Annuities explainedHow they work

You will need to buy an annuity in order to generate an income from your pension

You've spent years putting money aside into a pension scheme but what actually happens once you retire?

Sadly it is not as simple as just withdrawing the money. You must now convert your pension pot into an income, which is typically done by buying an annuity.

What is an annuity?

Quite simply, an annuity is a financial product which provides you with an income for life in return for a lump sum.

Rates are set by insurance companies and typically expressed as a sum per £10,000 or £100,000 of lump sum. So, for example, a 65-year-old man might be quoted a rate of, say £700 income for every £10,000 lump sum.

The major drawback is once you've handed the money over you can't get it back, and if you die soon after buying the annuity then the income you receive won't be anywhere near the amount you have paid in. However, there are steps you can take to protect yourself - see the Problem solvers section.

Insurers can afford to offer annuities that might pay out for 40-years or more because the risk of your living to 100 is pooled with lots of other people's risk. The people who die young effectively cross-subsidise those who live longer than average.

Who needs to buy one?

Anyone who has a lump sum and wants to convert this into an income can buy an annuity, but most people come across them for the first time when they're coming up to retirement and need to convert part of their pension fund into an income.

You'll need to buy an annuity with funds from any personal pensions, stakeholder pensions and most money-purchase employer schemes. The type of annuity you buy with your pension fund money is called a Compulsory Purchase Annuity. We also refer to these as Pension Annuities.

If you belong to an employer's final salary scheme, your pension is usually paid directly from the scheme so you don't have to think about annuities.

Also with some money purchase pension schemes from employers, the pension trustees may buy an annuity for you. Find out what your options are from your scheme manager.