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Published 05 April 2023

Pension Annuity: Retire with a Guaranteed Income

Buying a pension annuity with some or all of your pension pot means you can rely on a certain level of retirement income. There are different types of annuity that can provide for your loved ones after you die, pay a higher income if you’re in ill health or smoke, and keep pace with inflation.

Buying a pension annuity with some or all of your pension savings means you can retire with the reassurance of knowing that you’ll have a regular income for the rest of your life. Here’s what you need to know about the types of annuity that are available, whether a pension annuity could be right for you and how to buy an annuity.

What is a pension annuity?

A pension annuity is a policy sold by an insurance company that allows you to convert the money you’ve saved in a defined contribution pension into a guaranteed retirement income. Most people choose a pension annuity that will continue paying an income until they die, but there are annuities that will pay out for a fixed amount of time.

A pension annuity is just one of the options you have for withdrawing the money from a defined contribution pension at retirement. The rules allow you to take 25% of your pension savings as a tax-free lump sum. What remains can then be withdrawn if you’re willing to pay the tax charges, left invested and used to take payments via income drawdown, or used to purchase an annuity.

The money can be split between these options, and you can use all or some of your pension to buy an annuity. Depending on the type of annuity you choose, you may be guaranteed to receive a certain level of income throughout your retirement.

» MORE: What are your options at retirement?

Can anyone buy a pension annuity?

Buying a pension annuity usually only becomes an option once you reach age 55 (57 from 6 April 2028). The exceptions may be if you’re allowed to retire early because of serious ill health, you have a terminal illness, or if your job comes with a protected lower age of retirement.

The pension savings you’re using to buy an annuity must also be held in a defined contribution scheme, such as a personal pension, self-invested personal pension (SIPP) or workplace defined contribution scheme. You may however be able to buy a purchased life annuity using money that isn’t coming from a pension pot.

What are the different types of annuity?

There are a number of different types of annuity, each with their own purpose or features. These include:

Single life annuities

This is a pension annuity that pays an income solely to you. Single life annuities are the most popular type of annuity, but once you die the income stops as well.

Joint life annuities

A joint life annuity initially pays an income to you, but then continues to pay an income to your spouse, partner, or other beneficiaries you have nominated after you die. You can choose whether the income paid to your surviving partner is for the same amount that you received, or for two-thirds or half of what you were being paid. But be mindful that the more you want them to receive, the lower your starting income is likely to be.

Fixed-term annuities

Fixed-term annuities provide you with an income for a set number of years – usually between five and 10 years – and then pay a guaranteed lump sum back known as a ‘maturity amount’ that you can then use as you like – to buy another annuity or to choose pension drawdown, for example. This option – which may also be called a short-term annuity – can be useful if you think you may be able to secure a better annuity rate in the future than what you’re currently being offered.

Guaranteed annuities

These are annuities where you have purchased an optional guarantee period. A guaranteed annuity pays an income for a set period of time, even after you die. So if you choose a five-year guarantee period and die after two years, your dependants will continue to receive an income from the annuity for another three years.

Enhanced annuities

Also known as an impaired life annuities, these policies pay a higher income than standard annuities because they take into account health issues or lifestyle choices, which are likely to shorten your life expectancy. Conditions such as high cholesterol or diabetes, or being a smoker or overweight, could all make you eligible for an enhanced annuity.

Level annuities

Sometimes also called fixed annuities, a level annuity means your income will remain the same throughout the life of the annuity. A level annuity gives you the opportunity to secure the highest income possible straight away, but it won’t protect against the impact of inflation so will not buy you as much as it once did if prices rise.

Escalating annuities

With an escalating annuity, you start with a lower income than with a standard annuity but your income will increase each year. This may be by a fixed percentage or it could be linked to inflation, with the aim of maintaining the purchasing power of your annuity.

Investment-linked annuities

As their name suggests, the amount of income you receive with this type of annuity will be linked to the performance of investments – these will usually be in the form of ‘with profits’ or unit-linked funds. While investment-linked annuities can provide the opportunity to grow your income, there is also the risk of income dropping if the investments underperform, however it should be noted that these will still usually come with a minimum guaranteed amount that you will receive regardless of investment performance.

Capital or value-protected annuities

Taking a pension annuity offering capital or value protection provides you with the ability to allocate a portion of the capital you used to buy the annuity to be paid out to a beneficiary if you have received less than this amount in income payments when you die.

The various types of annuity that we have explained are not necessarily mutually exclusive, and can often be linked together. For instance, it might be possible to buy an enhanced single life annuity with a guarantee period, or a joint annuity with escalating payments.

However, while any guarantee or protection for spouses and other dependants can provide valuable peace of mind, it will usually mean you receive a lower starting income from your annuity each month.

How much income will I get from a pension annuity?

How much income you receive from a pension annuity will depend on the value of the pension savings you use to buy an annuity and the annuity rate that you’re offered by a pension provider.

As to what determines an annuity rate, this will depend on your personal circumstances, the type of annuity you want, and the features you want to include. The following will all usually be important:

  • your age
  • your health and lifestyle
  • where you live
  • whether you want an income for life or for a set amount of years
  • whether you want your annuity income to increase each year
  • whether you want your annuity to provide an income for someone else after you die
  • the general level of annuity rates available when you buy an annuity

Usually, the older you are when buying an annuity, the higher the annuity rate you’ll be offered. Similarly, if you have a medical condition that may curtail your life, or live in an area where life expectancy is generally shorter than other areas, you should also expect a higher annuity rate.

On the other hand, if you add guarantees to your annuity, want your income to rise in line with inflation, or want your annuity to pay out to loved ones when you die, you’re likely to be offered a lower annuity rate.

How do you calculate annuity income?

Most annuity providers will have a pension annuity calculator on their websites to help illustrate the retirement income you might expect.

For example, if you want to use £100,000 of your pension savings to buy an annuity and have been offered an annuity rate of 4%, this will give you a rough income of around £4,000 each year.

How are annuities taxed?

When accessing your pension, it’s possible to take up to 25% of your pot as a tax-free lump sum. Anything you take beyond that – including annuity income – is liable to income tax.

So if you buy an annuity with your pension, the income you receive will be taxed at your income tax rate.

» MORE: Learn about paying income tax

Where can I buy an annuity?

You can buy a pension annuity from a number of different insurers or retirement income specialists, although the choice of annuity providers has narrowed considerably over the past decade.

If your pension provider offers annuities, they will provide you with an indication of the income you could secure by taking an annuity out with them. But while this may be the simplest path to buying an annuity, it doesn’t guarantee that you are getting the best possible annuity rate. Indeed, you are under no obligation to take an annuity with your existing pension provider.

Instead, you can use what is called the open market option (OMO) to buy an annuity with any annuity provider. Shopping around for the best annuity income possible is a must because once you have bought an annuity, it’s almost impossible to transfer to another provider or cancel your annuity and get back your full capital. Therefore, you need to get your choice of annuity provider right first time.

What happens to an annuity when you die?

This depends on the type of annuity you choose, but in most instances the annuity will stop paying an income and the annuity provider will keep the capital you used to buy the annuity. This is because annuities are essentially insurance products, and any leftover capital is required to support those policyholders who live longer than the provider anticipated and whose own capital has been depleted.

The exceptions are if you choose a joint-life, guaranteed or capital-protected annuity – then your partner, spouse or other beneficiary/ies that you nominated will receive the payments they are due.

These will be tax-free if you are under 75 when you die, or liable for income tax at your beneficiary’s marginal rate if you are over 75.

» MORE: What will happen to my pension when I die?

Is pension drawdown better than an annuity?

The answer to this depends on how much certainty you want over your income in retirement and your willingness to take on risk.

If you want the security of knowing you’ll have a certain level of retirement income at your disposal, this is what a pension annuity can provide. But if your priorities are flexibility in how you can access your pension and the chance for future growth in your pension pot, this is where drawdown has the potential to deliver.

Neither option is perfect – drawdown involves your pension funds remaining invested, so there can be no guarantees of an income for life or that the income you draw won’t need to decrease at some point in the future. On the downside with an annuity, the income you secure depends on the pension annuity rates available at just one moment in time and, if you pass away early, a lifetime of pension saving may never deliver the level of financial benefit that it should.

To get the best of both worlds, using some of your pension savings to buy an annuity and some to enter drawdown might therefore be an option worth considering.

It is worth seeking professional financial advice before deciding to enter into drawdown or take out an annuity in order to ensure you choose the most suitable option for your specific circumstances.

» MORE: Could pension drawdown work for you?

Are annuities worth it?

Whether a pension annuity is the right choice will ultimately depend on your individual circumstances and the types of features that you are looking for. It is important to understand the pros and cons of pension annuities.

The benefits of a pension annuity

  • It can provide a guaranteed income for the rest of your life.
  • You could ask for your income to rise in line with inflation.
  • If you have poor health, an enhanced annuity might pay you a higher income.
  • If you live long into retirement, the total income you receive from your annuity could outstrip the capital amount you used to pay for it.
  • As your income is guaranteed, you don’t have to manage your own investments or worry about stock market performance.
  • Certain types of annuity allow for your loved ones to be supported financially after you die.

The drawbacks of pension annuities

  • If you die shortly after you buy an annuity, your pension savings could be lost and you will have received very little in the way of financial benefit.
  • You cannot change your mind or switch providers after you have bought an annuity.
  • If annuity rates are low, you may be disappointed with the income you receive.
  • To get the highest annuity rate for yourself, you’ll have to forgo the annuity types and guarantees that could see dependants provided for after you die.

The importance attached to securing the best pension annuity means there is a lot you need to consider when making a decision about an annuity.

At the very minimum you should shop around for the best pension annuity rates and if you’re in any way unsure, you should seek financial advice.

» MORE: How to get pension advice

WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.

About the Authors

Ruth Jackson-Kirby

Ruth is a freelance journalist with 15 years of experience writing for national newspapers, magazines and websites. Specialising in savings, investments, pensions and property.

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Tim Leonard

Tim is a writer and spokesperson at NerdWallet and holds the Chartered Insurance Institute (CII) Level 3 Certificate in Mortgage Advice. He has over 20 years’ experience writing about almost…

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