Annuities explained How 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's not as simple as simply 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 where you exchange a lump sum for income. In the case of pension schemes, you usually exchange your pension fund for an income payable for the rest of your life, often called a compulsory purchase annuity.
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, £350 income for every £10,000 of lump sum.
The major drawback with annuities is that 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've paid in. However, there are steps you can take to protect yourself – see the annuity options 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 (known as mortality gain).
Who needs to buy an annuity?
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 all or 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.
See our book Pensions Explained, which covers state, personal and company pension funds.
- For a personalised solution, call our experts on the Which? Money Helpline
- Take a look at our expert guide to writing a will
- Read our full guide to planning your retirement for more information about pensions
