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Income option – arrange an annuity

Discover the pros and cons of arranging an annuity. Learn why the people in our case study went for this option.

In this article
What is an annuity? How do annuities work? How did pensions change under the 2015 rules?
Is an annuity suitable for me? Where should I get advice about annuities? Annuities: a case study

What is an annuity?

An annuity is a product that allows you to convert your pension fund into a regular income that will last for the rest of your life.

The big benefit of an annuity is that your income is guaranteed. You’ll receive a fixed regular payment each year until you die, however long you live.

The flipside is that, up until now, if you die early, you won't usually be able to leave any to your family, irrespective of how much of your fund has been paid out (unless you've taken out a joint-life, value-protected or guaranteed annuity).

You are able to buy an annuity if you have a defined contribution workplace pension.

This is one that sees you pay into a pot but your pension income depends on investment performance or personal pension. 

You can transfer out of your final salary scheme (private schemes, but not unfunded public sector schemes) and buy an annuity if you wish. However, staying in your final salary scheme will usually be the prudent option.

Sales of annuities have fallen as people have increasingly opted for income drawdown, but arranging an annuity with part of your pension fund might still be a sensible option to consider.

If you opt for an annuity, you need to be very sure about it as you can't change your mind once you've bought it.

Better death benefits on annuities

Since April 2015, your spouse, partner or beneficiaries can receive the payments from a joint-life, guaranteed or value-protected annuity tax-free if you die before age 75.

Payments are taxed at the beneficiary's marginal rate if you're over 75.

A joint-life or dependent's annuity is now able to be paid to any nominated beneficiary after you die.

More about annuities: What is an annuity?


How do annuities work?

The income you receive from an annuity will obviously depend on the size of the fund you build up. Quotes for annuities are given as a percentage.

If you multiply your pension savings by the percentage, you’ll get how much income you’ll get each year.

For example, a pension fund of £100,000 with an annuity rate of 5% will produce an annual income of £5,000.

The Money Advice Service has an annuity comparison tool to allow you to compare rates.

The most common types of annuity are:

  • Single-life annuity – all the income is paid to you
  • Joint-life annuity – some or all of the income is paid to your partner after you die
  • Escalating or index-linked annuity – your income rises, usually in line with inflation
  • Enhanced annuity – pays you more income if you have a medical condition
  • Investment-backed annuity – your money remains invested, with the potential of higher returns
  • Fixed-term annuity – pay out for a fixed term, after which you get a lump sum.

How did pensions change under the 2015 rules?

DC pension holders aged 55 and over are able to access their fund however they wish (income or cash).

This is irrespective of the fund size and other sources of income, and has led to fewer people choosing to buy an annuity at retirement.  

As previously, you can take a 25% tax-free lump sum. Other funds drawn from your pension pot are subject to the marginal rate of income tax.

More flexible alternatives have lead retirees to consider other options instead of automatically turning their pension pot into an annuity.

Is an annuity suitable for me?

It may be that an annuity forms one part of your retirement solution.

Part of your fund could be set aside to buy an annuity (perhaps if you've a pension with a guaranteed annuity rate), to give you a regular core income, while the remainder stays invested.

In this way, you could cover your main bills in retirement and draw down money for any ‘extras’.

Another strategy might be to use income drawdown in the early years of retirement, before considering the different annuity options.

Arranging an annuity at a later date, say in your mid-70s, will allow the needs of later retirement and long-term care to be included in any decision-making.

Where should I get advice about annuities?

Which? has always argued that buying an annuity is a major decision, so consulting with an independent financial adviser is a sensible idea.

The fact that so many people have bought an annuity with their pension provider in the past and not received a great deal underlines the need for independent advice.

This hasn’t changed in the new pension world with the arrival of the government-backed Pension Wise guidance session.

A financial adviser will research the annuity market for you and make a recommendation based on your goals.

The Pension Wise session considers annuities as an option. The guidance session is being delivered by independent organisations, including The Pensions Advisory Service (TPAS) and Citizens Advice.

The Money Advice Service (MAS) offers support via a retirement adviser directory for consumers who would like to find a regulated financial adviser

Anyone with a DC pension who is approaching retirement and would like the chance to access Pension Wise can book an appointment on 0800 138 3944.

Annuities: a case study

John and Jean Burnard, Loughborough

John and Jean chose an annuity because ‘the offer on the annuity was too good to pass up’. They were approaching 75 and needed to cash in their pensions to give their finances a boost.

The guaranteed annuity rate on John’s pension was 15.4%, which became around 20% when he added Jean on a joint-life basis, because she qualified for an 'enhanced' annuity after a cancer diagnosis in 2008.

The offer on the annuity was too good to pass up

John Burnard

They were happy to have a monthly top-up to their state pension through the annuity payment.

John said: ‘We only had to live for another five years, therefore, to be in credit.’

With a guaranteed income from the Just Retirement annuity, the Burnards cashed in smaller pension pots to use as and when they needed them.

Which? expert view

The Burnards were extremely active in making sure that they got the best rate possible when arranging their annuity. A guaranteed annuity rate (GAR) can help convert your pension fund into an attractive regular income for the rest of your life, and that of your partner if you choose to add them to the annuity.

Asking whether you have any annuity guarantees or enhancements on your pension fund is essential before you cash in or shift your retirement funds. An annuity can still form part of your retirement planning, but you need to do your research to get a decent rate.