What is a pension annuity?

Pensions & retirement 23 May 2022

Using your pension to buy an annuity could help you gain a steady, guaranteed income in retirement. But what exactly is a pension annuity and how do they work?

Not to worry. We’ve done the research to help you get up to speed on this popular retirement product. In this handy guide, we’ll explain what pension annuities are, other options to consider and much more.

What is a pension annuity and how does it work?

An annuity is a retirement product that’s sold by insurance companies. You can purchase one using money from your pension pot. Annuities are a popular retirement planning option because they offer regular, guaranteed income.

In the past, annuities were the primary retirement income option if you had a personal or a defined contribution (DC) pension. Today, you have more options. Thanks to the 2015 pension freedoms, you now can access your pension savings from age 55 and can do what you like with it - including buying an annuity.

How annuities work is simple. You give some of your pension savings to an insurance provider as a lump sum, in exchange for an annuity that gives you a regular retirement income for life.

What kind of income can I expect with an annuity?

Think a reliable retirement income sounds good? Before you start searching for annuity rates, you should keep in mind that annuities aren’t one size fits all. There are tonnes of annuity products out there on the market, with many different types and options to choose from.

For one, annuities can payout monthly, quarterly, bi-annually or yearly, and payments are taxed as income. Usually, your provider will deduct this tax using your tax code before you receive your payments. The amount you receive from an annuity also depends on a few key factors:

  • Your age when you buy the annuity
  • The length of time you’d like the annuity to last
  • Your overall health and lifestyle
  • The price you paid for the annuity
  • Annuity rates (at the time of purchase)

You should also consider what will happen to your annuity after you die. If you’d like to leave some of your funds to loved ones, you may consider options such as value protection annuity. We’ll explain more about this in the next section.

Types of UK pension annuities

What types of annuities can I buy with my pension?

To help you narrow down your options, let’s explore the most common annuity options on the UK market.

Lifetime annuities

This type of annuity pays you an income for life. A lifetime annuity could be a good option if you want reassurance that you’ll have a steady income coming in.

Escalating annuities

You may usually see a lower starting income with an escalating annuity. But, it offers the benefit of rising income payments each year at a fixed rate.

Level annuities

A level annuity pays the same retirement income each year and typically offers a high starting income that’s often better than that of an escalating annuity. The downside with this type of annuity is that inflation could mean your income could take a hit.

Investment-linked annuities

An investment-linked annuity is a type of lifetime annuity. Your retirement income is linked to investments, and will rise or fall along with the investment market. But, there's no guarantee that you’ll get a return. For this reason, this option may not work for you if you have a low risk tolerance.

Fixed or short-term annuities

As the name suggests, this type of annuity pays you a set retirement income for a set period of time - usually five or 10 years. Like a mortgage, your rate will vary and you have the option to shop around for a better rate.

Enhanced annuities

Also called impaired life annuities, enhanced annuities pay out higher retirement income if you have been diagnosed with a serious illness or have a health condition that means you may have a shorter life expectancy. Some examples include cancer or diabetes.

Your general health and lifestyle could also affect the amount of income you receive. To gauge eligibility and what rate you could receive, your provider will ask you questions about your health and lifestyle.

 Joint life annuities

Popular with people that have partners or dependents, this type of annuity pays out to a beneficiary after you die. Payments from joint life annuities are usually smaller than those from single life annuities.

If you’re considering this option, do your research. Some providers don't offer joint life annuities if your partner is more than ten years your junior.

Single life annuities

Ideal for singles or people without dependents, a single life annuity pays out to you alone over your lifetime. It also offers more retirement income than a joint life annuity.

Value protected annuities

Often referred to as a capital protected annuity, this type of product helps you pass on capital to your loved ones when you die. Your provider will allow you to protect part of the initial capital you paid when you bought the annuity.

For example, you had a value protected annuity purchased with an £80,000 pension pot and protected the entire amount. If you died after receiving £30,000 worth of annuity income for retirement, your loved ones would receive a £50,000 capital return.

These types of annuities usually come with lower annuity rates, making them more expensive. Your family isn’t guaranteed to receive death benefits if the total amount of annuity payments you received was equal or more than the amount you protected.

Pros and cons of buying annuity with your pension

The pros and cons of annuities

Here are the pros and cons to consider as you weigh your retirement income options.

Annuity pros

  • Guaranteed retirement income for life (or for a fixed term)
  • Some annuity incomes rise with inflation
  • The stock market won’t affect your retirement income
  • Could offer more income if you’re in poor health

Annuity cons

  • You can’t change your mind or get a refund once you buy a lifetime annuity
  • Annuity rates often dip due to the market and competition
  • Annuities aren’t as flexible as drawdown

How do I buy an annuity in the UK?

Your pension provider may offer annuities, so it’s always good to explore their options and shop around. Getting quotes from many providers can help you weigh your options.

Comparison sites can be a helpful research tool, but don’t immediately jump on the cheapest rate you find. You can’t change your mind once you buy an annuity, which means you risk buying a product that may not be right for your needs.

Before you make a final decision, remember that you have several options once you reach a certain age. For most pension providers, this is usually age 55.

Always speak to your pension provider to see when you’re eligible to take your pension funds and what options are available to you.

Can I sell an annuity I bought with my pension?

Annuities are non-refundable and you can’t sell yours if you change your mind. But, some providers may let you cash in your annuity if it's worth less than £10,000. If you're considering this option, be aware that any payout will be subject to income tax. This means you may not receive as much as you would by taking it as regular income.

Do I need a financial adviser to buy an annuity?

Anyone can buy an annuity - and you don’t need to get advice to do so. But, you should think twice before buying one from your pension provider. According to the Financial Conduct Authority (FCA), people that buy annuities from their providers without shopping around could lose an average of £71 per year.

Money Helper’s free annuity comparison tool can help you compare annuity rates. Financial advisers may be able to access even lower rates than you may find through comparison sites, and save you time on paperwork.

Annuities are complex products, and can also be tricky to get your head around before setting one up. Getting expert advice from a financial adviser could help you ensure you make the right decision for your circumstances. A one-off fee for bespoke financial advice could far outweigh the thousands you may lose if you buy the wrong annuity.

A financial adviser can help you:

  • Compare annuity rates, products and options
  • Understand what products would suit your needs
  • Estimate how much income you could get from your annuity
  • Determine whether an annuity may affect your benefits
  • Explore all your available retirement income options
  • Save time by comparing rates, products and providers for you

Alternatives to annuities

Buying an annuity is one of many options available to you when you reach retirement age. As mentioned earlier, an annuity could offer a guaranteed retirement income. But if you would prefer a more flexible way to take your income or think you may change your mind in the future, it may be worth considering drawdown.

Pension drawdown

Sometimes called flexi-access drawdown or flexible income, drawdown allows you to access your pension fund as and when you need it. Currently, the government has set a minimum age of 55 to access pension drawdown without incurring a tax penalty. But, this will increase to 57 in 2028. Depending on your pension scheme, you can usually take a tax-free cash lump sum if you take up to 25% of it when you move your pension savings into drawdown.

While this flexibility can seem appealing, it does come with risk. The ability to access your cash easily means you must keep track of withdrawals to avoid running out of money. Your provider may also charge transaction fees. These charges can add up and take a big chunk of your retirement savings. And, depending on how you invest your funds, you may not see a return on your savings.

Pension annuity vs drawdown

Choosing between using your pension savings on an annuity or drawdown is a big decision. If you can’t decide between pension drawdown and an annuity, there is another option: both. There’s no set rule that says you have to use your entire pension fund to buy an annuity or move your funds into drawdown. This could give you extra flexibility.

For example, if you have a £100,000 pension pot, you could:

  • Buy an annuity with £50,000
  • Move £20,000 into drawdown
  • Keep the remaining £30,000 invested

If you need support to explore your retirement income options, speak to a regulated financial adviser.

Other options to consider

Again, annuities are just one option. Have a Your options at retirement include:

  • Taking the first 25% of your pension pot without paying tax
  • Leaving your pension pot alone to keep growing
  • Using some of your savings to buy an annuity
  • Moving some of your pension funds into drawdown
  • Reduce your working hours and phase into retirement
  • Investing some of your money
  • Combining some of the above options

Match with an expert pensions and annuity adviser

Get expert advice on annuities and your pension income options

Planning for retirement can seem like a mammoth task, but you don’t need to tackle it alone. We can help you find the support, guidance and bespoke advice you need by connecting you with a regulated financial adviser in your area.

With over 950 happy customers rating us ‘Excellent’ on Trustpilot, we’re positive our free adviser matching service could help you too.

An adviser can help you explore your pension income options, including whether annuities could work for you. They’ll help you compare rates and help you find the right solution for your needs.

Ready to explore your retirement income options? Click on the link below to complete our simple form. We’ll match you with an expert, who’ll help you explore your options with a free consultation.

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Editor’s note: This article was originally published in October 2015 and has been updated for accuracy, freshness and comprehensiveness.