What are annuities?

Annuities are one way of cashing in a defined contribution pension pot. You purchase an annuity from an insurance provider to give you an income, for life or for a fixed term. We explain everything you need to know about annuities, from how much you’re likely to get to whether you’ll pay tax on annuity income.

What is an annuity?

An annuity is an insurance product that offers an annual income – either for the rest of your life or for a fixed period – in exchange for a lump sum from your defined contribution pension savings. The insurer is hoping that it doesn’t end up paying out more than it takes from you in a lump sum, while you are hoping you live long enough that you receive more in income than you originally paid. You’re effectively betting against one another. This affects the annuity rate the provider will offer you.

What is an annuity rate?

An annuity rate is the amount of your total pension pot that the provider will pay out each year. Say you have £250,000 saved and you get a rate of 5%, you’ll get an annual income of £12,500 every year until you die.

What is a guaranteed annuity rate?

A guaranteed annuity rate (GAR) is one that was set in the terms and conditions of your pension policy when you took the policy out. Annuity rates in the 1980s and 1990s were higher than they are today. If you started paying into an annuity back then, and have a GAR, you’ll almost certainly receive a higher rate than you would by shopping around among providers today. In some cases, GARs can be double today’s rates.

How much income will I get from an annuity?

We’d love to be able to give a categorical answer to this question. But, in reality, it depends on a number of factors. These include:

• The size of the pension pot that you use to buy the annuity
• Annuity rates at the time you buy
• Your age, health and lifestyle when you buy your annuity
• How long you want the annuity to last – for a fixed term or for your lifetime
• Where you expect to live when you retire
• Which annuity type, income options and features you choose
• Whether your pension provider offers a guaranteed annuity rate

Does an annuity pay out an income as long as I live?

It depends on whether you opt for a lifetime or fixed-term annuity.

• Lifetime annuities, as the name suggests, pay out an income for the rest of your life – no matter how long you live.
• Fixed-term annuities pay out an income for a pre-defined period; 5 or 10 years is typical. At the end of this period, they may pay out a “maturity amount”. This lump sum is the money you originally paid, plus any investment growth from it, but minus the income you’ve received so far.

Neither is better or worse, they simply serve different purposes. Lifetime annuities give you the certainty of a regular payment for life, and the confidence that you won’t be any worse off if annuity rates fall.

Fixed-term annuities are typically regarded as more flexible, because you can choose what to do with the money you have left once the fixed term ends. For example, you could shop around for a new annuity, or invest it. You carry the risk that annuity rates will fall, potentially leaving you worse off. But, if they rise, you will be able to switch to an annuity that pays more monthly income.

What types of annuity are there?

There are lots of different types of annuity on the market. Here’s a brief description of the main types:

Level annuity

The insurer pays out a level amount each year for the remainder of your life. You tend to get a higher rate with these, but inflation will reduce the spending ability of your income over time, so you won’t get as much for your money towards the end.

Escalating annuity

Escalating annuities pay out a little more each year than the previous year. You can choose for it to rise by a certain percentage or have it rise with inflation, typically linked to the Retail Prices Index. These annuities cost more, but will rise in time.

Single life annuity

This is the most popular type of annuity. It will only pay out to you, so if you die, that’s it. You can get joint life annuities if you want a partner who might outlive you to keep receiving payments after your death.

Joint life annuity

This type pays you an income until you die, and then will pay out to your partner until they die. You can choose how much they receive as a percentage of what you received. You tend to get a lower starting rate for this type compared with a single life annuity as the insurance provider could end up paying more in the long run.

Enhanced annuity

An enhanced annuity pays a higher income than you would otherwise receive because of factors that mean your life expectancy is shorter than average. These can include medication conditions, or lifestyle factors such as smoking or obesity.

Value-protected annuity

If you die before receiving the full value of your annuity, a lump sum is paid to your beneficiaries (or your estate). The lump sum is normally the difference between the amount you paid for your annuity and the amount you received in income before you died.

Guaranteed annuity

This isn’t so much a type of an annuity as it is an add-on to an existing annuity. You can have a guaranteed period on your annuity which means it will pay out for a certain number of years even if you die. So if you take one out today with a guarantee of 10 years, and a year from now you die, it would continue to pay out for an additional 9 years.

Does age and health affect annuity rates?

Potentially, yes. To put it bluntly, if the annuity provider reckons you’ll kick the bucket soon, it will offer a higher rate. If it thinks you’ve got a few extra years in you, you’ll be offered a lower rate.

How age affects annuity rates

Annuity rates are closely linked to life expectancy. So, fairly obviously, one of the first things an annuity provider will consider is how old you are when you buy an annuity. The younger you are when you buy an annuity, the lower your rate is likely to be.

According to MoneyHelper’s annuity calculator, as of July 2024, a 60-year-old in good health buying an annuity with a £250,000 lump sum might get £1,365 a month for a lifetime, single life, level annuity. All else being equal, a 70-year-old might get £1,688 a month – £323 a month more.

How health affects annuity rates

If you have health conditions that affect your life expectancy, you could qualify for what’s known as an “enhanced annuity”. These pay you a higher annuity rate to reflect the fact that you may not live as long as average. How much more you’ll receive will depend on the seriousness of your condition. Something like high blood pressure, with no associated conditions, might increase your annuity income a little. More serious conditions, such as a stroke, might increase your rate substantially.

Lifestyle factors, such as smoking, may also qualify you for an enhanced annuity. Even if you don’t yet have any associated health conditions, the annuity provider may assume that you are more likely to develop conditions that could affect your life expectancy.

Is it worth shopping around for an annuity?

Heck, yes. Here at Finder, we’re always banging on about the benefits of shopping around, and annuities are no exception to the rule. The difference between the best and worst rates on the market can add up to hundreds, or even thousands, of pounds a year.

Let’s build on the scenario we used earlier, of a healthy 60-year-old buying a lifetime, single life, level annuity with a £250,000 pot. In July 2024, MoneySaver’s annuity calculator returned quotes from different providers ranging from £1,229 to £1,365 a month. Over a year, that’s a difference of more than £1,600.

How do I choose the best type of annuity?

As with most things, this depends on you, your circumstances and your health. If you read through the different types above then one might seem to suit you more than others. As with anything to do with pensions, it’s important to get advice before you act.

You can also consider the following:

• What would you value more; a guaranteed income for life or the flexibility to reassess your options after a certain period?
• Do you want your income to rise with inflation?
• Would you take a higher rate if it means your income won’t rise with inflation?
• Do you have anyone that will depend on the payments after your death?
• Do you have any health conditions or lifestyle factors that could affect your life expectancy?

Will I be taxed on my annuity?

You’ll pay tax on annuity income in the same way that you pay tax on your income while working. If you get a state pension, the amount you receive from your annuity will be added to the state pension amount plus any other income (from a defined benefit pension, for example) to work out your total annual income. This figure will determine how much tax you’ll pay.

What are the alternatives to an annuity?

If you have a defined contribution pension then, when you’re approaching retirement, you’ll need to make some decisions about how to access the pension pot you’ve built up.

An annuity is one option but, since the pension freedoms of 2015, there are several alternatives available. These include:

• Withdraw 25% of your defined contribution pension pot as a tax-free cash lump sum.
• Leave your pot invested. If you have several pension pots, you can leave some of them invested and access the money in others.
• Leave most of the money invested and take a regular income, known as pension income drawdown. You can take out as much or as little income as you want.
• Take the whole pot out and do with it as you wish. However, you should think carefully before doing this unless the pot is fairly small as you could incur a high tax bill.
• Withdraw lump sums as and when you need them, leaving the rest invested. If you choose this option, rather than being able to withdraw 25% as a single tax-free lump sum, the first 25% of each smaller lump sum you withdraw will be tax-free.

You don’t necessarily have to pick just one option. For example, you could take your tax-free lump sum then buy an annuity with part of your remaining pension pot, and go into income drawdown with the rest. If you need some help understanding your options, the free, government-backed Pension Wise service offers free guidance to over 50s with defined contribution pensions. Take a look at our full guide on your options for taking money from your pension.

If you have a defined benefit (often called final salary) pension, the options above won’t apply. Defined benefit pensions pay out a regular retirement income based on a proportion of your salary while you were with a company. They’ll usually secure you a substantially higher income than you’d get from an annuity for the same contributions, so are well worth having.

Expert comment - Is it better to buy an annuity or use pension drawdown?

George Sweeney

Deputy editor

Unfortunately there's no black or white answer to this. There are a few different factors you'll have to take into consideration that can be hard to quantify. Using part or all of your pension pot to buy an annuity can give you peace of mind knowing that you'll receive some level of guaranteed income for the rest of your life (or a fixed period of years). However, it's impossible to know how long you'll live for and because an annuity provides a fixed income you have less flexibility and control over withdrawals.

If you opt for pension drawdown, you have greater control over your retirement pot, your withdrawals and how it's invested. By maintaining a pension pot and drawing down, you're not guaranteed a yearly income for life but you could end up better off because of this. You're in control and it can be possible for your money to stretch further in retirement. But, you'll have to be more comfortable with the prospect of seeing your savings fluctuate over the years (sometimes growing and sometimes declining).

So, when making a decision, you need to think about the financial implications, but also how a regular or irregular income fits in with your lifestyle in retirement. You need to consider the quantifiable elements but also the unquantifiable elements like peace of mind. If you're really stuck or struggling to decide on a path, it's often worth discussing your options with a financial adviser who specialises in retirement planning.

Pros and cons of annuities

Bottom line

Annuities remain an important option for those cashing in their pension pots, but you should weigh up their pros and cons against the alternatives, such as pension income drawdown. If you decide an annuity is right for you, take some time to review the different types so that you make the right choice for your personal circumstances. And, as always, shop around among annuity providers to secure the best possible rate. Doing so could make a difference of thousands of pounds a year.

Frequently asked questions

• Do I have to buy an annuity when I retire?

  No. Until April 2015, most people with a defined contribution (DC) pension had little choice but to buy an annuity to fund their retirement. Since then, new rules – widely known as “pension freedoms” – opened up the ways in which retirees with a DC pension can access their pots. Find out more in our full guide on taking money from your pension.

• Does annuity income rise in line with inflation?

  It depends on the type of annuity you buy. Level annuities tend to offer higher rates initially, but your income won’t rise in line with inflation, so over time the value of the money you get may be eroded. If you want your income to reflect changes in cost-of-living increases, you’ll need an escalating annuity. These can either be linked to official inflation measures, or to a set percentage (3% or 5%, for example). Escalating annuities will help future-proof your income against increases in the cost of goods and services, but they tend to offer much lower rates initially, so it may take some time to be paid more than a level annuity would pay from the get go.

• Can I leave my annuity to beneficiaries after I die?

  Again, this depends on the type of annuity you’ve bought. Standard annuities won’t pay anything to your loved ones after you die. If this is important to you, opt for a joint-life, guaranteed or value-protected annuity. These will pay some form of income or lump sum to your spouse or partner or, in some cases, other named beneficiaries after you die. Check our summary of the different types of annuity for more details.

To make sure you get accurate and helpful information, this guide has been reviewed by George Sweeney, DipFA, a member of Finder's Editorial Review Board.

Written by

Ceri Stanaway

Writer

Ceri Stanaway is a researcher, writer and editor with more than 15 years’ experience, including a long stint at independent publisher Which?. She’s helped people find the best products and services, and avoid the pitfalls, across topics ranging from broadband to insurance. Outside of work, you can often find her sampling the fares in local cafes. See full bio