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What is an annuity?

By Paul Davies

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What is an annuity?

Discover how annuities work, how much income you could get by buying one with your pension savings and whether an annuity could be right for you. 

Video transcript

An annuity is a financial product that allows you to turn the pension contributions you made while you were working into a regular income after you retire. You hand over your pot of pension savings to an annuity provider, and it guarantees to pay out a certain amount every month until you die. There are different rates, so it's worth shopping around.

Don't just take the first offer from your pension provider. You'll get a quote as a percentage - if, say, your pension pot is £100,000, and the provider quotes a rate of 6%, it will pay you £6,000 a year.

Unless you get an
annuity that covers you and your partner, known as a guaranteed or joint-life annuity, the provider keeps what's left in your pot when you die. Essentially, providers are making a bet that you won't live so long that you'll use up all the money in the pot or more.

Annuities have been common but,
from April 2015, you'll be able to take all of your pension pot as cash in one go, subject to tax, or you could leave it invested and take out what you like each year.

Either way, it's essential that you get good advice. For more about pension options, see which.co.uk/pensionoptions

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.

Find out more: Your full pension options

What else do I need to know about annuities?

There are several different types of annuity available. A single-life annuity covers just you, while a joint-life annuity pays you an income that, after you die, goes on being paid to your partner or spouse until they die. An enhanced annuity is for people who have a shorter life expectancy, and it will pay out more to reflect that, while escalating annuities rise to keep pace with inflation. A value-protected annuity will allow you to bequeath the remainder of your pot, after any payments are deducted, upon death at any age.

You'll pay income tax on your annuity income. Your spouse, partner or beneficiaries 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 the beneficiary's marginal (income tax) rate if you're over 75 when you die. For other types of annuity, the insurer keeps anything that’s left when you die.

Annuity - examples of what you might get - infographic

What does it mean for me?

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 5.5%, you'll get an annual income of around £5,500 a year. See our example, right, and a member’s story, below.

In our example, Caroline can expect to live an extra 20 years (a 65-year-old man could expect another 18).

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 May 2015 and will vary as gilt prices fluctuate. You can run your own annuity rate comparison using the Money Advice Service annuity calculator.

An annuity is worth considering 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.

Member's story

silhouette avatar

James (who asked to remain anonymous), 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. Shopping around for the best annuity rate and asking whether you qualify for an enhanced annuity are essential before you buy.

  • Last updated: January 2017
  • Updated by: Paul Davies



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