What is an annuity?
An annuity is an insurance product that allows you to swap your pension savings for a guaranteed regular income that will last for the rest of your life.
How much you get is determined by the rate the annuity provider offers.
People who have serious health problems should be offered a higher rate than someone who’s likely to live for many years. The insurer is essentially taking a bet that it won’t end up paying out more than the total pot.
Buying an annuity used to be the only option for most people with a defined contribution pension (where you save into a pension scheme over your working life to build up a pot).
The pension changes of April 2015 opened up more choices, but opting for an annuity will still be right for some people.
What type of annuity should I buy?
Annuities come in all shapes and sizes, but it's vital that you pick the right one - because once you buy, you can't change your mind.
Since April 2015, you've been able to withdraw as much of the money as you want when you reach 55 as another option, although it will be taxed as income.
You'll have to weigh up a number of options that will influence which type you end up buying – if an annuity is the right choice for you.
Key things you should consider when deciding on your pension options (eg an annuity, income drawdown or cashing in your pension) include:
- whether you want protection against inflation
- how much risk you’re prepared to take
- whether anyone else is dependent on you for income
- how much flexibility you need to change your pension after it has started to be paid
- how much control you want over your investments
- what charges you'll need to pay
- whether you want to provide an inheritance for your survivors
- what your state of health is, and whether you are or have been a smoker.
Always shop around before buying an annuity - it's an irreversible decision. Find out more about the best ways to do this in our guide to buying an annuity.
The different types of annuity
How much annuity income will I get?
When you get a quote for an annuity, you'll be given a rate as a percentage. You base the calculation on your total pot to find out how much retirement income you'll get every year.
So, if you have £100,000 in your pension pot and are offered an annuity rate of 5.0%, you'll get an annual income of around £5,000 a year. See our example, right, and a member’s story, below.
In our example, Caroline can expect to live an extra 21 years (a 65-year-old man could expect another 19).
You'll generally find that the older you are when you arrange an annuity, the higher the annuity rate you'll get from your chosen provider. Money can be paid monthly, quarterly, half-yearly or yearly, depending on your company.
These rates are correct as of January 2018 and will vary as gilt prices fluctuate. You can run your own annuity rate comparison using the Money Advice Service annuity calculator.
Do I pay tax on my annuity?
The money you get paid from an annuity is treated as income, and therefore subject to income tax.
Your annuity income will be added to any other sources of income you have in retirement, including the state pension, to work out the rate of income tax you'll pay.
Find out more in our guide to tax on pensions.
What happens to my annuity when I die?
For most types of annuity, the insurer keeps anything that’s left when you die.
But your spouse, partner or anyone you've nominated will receive the payments from a joint-life, guaranteed or value-protected annuity tax-free if you die before age 75.
Payments will be taxed at your heir's marginal (income tax) rate if you're over 75 when you die.
Pros and cons of annuities
Annuities could be right for you if...
- you want a guaranteed income for the rest of your life
- you don’t want your retirement income to be subject to stock market fluctuations
- you want your income to rise with inflation
- you’ve had poor health and will qualify for a higher income.
An annuity might not be the best option if…
- you have a very short life expectancy
- you may change your mind
- you want to keep your money invested
- you want a single annuity but want to leave something behind
- you’re wary of taking your chances with the annuity rate at the time of purchase.
Buying an annuity: a case study
James, aged 66, Devon
Which? member James was looking forward to retiring in March 2015. He has three separate pensions and took his initial personal pension as an annuity at age 60.
Now, six years later, he’s decided to buy annuities with the other two, which include his main pot.
James’ main pension fund is with Prudential (£112,000) and, in March 2015, James opted for a joint-life annuity that pays his wife 100% of the income if he dies.
Having taken the maximum tax-free lump sum that the rules allow (£28,000 – that’s 25% of £112,000), the annuity income will be £4,689 a year.
I prefer the certainty of an income for life. I have never been a gambler.
He sensibly shopped around, getting 10 quotes from different pension companies before deciding to stick with his own pension provider.
James also checked with his provider to see whether his contract had a guaranteed annuity rate (GAR) on it – a guaranteed rate will pay out a higher amount than the average.
Which? expert view
Using some of your pension pot to buy an annuity may form part of a sensible strategy. This means you’ll have at least some income for the rest of your life – and so will your spouse if you opt for a joint annuity.