What Is An Annuity? [Explained & All You Need To Know]

Anthony Burgess (Pension & Investments)

Written by Anthony Burgess (Pension & Investments) on July 23, 2018

Updated June 6, 2019

Pension annuity explained

When it comes to choosing how to manage your pension pot and retirement finances, there are many options to consider. One popular type of retirement income is an annuity, which provides a guaranteed income for either a fixed number of years or for the rest of your life.

It is essential to understand that annuities are irreversible and once you have purchased one you can’t change your mind later on. With this in mind, it is vital to properly understand exactly what an annuity is and how they work before deciding if it is the right option for you. This guide will cover what you need to know so that you can make an informed decision.

What is an annuity?

What is an an annuity?

What is an an annuity?

An annuity is a contract with an annuity company where they agree to pay you regular income during your retirement. These are usually offered by life insurance companies and are bought with either a pension fund or life savings.

Although annuities are usually purchased from a life insurance company, they are a very different product to life insurance. An annuity does not require any medical checks or examinations, and instead of only paying out after your death, an annuity is used to provide you with an income for the remainder of your life.

The size of the regular payments is determined by the rate the annuity provider offers you. Those with serious health problems will usually be offered a higher rate than a healthy individual that is likely to live for many years.

Years ago, an annuity was the only option for individuals with a defined contribution pension. However, changes to pension regulations in 2015 opened up more opportunities for those in retirement. An annuity will still be the right choice for a lot of individuals, and it is essential to correctly understand what an annuity is and how they work before deciding which option is right for you.

The pension pot that you have saved up for throughout your working life is used to buy an annuity. In simple terms, you are exchanging the sum of money you saved for retirement for a regular income. You don’t have to choose an annuity to get by in your retirement, but it can help to provide some peace of mind that you have guaranteed income for the future. It is also possible to build in a continuing income for dependants in the event of your death.

You don’t always have to use your whole pension pot to buy an annuity; you can choose to use a portion of it for an annuity and take the rest as a tax-free cash lump sum if you want to. When you use the money in your pension to buy an annuity, you can take 25% of the amount as tax-free cash and use the remaining 75% for the annuity. The income you receive from an annuity is taxed as normal income.

The amount of regular retirement income that you will receive from an annuity, and the duration of the payments, will depend on a number of factors including your health and lifestyle, the size of your pension savings, annuity rates and the type of annuity you choose.

For individuals suffering from a medical condition or are smokers or overweight could be able to get a higher income by choosing an ‘impaired life’ or ‘enhanced’ annuity option. Only some annuity providers offer these, so it is vital to shop around.

Once you have purchased an annuity you have no option to change your mind later on and get your pension savings back. Make sure you are 100% certain that an annuity is the right choice for you before committing to a lifelong agreement.

What type of annuity is right for me?

There are a number of different options available when it comes to buying an annuity, and it is important that you choose the right one for you. There are a few factors you need to consider when deciding which annuity, if any, is the right option for your retirement.

These factors include aspects such as;

  • Whether you want to be protected against inflation
  • Whether you have any dependants
  • How much flexibility and control you want over your payments
  • Whether you want to leave any inheritance after your death.

Once you know your options on these factors and know what you want to gain from your annuity, then you can start considering which type is best suited to you and your current situation. These are the main types of annuity:

Level Annuities

A level annuity will pay out a flat amount of income every single year for the duration of your life. This makes it easy for budgeting and managing your finances as you know exactly how much money you will have for the future. One of the most significant advantages of level annuities is that you get the highest possible rate at the beginning. The main downside is that over time, inflation will mean your money won’t go as far in later years.

Escalating Annuities

If you want to make sure your annuity payments hold their value against inflation, an escalating annuity could be the option for you. These will pay out an increasing amount every year. You can set the increase by either choosing a specific percentage, such as 4% or opt for them to increase in line with inflation.

If you decide to keep them in line with inflation, most providers will use the Retail Prices Index (RPI) to determine the increases. For the first few years of an escalating annuity, the income you receive is likely to be about half of what you would receive from a level annuity. In some cases, it can be as long as 20 years for an escalating annuity to pay out more than a level annuity.

Joint Life Annuities

A joint life annuity is an excellent option if you have a spouse or partner who depends on your income and doesn’t have a pension of their own. These annuities will pay you an income for the duration of your life, and then after your death will continue to pay an income to your spouse until they pass away.
The payments can remain the same after the first death or can be reduced to a third or half of the original payments.

Single Life Annuities

In contrast to joint life annuities, a single life annuity means that the income is paid only to you for the duration of the agreement. If you have a partner or spouse who might outlive you, this option can cause issues if they don’t have their own retirement income set up.

Guaranteed Annuities

If you opt for an annuity with a guarantee period, your retirement income will be paid out for a predetermined number of years even if you pass away in this time frame. Most guaranteed annuities are for five or ten years, meaning your payments will be made for this length of time. If you die during the annuity term, the income payments will continue to be made to a beneficiary until the term is up.

Fixed Term Annuities

As the name suggests, a fixed term annuity will only pay out for a fixed duration. You will still receive regular income payments, but only for the term specified which is usually five or ten years. At the end of the term, you will receive a capital sum which can be used as a cash lump sum to keep, or you can invest in another retirement income product.

This option is best suited to those who don’t want to be locked into one single rate for the rest of their life and gives the freedom to shop around for a better deal later in life.

Value Protected Annuities

A value protected annuity ensures that when you pass away, your beneficiaries will receive a lump sum for the difference between the income you received and the amount you paid for your annuity. This is a good option for those worried about losing a large amount of their pension to an annuity and not leaving much behind for loved ones. If your policy has paid out more than you paid for it, then there will be no lump sum payment after your death.

Enhanced Annuities

Most annuities are based on the current average life expectancy ages. As not everybody will live as long as the average, some annuity providers offer enhanced annuities to those in poor health or with certain lifestyle conditions. Individuals who smoke or are overweight could be eligible for an enhanced annuity, as well as those with existing medical conditions.

This option is definitely worth considering if you have been unwell as you can increase your income payments by as much as 50%.

Some pension providers might contact you with an offer of an annuity as your retirement age approaches. Most of the time this initial offer will not be the best deal you can get so never accept it automatically. Shop around before deciding on a final option.

Who can get an annuity?

Until recently, everyone with a pension in the UK was required to convert at least 75% of it into an annuity at the age of 75. Now there is no requirement to get an annuity, but anyone can choose to buy one if they want to. Even if you are under the age of 75, you can get an annuity, and it is often a good idea to get one at a younger age than this.

Most pension providers will allow you to use your pension to buy a retirement income plan after the age of 55. All you need to get an annuity is either a pension fund or substantial savings that you want to use for your retirement, meaning that anyone can get one as long as they are able to fund the purchase.

If you are using your own savings to buy an annuity instead of a pension pot, remember that an annuity is often a gamble. If you live a long and healthy life after buying it, you can end up better off. However, if you pass away one year after buying an annuity, all your life savings will be gone.

How much does an annuity cost?

The cost of an annuity is determined by the annuity rate you get from the provider. These rates vary between providers and annuity types and are usually shown as the amount of money you will get per year for every £10,000 paid in.

For example, an annuity rate of 3% means you would get £300 a year for every £10,000 invested, so if you paid in £70,000, you would get £2,100 paid to you every year. Annuity providers will calculate these annuity rates using a few personal factors:

Your Life Expectancy

An annuity operates in a similar way to insurance, as all your money is put into one pot and then paid out for the duration of your life. Individuals who pass away sooner will get a smaller share of the pot, while those who live longer will receive a bigger share, and annuity rates reflect this. If you are expected to live longer, you will be offered a lower rate because the provider will have to pay you for a longer length of time.

Your Health

Similarly to your life expectancy, if you are in poor health or have an existing medical or lifestyle condition such as smoking, then you will be expected to live for a shorter time and can get a better annuity rate. This is usually where enhanced annuities come into play, and in some cases, an enhanced annuity can give you up to 50% more income.

Gilt Yields

Gilts are government bonds which are purchased by insurers and used to partly fund annuities. In return for buying gilts, the government will pay insurers a fixed interest amount which is linked to the best rate and inflation. This means that when the best rate and inflation are low, the gilts have less worth which causes annuity rates to drop.

Interest Rates

When interest rates are low, it will also lower the annuity rates. This is because pension pots are partly funded by the interest that is earned while the money is invested, meaning you will get less for your money when interest rates are low.

Up until December 2012, insurers would rate annuities depending on your gender, and as men have a lower life expectancy than women, women were offered worse rates. New regulations mean that insurers can no longer offer different rates depending on gender.

What are the advantages of an annuity?

As with any finance or insurance product, it is important to properly consider and weigh up the pros and cons of an annuity before making a decision. Especially as annuities are irreversible and there is no option to change your mind at a later date. The advantages of an annuity are:

Guaranteed Income

When you buy an annuity, you are guaranteed to receive a regular income for either the agreed fixed term or for the rest of your life. If you have a lifetime annuity, you have peace of mind that no matter how long you live for, you will receive a regular income.

Guaranteed Value

The income you receive from an annuity is guaranteed to remain the same or rise throughout your life but will not fall. Even in the event of a stock market crash or similar, your annuity income will not be affected.

Inflation Protection

Some types of annuities, such as escalating annuities, will pay a higher amount every year to protect you against the rise in inflation. This covers you against rising costs of living and means your regular income will always be worth the same amount every year.

Higher Income For Health Issues

For those individuals who suffer from a medical condition or health issues, you could be entitled to a higher annuity income because of the lower life expectancy. Buying an annuity is one of the very few times that being a smoker or overweight can work in your favour and get you a higher rate.

Income For Partners

If you have a spouse or partner who depends on your income or doesn’t have their own pension, then choosing a joint life annuity will mean they continue to receive payments even after your death.

All income paid by an annuity is taxable and taxed as income. In most cases, the annuity provider will deduct tax using your tax code before paying the income to you. You do not need to pay any National Insurance contributions on income from an annuity.

What are the disadvantages of an annuity?

While annuities come with a range of great benefits; there are also some downsides that should be properly understood. The disadvantages of annuities are:

Irreversible Contract

An annuity is a contract between you and the annuity provider, and in most cases, you cannot change your mind or cash it in once you have taken it out. Once you have agreed to an annuity, you must keep it for either the rest of your life or for the term agreed with your provider.

This makes deciding on an annuity a huge commitment and one that should not be taken lightly as it will affect your income for your lifetime.

Low Rates

Currently, rates for annuities are not great although are on the rise. A few years ago, the financial crisis and rising life expectancy resulted in very low annuity rates that are now starting to increase slowly. As annuity rates are affected by so many factors, you could end up with a low rate that results in you losing out on your pension savings.

No Chance For Growth

By taking your money out of a pension pot and using it to buy an annuity, you are taking away any chance of growing your savings further. If you left your money invested in the stock market, your savings could increase considerably if share values rise. Although, the opposite is also true, and leaving your retirement savings invested can also result in losing money.

Nothing To Leave Behind

Depending on the type of annuity you choose, you could end up using all your savings to buy an annuity that pays nothing to your family after you pass. Some types of annuities, however, will either pay your family a lump sum after your death or continue to pay them regular income payments.

Risk Of Losing A Lot

Buying an annuity can be a bit of a gamble, as you could end up losing all your pension savings if you do not live as long as expected. If you pay all your savings into an annuity and then pass away a year later, your family will not get the remainder of your pension back (depending on the type of annuity you choose).

It is possible to buy more than one annuity, so if there are two types that you are struggling to choose between you could put half your savings into each. For example, if you want an escalating annuity to cover yourself against rising inflation, but also want the protection that comes with a value protected annuity, you could invest some of your savings into each.

What are the alternatives to an annuity?

It is no longer a requirement to have an annuity with your pension fund, meaning you are free to choose any type of retirement income you want. Deciding how to manage your money during retirement is an important financial decision that you will need to make.

It is essential to make sure you are completely happy with the decision you are making and that you understand all the options available to you, as well as the risks involved.

There are a number of other options available to you other than an annuity, and some may be more suitable to you and your financial situation. An annuity is not the only way to generate a useful and reliable income from your pension pot or retirement savings, and an increasing number of pensioners are choosing alternative methods since annuities became a choice not a requirement in 2015.

A great benefit of an annuity is that once it has been bought it can be left to its own devices and no further effort is involved, but other methods don’t need to take a huge amount of time and effort. Here are some of the main alternatives to an annuity:


For anyone over the age of 55, drawdown is a flexible alternative to an annuity with the potential to raise the value of your savings and income through investments. As with an annuity, you can take 25% of your pension as a tax-free lump sum, and then the remaining 75% remains invested and can be used as a variable income.

You are free to decide where to invest and how much income to take. Drawdown provides much more flexibility than a lifetime annuity, but also comes with considerable risks. If you choose to take too much out of your savings, your investments perform badly, or you live longer than you expected then you risk running out of funds completely. If you choose to invest by yourself, these decisions are your responsibility and can leave you with nothing.

Investing In Stocks And Shares

It is becoming increasingly popular for individuals to choose to invest their pensions or life savings into stocks and shares themselves, instead of buying an annuity. In most cases, if you want to successfully generate a retirement income by owning shares, bonds or funds, you will need the help of a fund supermarket or fund shop.

Fund shops are online platforms that can handle the administration and taxes of a self-invested personal pension. It can be complicated to choose the best fund supermarket for your needs, and it is important to shop around to find one that works for you. There is a range of different types of investments you can make with your pension, and it isn’t recommended to start investing by yourself without some prior knowledge or experience.

Peer to Peer Lending

Banks operate by using the money in customers’ savings accounts to lend out to borrowers in the form of loans. With peer to peer lending, you are essentially taking out the middleman and lending directly to individuals and businesses yourself.

There are a number of peer to peer saving websites out there that allow you to split your savings among a large number of different borrowers. This means you won’t lose everything if one individual defaults on their loan. Various peer to peer lending companies charge different interest rates so do your research to find one that is reasonably priced and reliable.

Buy to Let

For those who don’t want to risk their savings on stocks and shares that they don’t properly understand, buying a residential property to rent out can be a great alternative. Depending on the area you are in, you can often make a large profit on purchasing a residential property and renting it out.
However, this option does come with a lot more work and additional costs, as you will end up being a landlord you will be responsible for keeping the property in order, and this can sometimes end up being expensive.

One of the easiest ways to decide if an annuity is the right option for you is to determine whether you are concerned about further investing your pension during your retirement. If you are not too bothered by no longer investing your savings then an annuity might suit you best, however, if you want the chance for your pension to continue to grow then an annuity probably isn’t right for you.

How to choose an annuity?

Manoeuvring your way around the ins and outs and various types of annuities can be complicated, but it is essential to know all the details before deciding which option is best for your future. There are so many different types of annuities out there, and so many providers to buy them from, that it can be difficult to know which is right for you.

Ultimately, if you decide an annuity is the best choice for you, then when it comes to choosing a provider and annuity type just look for the option that gives you the best possible pension for the money you have.

Using a pension pot or savings to buy an annuity can be a sensible retirement strategy as it means you will get at least some guaranteed income for the rest of your life. If you choose a joint annuity, then you are also giving yourself peace of mind that your partner will have a guaranteed income for their life as well.

It is absolutely essential to shop around for the best possible annuity rate and always ask providers if you could qualify for an enhanced annuity. You might not think you would be eligible for an enhanced agreement, but it is always worth asking as the rates are much more favourable.

Always keep in mind when shopping around for an annuity that you do not need to use your entire pension pot. If you aren’t 100% sure that it is the right choice for you, just use some of your savings to buy an annuity and keep your options open.

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