What is an annuity?

3 minutes

A pension annuity can convert some or all of your retirement savings into a regular income. Learn more about the benefits and the different types with our helpful guide.

An annuity provides a guaranteed income using your pension savings

  • What is an annuity?
  • What are the different types of annuity?
  • What are the pros and cons of annuities?

What is an annuity?

A pension annuity turns your pot of retirement savings into a regular 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.

Following the pension freedoms of 2015, retirees now have more flexibility over how they access their savings. As a result, it’s also vital to weigh up the pros and cons of annuities, and whether alternatives like income drawdown may be more suitable.

What do I need to know about pension annuities?

The financial consequences of a lengthy retirement may seem daunting – and that’s where annuities come in.

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.

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.

You can choose to withdraw 25% of your retirement savings tax-free and then buy a pension annuity with the remaining money, or even use it as part of a blended solution. Alternatively, you can convert your entire pot into an annuity.

What are the different types of pension annuity?

The first decision you’ll need to make when turning your savings into a pension annuity is how long you want the contract to last. Choose either:

  • A lifetime annuity. As the name suggests, this guarantees to pay you a regular income from the start of your retirement until the end of your life.
  • A fixed-term annuity. This pays you an income for a set period only. Fixed-term annuities generally last between one and 20 years and provide more flexibility than lifetime products. You’re paid a lump sum at the end of your term, which you can then spend or invest how you choose.

Each pension annuity can be tailored even further. The main options include:

  • Level annuities, which pay the same level of income each year until the end of your life.
  • Escalating annuities, where your income rises over time to tackle inflation. Your income can go up by an agreed fixed rate or match an inflation index.
  • Single-life annuities, where your payments come to an end once you pass away. With joint-life annuities, your partner can continue to receive an income once you're gone.

It may also be worth exploring enhanced annuities if you're a long-term smoker or suffer from a health condition. You'll normally be offered a higher income with an enhanced policy because of your shorter life expectancy.

Heart conditions, cancer and diabetes are among the health issues an enhanced pension annuity might cover. You may need to attend a medical examination as part of the application process.

How much pension annuity income will I receive?

There's no one-size-fits-all annuity income. Instead, a range of factors will determine how much you receive from your provider. These include:

  • The type of pension annuity you're buying. Level annuities, for example, pay the same amount each year, whereas the sum rises over time with escalating products.
  • Your retirement savings pot. A larger pension pot should provide you with a bigger annuity income.
  • Your general health. You could be eligible for an enhanced annuity if medical or lifestyle factors threaten to reduce your life expectancy.
  • Your age. Buying an annuity earlier in life means your money may have to last longer.
  • The annuity rate you’re offered. Rates vary between providers so it’s useful to shop around.

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 are the pros and cons of annuities?

It's important not to rush into any decisions when it comes to your retirement finances. Take a close look at the potential advantages and disadvantages of annuities before signing up to any products.

Advantages of annuities include:

  • Peace of mind. A lifetime annuity can stop you running out of money during retirement by offering a guaranteed income for the rest of your life.
  • A broad choice. With everything from fixed-term products to single and joint-life policies available, there's plenty of choice. Enhanced annuities also cater for those with long-term health conditions.
  • Their ability to fight inflation. An escalating pension annuity helps you keep pace with the cost of living, by stopping inflation from eating away at your income.

Disadvantages of annuities include:

  • Inflexibility. It can be difficult to exit an annuity contract if you change your mind.
  • Fluctuating rates. The Bank of England base rate is just one external factor that can shape annuity rates. It means the timing of your retirement can be crucial to the rate you're offered.
  • Tax. Your annuity payments may be subject to income tax, which is important to factor into your calculations.

Annuities aren't for everyone, and you may find other retirement products like income drawdown more suited to your lifestyle and goals. Always compare annuity rates between different providers and do your homework when it comes to the types of policies on offer.

Explore your pension options with our retirement advice service and try our annuity calculator to size up your potential income. If you do decide that you want to buy an income for life, then we will do the shopping around for you to get you the highest income.

Pension annuity FAQs

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 a guaranteed pension annuity?

A guaranteed pension annuity ensures an income will be paid by your provider for a set period, even if you pass away. It means your loved ones should continue to receive annuity payments after you're gone.

What is a single-life annuity pension plan?

With a single-life annuity, your payments come to an end as soon as you die. In contrast, joint-life annuities carry on paying an income to your family after you pass away. The annuity rates on single-life products can be higher, but you won't have the benefit of knowing your family will be taken care of.

What is a good rate for a fixed annuity?

The rate you receive on a fixed-term annuity can depend on factors like your pension pot, age and the length of your contract.

Annuity rates will differ for each person, so it’s important to compare providers. With fixed annuities, you receive an income for an agreed period (for example, ten years). A lump sum is paid out when your contract ends, which can be spent however you want.