Quick answer
An annuity allows you to use some or all of a defined contribution pension to buy a guaranteed income.
Depending on the type selected, that income might continue:
for the rest of your life
or:
for a fixed period.
MoneyHelper confirms that lifetime annuities can provide guaranteed income for life, while fixed-term annuities can provide income for an agreed period.
That certainty is the big attraction.
But there is a trade-off.
Once a lifetime annuity has been purchased and the cancellation period has passed, you generally cannot simply decide several years later that you'd prefer your original pension pot back.
So an annuity is not just another withdrawal.
It is a decision about what job you want part of your pension to do for the rest of retirement.
How does an annuity work?
Imagine you have £300,000 in a defined contribution pension. You might decide to use £100,000 to buy an annuity.
An insurance company then agrees to pay you an income according to the terms selected. You could leave the remaining £200,000 within other pension arrangements, depending on your pension and retirement strategy.
You do not necessarily have to use your entire pension to buy an annuity.
MoneyHelper confirms that people can use all or part of their pension to buy guaranteed income and potentially use different retirement options with the remainder.
Steve's observation
An annuity is essentially a trade.
You say: "I'm giving up control of this piece of capital."
The insurer says: "In exchange, I'll take responsibility for paying the agreed income."
That's why the decision isn't really: "Are annuities good or bad?"
It's: "How much certainty do I want to buy, and how much flexibility do I want to keep?"
What is a lifetime annuity?
A lifetime annuity provides an income for the rest of your life.
That means if you live much longer than expected, the income can continue according to the terms of the contract.
This removes one of the biggest risks associated with managing a pension yourself: running out of that particular source of income because you lived too long.
That doesn't mean the income will necessarily meet all your future spending needs. Inflation and the options chosen when purchasing the annuity still matter. But the contractual income itself is designed to continue for life.
What is a fixed-term annuity?
An annuity doesn't always have to last for life.
MoneyHelper says fixed-term annuities can provide income for an agreed period — currently potentially between one and 40 years depending on the product — and may include an agreed maturity amount at the end.
For example, someone might use a fixed-term arrangement to provide income for several years and then reassess their retirement choices later.
A fixed-term annuity therefore operates differently from giving up capital permanently for a lifetime income. Exact terms vary considerably between products.
How much income will an annuity pay?
There is no universal annuity rate. The income offered can depend on factors including:
- how much pension money is used;
- your age;
- your health;
- market conditions and interest rates;
- whether the income is level or increasing;
- whether benefits continue for somebody else after your death;
- and what other protections you choose.
MoneyHelper confirms that age, health, location, market factors and the options attached to the annuity can all affect the rate offered.
That means: £100,000 of pension does not automatically buy a fixed amount of income. Quotes need to be obtained at the time the decision is being considered.
Why does age affect annuity income?
Broadly, the insurer is estimating how long it may need to make payments. Someone purchasing a lifetime annuity at an older age may therefore receive a different income from someone buying the same type of annuity much younger.
But age is only one factor. Health can also materially affect the rate.
Could poor health actually increase my annuity income?
Potentially, yes. This surprises people.
Some providers offer what are known as enhanced annuities or impaired-life annuities.
MoneyHelper confirms that medical conditions, smoking, weight and other health or lifestyle factors can result in a higher annuity income because they may affect the provider's estimate of life expectancy.
That means it is important to answer medical and lifestyle questions accurately. This is not the time to say: "Oh, I'm fine really." If you qualify for an enhanced rate, failing to disclose relevant information could mean receiving less income than might otherwise have been available.
Coaching point
When comparing annuities, don't just ask: "Who gives me the highest headline rate?"
Ask: "Have we given every provider the same complete information about my health and circumstances?"
A better quote based on incomplete information isn't necessarily the best quote available to you.
What is a level annuity?
A level annuity normally pays the same amount of income throughout its payment period. For example, £8,000 a year might continue at £8,000.
The advantage is that level annuities typically provide a higher starting income than comparable increasing annuities.
The obvious problem is inflation. £8,000 today may buy considerably more than £8,000 in 15 or 20 years.
What is an increasing annuity?
An increasing or escalating annuity is designed to rise over time. The increase might be:
- a fixed percentage;
- or linked to inflation under the product's terms, sometimes subject to a cap.
MoneyHelper confirms that increasing annuities generally begin with a lower income than comparable level annuities because the payments are designed to rise later.
So there is another trade-off: more income now versus potentially greater protection against rising living costs later.
Pause for thought
- Would you rather have: more income in your first five years or an income designed to retain more spending power in your 80s?
- There isn't one answer that suits everybody.
- But pretending inflation doesn't exist isn't much of an answer either.
What happens when I die?
This depends entirely on the options selected. A basic single-life lifetime annuity may stop when you die.
However, MoneyHelper confirms that annuities can include features such as:
- joint-life income;
- guarantee periods;
- value protection;
- and certain other death-benefit options.
Those protections generally come at a cost because adding them can reduce the starting income you receive.
What is a joint-life annuity?
A joint-life annuity can continue paying an agreed level of income to a spouse, partner or other qualifying dependant after your death, depending on the contract.
You may choose, for example, for a proportion of your income to continue. The precise percentage and terms are selected when the annuity is arranged.
This can be particularly important where one partner relies heavily on the other's pension income.
What is a guarantee period?
A guarantee period can provide continued payments for a specified minimum period even if the annuity holder dies sooner.
For example, if an annuity has a 10-year guarantee and the holder dies after seven years, payments or an equivalent benefit may continue for the remainder of the guarantee period, according to the product terms.
MoneyHelper confirms guarantee periods can be added to certain annuities and can provide benefits to beneficiaries after death.
What is value protection?
Value protection is another possible death-benefit option. Broadly, it can allow some of the difference between the amount used to purchase the annuity and the income already paid to be returned to beneficiaries, depending on the product terms.
Again, adding protection can reduce the income initially available. There is rarely a free extra. More guarantees usually mean paying for those guarantees somewhere within the pricing.
What happens to my original pension pot?
With a lifetime annuity, the money used to buy the annuity has effectively been exchanged for the contractual income and benefits selected. It is no longer an investment pot that you can simply dip into whenever you choose.
That is the fundamental difference from pension drawdown.
With drawdown, you generally retain an invested pension fund and decide how much to withdraw. With an annuity, you exchange some or all of that capital for agreed income terms.
For the drawdown explanation, see What Is Pension Drawdown and How Does It Work?
Can I take tax-free cash before buying an annuity?
Usually, yes, subject to your pension rules and available Lump Sum Allowance.
MoneyHelper confirms that people can usually take up to 25% of relevant pension benefits as tax-free cash, within the applicable Lump Sum Allowance, before using the remaining pension to purchase an annuity.
But remember: the more pension capital you remove as tax-free cash, the less remains available to purchase retirement income.
We've covered that decision in Should I Take My 25% Tax-Free Pension Cash?
Is annuity income taxable?
Generally, yes.
HMRC confirms income from annuities purchased using registered pension benefits is generally taxable as pension income.
Your annuity income therefore sits alongside other taxable income such as:
- State Pension;
- employment income;
- other private pensions;
- rental income;
- and relevant savings or investment income.
GOV.UK confirms that pension income forms part of total taxable income when assessing Income Tax.
Can an annuity run out?
A lifetime annuity is designed to continue paying the contractual income for your life. That is one of its defining advantages over an invested drawdown pot. You are transferring longevity risk to the annuity provider.
However, don't confuse: income guaranteed for life with income guaranteed to maintain your lifestyle for life.
A level annuity may lose spending power through inflation. So the structure of the income still matters.
What happens if investment markets crash?
Once pension capital has been exchanged for a lifetime annuity, the agreed income is no longer directly dependent on the day-to-day investment value of your former pension fund.
MoneyHelper highlights this as one of the reasons people may value annuities: the annuitised part of their retirement income is not dependent on their own invested pension pot continuing to perform.
That can provide valuable certainty. But you've achieved that certainty by giving up investment flexibility over the capital used to buy the annuity.
Should I shop around?
Yes — at the very least, understand the wider market before committing.
Annuity providers can offer different rates. Your existing pension provider is not automatically the provider offering the most suitable or highest available income.
MoneyHelper provides an annuity comparison service and specifically encourages consumers to compare what different providers may offer. This is sometimes referred to as using the open market option.
What if my existing pension has a guaranteed annuity rate?
Check before transferring anything.
Some older pension contracts contain guaranteed annuity rates. MoneyHelper warns that these can sometimes provide a higher guaranteed income than currently available market rates.
If a pension contains one, transferring the pension elsewhere could potentially mean losing it.
This is exactly why consolidation shouldn't happen simply because several pensions are inconvenient.
Do I have to choose between annuity and drawdown?
Not necessarily.
Retirement planning does not need to be Team Annuity versus Team Drawdown.
You could potentially use different pension assets for different purposes. For example, somebody might use part of a pension to create guaranteed income for essential expenditure while retaining other capital in drawdown for flexibility.
MoneyHelper confirms people can annuitise part of a pension and use other pension money differently.
That can turn the decision from: "Which product wins?" into: "What job does each part of my retirement money need to do?"
Steve's observation
I think annuities and drawdown often get presented like two football teams.
Choose your side.
But retirement isn't Match of the Day.
Perhaps I want enough guaranteed income so the council tax, heating and supermarket don't depend on the stock market.
And perhaps I want another part of my money flexible so I can travel, help the family or spend more in the early years.
Those aren't contradictory objectives.
They're different jobs.
Frequently asked questions
What should I do next?
Before considering an annuity, establish:
- How much guaranteed income you already have
- How much essential expenditure needs covering
- How much pension capital you're considering using
- Whether tax-free cash is required
- Whether income should remain level or increase
- Whether somebody else needs income after your death
- Whether health could qualify you for an enhanced rate
- Whether any existing pension contains a guaranteed annuity rate
Then get comparable quotations. Do not compare: one provider's basic annuity with another provider's escalating joint-life annuity and conclude that one has a better rate.
You need to compare like with like.
The Open Door Wealth View
An annuity solves a very specific retirement problem: certainty.
It can turn pension capital into income that doesn't require you to decide every year how much to withdraw or worry that the particular capital used to buy the lifetime income will run out because you live longer than expected.
But that certainty has a price. You give up flexibility over the money used to buy it.
That's why I wouldn't start with: "Should I buy an annuity?"
I'd start with: "How much of my retirement income do I want to know is going to arrive whatever happens?"
Once you know that, you can begin deciding whether an annuity has a job in your retirement plan.