuity is set up, it can’t usually be changed, 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 normally be sold, you can include a beneficiary through a joint-life annuity. You can also add a lump sum death benefit, often known as 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 help, with options like joint-life, value protection, or a guarantee period to ensure payments continue to your beneficiaries after your death, depending on your policy.

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. Request a call back from our pension advisers today.

Pension annuity FAQs

You may have more queries about pension annuities and how does annuity work? 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 a similar 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.

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. If you do decide to cancel, you will usually need to purchase an alternative annuity with a different provider. It will not normally be possible to reverse your decision in its entirety. After that the cancellation period expires, your annuity will continue to run for the rest of your life (unless it is a fixed term annuity).

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.