What are annuities?

You can spend a lump sum of your pension pot on an annuity, which gets you a regular income for the rest of your life. Find out how.

Annuities are a way of cashing out on your pension pot. You purchase an annuity from an insurance provider to give you an income for life. We explain everything you need to know below.

Saving for your retirement can seem a little confusing – how much do you need to save? How many years do you need to be able to cover? How do you work out how much you’ll spend while retired? It doesn’t help that the state pension amount and pension age changes at least every few years.

Here, we’re going to cover annuities. These are something you usually consider when you’ve saved up your pot, but it’s worth understanding them before this, so you know what’s coming.

We all imagine that at our pension age, we get access to our pension the same way Harry Potter got access to his parents’ fortune. Unfortunately, a goblin isn’t going to lead you to your vault and give you free rein of your money. You are able to get access to it from age 55, but you’ll be taxed on most of it this way.

There are several ways to get access to your money, and one of them is an annuity.

What is an annuity?

An annuity is an insurance product that offers an annual income for the rest of your life in exchange for a lump sum. 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 to work out better off. You’re both betting against one another.

What is an annuity rate?

An annuity rate is the amount of your 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.

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.

What types of annuities are there?

There are loads of different types of annuity on the market.
Here’s a brief description of each one:

Level

The insurer pays out a level amount each year for the remainder of your life. You tend to get a high 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

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, which will be raised in line with the Retail Prices Index. These annuities cost more, but will rise with inflation.

Single life

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

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.

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.

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:

  • 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?
  • How much does the annuity cost?
  • How healthy are you? Do you smoke? Any medical conditions?

Will I be taxed on my annuity?

You’ll pay tax on your annuity 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 to work out your annual salary. This figure will determine how much tax you’ll pay.

Pros and cons of annuities

Pros

  • You can get a guaranteed income for life.
  • Your income can be protected from inflation and fluctuations in the stock market.
  • If you have poor health, you may be offered a higher rate.

Cons

  • If you die earlier than you originally thought, your dependents may lose out on the rest of your pension pot.
  • Annuities are irreversible. That means there’s no going back.
  • Your pension is no longer invested, so you wouldn’t benefit from a rising stock market.
We show offers we can track - that's not every product on the market...yet. Unless we've said otherwise, products are in no particular order. The terms "best", "top", "cheap" (and variations of these) aren't ratings, though we always explain what's great about a product when we highlight it. This is subject to our terms of use. When you make major financial decisions, consider getting independent financial advice. Always consider your own circumstances when you compare products so you get what's right for you.

More guides on Finder

  • How much pension do I need to retire?

    We explain how to work out the retirement income you’ll need, and what you can do if you haven’t saved enough.

  • Taking your entire pension pot

    We outline the pros and cons of withdrawing your whole pension as a cash lump sum, and why this could result in a high tax bill.

  • Retirement and pension advice

    We explain the free and paid-for advice that’s available if you need help to understand your retirement options and make the right choices.

  • Is my pension lump sum taxable?

    Under pension freedoms, you can usually take 25% of your pension as a tax-free lump sum. Here’s what you need to know.

  • Defined benefit and final salary pensions

    Do you have a final salary or career average pension? If so, you’re in a minority. We explain the ins and outs of defined benefit pensions.

  • Moneyfarm pension review

    We outline the pros and cons of Moneyfarm’s personal pension to help you decide if it’s the right home for your retirement savings.

  • Plum pension review

    Plum’s clever micro-saving algorithm makes it easy to drip-feed your retirement savings. But is its personal pension worth having overall?

  • Taking money from your pension

    We give you the lowdown on when you can access the money in your pension pot, and how pension freedoms work.

  • Can I get my pension contributions back?

    Find out about getting your pension contributions back and how to get a refund.

  • Pension recycling

    We explain the potential tax benefits and the limitations of taking money out of one pension and recycling it into another.

Ask an Expert

You are about to post a question on finder.com:

  • Do not enter personal information (eg. surname, phone number, bank details) as your question will be made public
  • finder.com is a financial comparison and information service, not a bank or product provider
  • We cannot provide you with personal advice or recommendations
  • Your answer might already be waiting – check previous questions below to see if yours has already been asked

Finder.com provides guides and information on a range of products and services. Because our content is not financial advice, we suggest talking with a professional before you make any decision.

By submitting your comment or question, you agree to our Privacy and Cookies Policy and Terms of Use.

Questions and responses on finder.com are not provided, paid for or otherwise endorsed by any bank or brand. These banks and brands are not responsible for ensuring that comments are answered or accurate.
Go to site