What is an annuity?

What is an annuity?

An annuity is an insurance product that allows you to swap your pension savings for a guaranteed regular income that will last for the rest of your life.

How much you get is determined by the rate the annuity provider offers.

People who have serious health problems should be offered a higher rate than someone who's likely to live for many years. The insurer is essentially taking a bet that it won't end up paying out more than the total pot.

Buying an annuity used to be the only option for most people with a defined contribution pension (where you save into a pension scheme over your working life to build up a pot).

The pension freedoms opened up more choices, but opting for an annuity will still be right for some people.

Video: annuities explained

Check out our short video to find out how annuities work and whether they're right for you.

What type of annuity should I buy?

Annuities come in all shapes and sizes, but it's vital that you pick the right one - because once you buy, you can't change your mind.

Since April 2015, you've been able to withdraw as much of the money as you want when you reach 55 (rising to 57 in 2028) as another option, although it will be taxed as income.

You'll have to weigh up a number of options that will influence which type you end up buying - if an annuity is the right choice for you.

Key things you should consider when deciding on your pension options (eg an annuity, income drawdown or cashing in your pension) include:

• whether you want protection against inflation
• how much risk you're prepared to take
• whether anyone else is dependent on you for income
• how much flexibility you need to change your pension after it has started to be paid
• how much control you want over your investments
• what charges you'll need to pay
• whether you want to provide an inheritance for your survivors
• what your state of health is, and whether you are or have been a smoker.

Always shop around before buying an annuity - it's an irreversible decision. Find out more about the best ways to do this in our guide to buying an annuity.

What are the different types of annuity?

Level annuities

Level annuities pay out a flat, or 'level', amount of income every year for the rest of your life. The advantage of this type of annuity is that you get the highest rate possible at the start.

However, inflation will eat into this flat rate of income over time, meaning you won't be able to buy as much with your money in later years.

Escalating annuities

These pay out an increasing amount each year. You can opt for a specific percentage increase each - say, 3% - or in line with inflation. The latter is usually pegged to the Retail Prices Index (RPI).

Escalating annuities protect your retirement income from inflation, but they're expensive.

When you first buy one, the income you'll be paid is likely to be around half that of a level annuity, and it could take as much as 20 years for you to be paid more than a level annuity

Single life annuities

Single-life annuities - meaning that the income is paid only to you - account for around two-thirds of all those sold, but if you have a partner who might outlive you, it can cause problems.

You could buy an annuity with a guarantee, which will carry on paying out for at least five or ten years after you buy it, even if you die during this period. But the best way to provide for a surviving partner is to buy a joint-life annuity.

Joint life annuities

These annuities pay you an income then, after you die, an income to your partner or spouse until they die.

You can set the amount that is paid after the first death at 100% (the same as the initial rate), or 66% or 50%. The starting rate is lower than for a single-life annuity, but a joint-life annuity could end up paying out more in the long run.

Guaranteed annuities

An annuity with a guarantee period means your retirement income will be paid out for a specific number of years from the time you take out the policy, even if you die.

For example, if you take out an annuity with a 10-year guarantee period and die after three years, the payments would continue for seven more years. Adding a guarantee will not reduce the income level significantly.

Value-protected annuities

This type of annuity ensures that when you die, your estate or beneficiaries receive a lump sum which is the difference between the amount you paid for your annuity and the gross income (that's the payments made before tax) you received from your annuity before you died.

If your policy has already paid out more than you bought it for, there will be no lump sum death benefit when you die.

Fixed-term annuities

Fixed-term annuities are like standard annuities in that they pay a set amount each year.

However, they stop after a certain period (normally five or ten years) and, on maturity, they pay out a capital sum, which you can use to purchase a standard annuity or invest it in another product.

You aren't locked into a single rate for life and you can shop around for a better deal later on.

Enhanced annuities

Standard annuities are based on average life expectancy, currently 84 for men and 86 for women.

But not everyone lives this long, so some providers offer enhanced annuities to people in poor health or with lifestyle conditions that mean they might die earlier.

They're worth considering if you've been ill - you can increase your annuity income by as much as 50%. Find out more in our guide to enhanced annuities.

How much annuity income will I get?

When you get a quote for an annuity, you'll be given an annuity rate as a percentage. You base the calculation on your total pot to find out how much retirement income you'll get every year.

So, if you have £100,000 in your pension pot and are offered an annuity rate of 5.0%, you'll get an annual income of around £5,000 a year. See our example, right, and a member's story, below.

In our example, Caroline can expect to live an extra 21 years (a 65-year-old man could expect another 19).

You'll generally find that the older you are when you arrange an annuity, the higher the annuity rate you'll get from your chosen provider. Money can be paid monthly, quarterly, half-yearly or yearly, depending on your company.

These rates are correct as of April 2024 and will vary as gilt prices fluctuate. You can run your own annuity rate comparison using the Money Helper annuity calculator.

Do I pay tax on my annuity?

The money you get paid from an annuity is treated as income, and therefore subject to income tax.

Your annuity income will be added to any other sources of income you have in retirement, including the state pension, to work out the rate of income tax you'll pay.

Find out more in our guide to tax on pensions.

What happens to my annuity when I die?

For most types of annuity, the insurer keeps anything that's left when you die.

But your spouse, partner or anyone you've nominated will receive the payments from a joint-life, guaranteed or value-protected annuity tax-free if you die before age 75.

Payments will be taxed at your heir's marginal (income tax) rate if you're over 75 when you die.

What are the pros and cons of annuities?

Annuities could be right for you if...

• you want a guaranteed income for the rest of your life
• you don't want your retirement income to be subject to stock market fluctuations
• you want your income to rise with inflation
• you've had poor health and will qualify for a higher income.

An annuity might not be the best option if…

• you have a very short life expectancy
• you may change your mind
• you want to keep your money invested
• you want a single annuity but want to leave something behind
• you're wary of taking your chances with the annuity rate at the time of purchase.

Buying an annuity: a case study

James, aged 66, Devon

Which? member James was looking forward to retiring. He has three separate pensions and took his initial personal pension as an annuity at age 60.

Now, six years later, he's decided to buy annuities with the other two, which include his main pot.

James' main pension fund is with Prudential (£112,000) and James opted for a joint-life annuity that pays his wife 100% of the income if he dies.

Having taken the maximum tax-free lump sum that the rules allow (£28,000 - that's 25% of £112,000), the annuity income will be £4,689 a year.

He sensibly shopped around, getting numerous quotes from different pension companies before deciding to stick with his own pension provider.

James also checked with his provider to see whether his contract had a guaranteed annuity rate (GAR) on it - a guaranteed rate will pay out a higher amount than the average.

Which? expert view

Using some of your pension pot to buy an annuity might form part of a sensible strategy. This means you could have at least some income for the rest of your life - and so might your spouse if you opt for a joint annuity.

Shopping around for the best annuity rate and asking whether you qualify for an enhanced annuity are essential before you buy.