What is a pension annuity?

A pension annuity is a type of insurance policy that gives you a guaranteed retirement income for life. You can buy an annuity plan with all or some of your pension pot to receive income payments. There are several types to choose from.

Ruth Jackson-Kirby Published on 24 March 2021. Last updated on 25 March 2021.
What is a pension annuity?

An annuity can form a valuable part of your retirement income but falling rates in recent years have put many people off. Here’s what you need to know about annuities.

What is an annuity?

An annuity is an insurance policy that gives you a guaranteed retirement income for a certain amount of time. You can use all or some of your pension to buy an annuity and ensure you have something to live off throughout your retirement.

There are a number of different annuities you can choose from. These include:

  • Single life – an annuity that pays just you an income.
  • Joint life – an annuity that continues to pay an income to your spouse or partner after you die.
  • Fixed-term annuity – these policies pay an income for a set number of years, then you receive a guaranteed amount back that you can invest or use to buy another annuity. They may also be called short-term annuities.
  • Guaranteed period – this type of annuity pays an income for a set period regardless of whether you die. This can be helpful for any dependents you may have.
  • Enhanced – also known as an impaired life annuity, these policies pay a higher income than standard annuities because they take into account health or lifestyle issues that mean you are likely to die early. For example, this could be because you smoke or have diabetes.
  • Escalating – your income will start lower but increase each year. This may be by a fixed amount or linked to inflation.
  • Level (or fixed) – your income will remain the same throughout the life of the annuity.
  • Investment-linked – the amount of income you receive will be linked to the performance of investments.
  • Capital (or value) protection – a portion of the capital you used to buy the annuity will be paid out to a beneficiary if you die within a set period of time.

Different types can be linked together. So, you could buy an enhanced single life annuity with a guarantee period or a joint annuity with escalating payments.

Any guarantee or protection for spouses and other dependants can provide valuable peace of mind but will mean you receive a lower income each month.

» MORE: Make the most of your pension

What income will I get from an annuity?

How much income you receive from an annuity will depend on a number of factors including:

  • How much money you have to buy an annuity.
  • Your age.
  • Your health and lifestyle.
  • Whether you want the income to increase each year.
  • Whether you need the annuity to provide an income for someone after you die.
  • Annuity rates at the time of purchase.

How to buy a pension annuity

There are a number of ways you can buy an annuity. The simplest is via your existing pension provider, but this may not guarantee you the best possible rate. It is better to shop around for the highest income possible on websites such as the MoneyHelper or via an annuity broker.

Once you have bought an annuity there is no going back. This means it is absolutely essential that you choose the best annuity for your circumstances. It is, therefore, a very good idea to get professional help with choosing an annuity and planning your retirement income.

» COMPARE: Pension rates

How are annuities taxed?

When you access your pension, you can take up to 25% as tax-free. Anything you take beyond that is liable to income tax. This includes annuity income. So, if you buy an annuity with your pension the income you receive from it will be taxed at your income tax rate.

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 insurer will keep the capital you used to buy the annuity. This is because annuities are essentially insurance products – any leftover capital is required to support those policyholders that live longer than the provider anticipated and whose own capital has been depleted.

If you chose a joint-life, guaranteed or capital-protected annuity then your partner, spouse or other beneficiary that you nominated will receive the payments tax-free if you are under 75 when you die. The payments will be liable for income tax if you are over 75 when you die.

» MORE: When I pass away, what will happen to my pension?

The pros and cons of pension annuities

There is a lot to consider when making a decision about an annuity.

The benefits

  • A guaranteed income for the rest of your life.
  • If you have poor health, then an enhanced annuity can take that into account and pay you a larger income – this is one time where it pays to be 100% honest about your lifestyle. Any sneaky cigarettes or alcohol units could help boost your income.
  • If you live longer than the insurance company anticipates you could end up receiving a larger income from your annuity than the capital 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.

The drawbacks

  • If you die shortly after you buy an annuity your money could be lost, with you having received very little.
  • You cannot change your mind after you have bought an annuity.
  • If annuity rates are low you may be disappointed with the income you receive.

It is also worth remembering that you don’t have to use your entire pension to buy an annuity. You could use part of your savings to buy an annuity and guarantee yourself a small lifetime income – perhaps enough to cover the essentials – then opt to go into drawdown with the rest of your pot.

» MORE: How to plan for retirement

Where can I go for pension advice?

Everyone aged over 50 with a pension is entitled to a free pension consultation with the government’s Pension Wise service. However, this is only guidance and will not take your individual circumstances into account. For comprehensive, tailored advice you will need to contact an independent financial adviser, although they will charge for their services. You can find an IFA at Unbiased or via the Personal Finance Society.

» MORE: How to get pension advice

Image source: Getty Images

About the author:

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

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