What is a pension annuity and how does it work?

Written by Retirement Line
Reviewed by Mark Ormston

Rates Data Last Updated: 2nd December 2024

As the UK's largest pension annuity broker*, our aim is to help you understand your annuity options.

We help thousands of people each year, providing all the information and guidance you need to make an informed decision about arranging your annuity income.

If you are considering buying an annuity, we can help you ‘shop around’ for the highest annuity income, by comparing the UK’s best annuity rates, quotes and providers without obligation.

On this page:

• What is an annuity?
• Your guide to pension annuities
• How does an annuity work?
• How much income will an annuity generate?
• Will my income increase each year?
• How often will I receive my annuity income?
• What is an annuity death benefit?
• How does an annuity work in terms of taxation?
• Examples of annuity income levels
  
• What are the benefits and risks of annuities?
• Pension annuity features
• Considerations when taking an annuity
• Comparing annuities with other retirement income products
• Annuity FAQ's
• More about annuities

What is an annuity?

An annuity lets you turn your private pension savings or some types of company pension into a regular income. An annuity provider (usually an insurance company) agrees to pay you this income in return for the money you have saved into your pension.

The annuities we can arrange for you with leading providers provide a stable and guaranteed income, unaffected by changes in interest rates or the stock market. You can choose to take your income for the rest of your life, or for a set amount of time. 

Your guide to pension annuities

This guide includes key information you might need when deciding whether to choose a pension annuity. We’ve included links to further information about annuity features and options.

To find out how much annuity income you might receive, try our free pension annuity calculator. If you’d prefer to speak to one of our Annuity Specialists, simply call 0800 652 1316 or request a callback. They’ll be able to talk you through your options and help you choose the best annuity for your needs.

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How does an annuity work?

From the age of 55 you have the option of exchanging the money in your ‘defined contribution’ or ‘money purchase’ pension pot for a regular income from an annuity. Each of the UK's annuity providers offer different annuity rates and product features.

If you’re looking for regular, guaranteed income for life or a fixed term, an annuity might be suitable for you. Annuities provide certainty, allowing you to budget effectively as you’ll know exactly how much income you will receive.

This means you’ll have peace of mind when it comes to your finances. There won’t be any unexpected fluctuations in your annuity income because it’s generally not dependent on investment markets or stocks and shares. Also, once your annuity is set up there are no ongoing charges to pay as annuity costs are built into the annuity rate.

An annuity may also be the right choice if you’d like to provide an income for a dependent after your death. Annuities come with the option of death benefits, so your chosen beneficiary can benefit when you’re no longer around.

How much income will an annuity generate?

How much income you receive will depend upon several factors. They are all taken into account by annuity providers when calculating the annuity rate they offer you. It is this annuity rate that ultimately determines how much your annuity costs.

Here are some of the main factors that will affect how much income you can expect from your pension annuity: 

The size of your pension savings

This is likely to be the factor with the biggest impact on the level of income you receive. The bigger your pension fund, the more annuity income you will receive.

You can take out up to 25% of your pension savings as a tax-free cash lump sum before buying an annuity. If you choose not to take a lump sum you will increase your regular annuity income, but this will be taxable at your marginal rate of tax.

Your age

Generally, the younger you are when you take your pension annuity, the smaller the income payments you’ll receive. But this needn’t be an automatic reason to wait until you are older, as you may receive less income over the long term if you delay starting your annuity.

Whether you choose a lifetime or fixed term annuity

Annuity income is either paid for the rest of your life, or for a set period:

• A conventional lifetime annuity pays you an income for the rest of your life. It means that your pension savings will not run out and your payments will continue until you pass away, no matter how long you live.

• If you don’t wish to commit to a lifetime annuity, you can instead choose a fixed term annuity. This is a more flexible annuity with an income and term of your choice and lets you keep your options open for the future.

Do you qualify for an enhanced annuity?

If you have certain medical conditions or make certain lifestyle choices, you may qualify for extra income with an enhanced annuity. Enhanced annuities are available only on a lifetime basis, and not for a fixed term.

Having an adverse medical history or current medical condition isn’t usually to your financial advantage. But the opposite is true with annuities. UK enhanced annuity providers have identified more than 1,500 medical conditions and lifestyle choices that could qualify you for more income.

Those who qualify could be entitled to up to 75% more income than people with a clean bill of health. We help nearly 90% of our lifetime annuity clients secure an enhanced annuity - and a higher retirement income. 

To find out whether you qualify for an enhanced annuity, call us on 0800 652 1316 or request a callback. One of our Annuity Specialists will take you through a health and lifestyle questionnaire to check your eligibility.

Gilt yields

Annuity providers typically link the rate they offer to the yields of long-term government bonds (also known as gilts). These yields are linked to the Bank of England base rate, so when the base rate rises, annuity rates are also likely to rise.

Will my income increase each year?

The UK State Pension increases each year under the ‘triple lock’ arrangement. With an annuity however, you decide whether to take your income on a level or increasing basis. 

A level annuity

With a level annuity, you’ll receive the same guaranteed annuity income each year. Choosing this option means that your income will have less buying power as each year passes, due to the effect of inflation. 

An escalating annuity

With an escalating or increasing annuity, you will initially receive lower payments than a level annuity. Payments then rise in line with inflation or at a fixed rate with each year that passes. It can take many years for an escalating annuity to start paying as much as the level annuity. 

Choosing between a level or escalating annuity

Which option is right for you depends on factors such as your age, your other income sources and your plans for retirement. You can read more about level vs escalating annuities. Or for quotes so you can compare your options, call our friendly team of Annuity Specialists today on 0800 652 1316 or request a call back.

How often will I receive my annuity income?

As well as choosing whether to receive a level or increasing income, you can also select the frequency of your annuity payments. You can normally receive your income monthly, quarterly, half-yearly or annually. 

You can also decide whether to take the income in arrears or in advance. You will receive the highest income if you choose to be paid in arrears, rather than in advance. Also, choosing annual payments in arrears would mean a higher annuity income than monthly payments. However, you may prefer to take a monthly income if you have been used to receiving a salary in this way. 

What is an annuity death benefit?

There are a number of ways that you can make sure that a beneficiary would receive either regular payments or a lump sum when you pass away: 

• A joint life annuity continues to make payments to your beneficiary for the rest of their life. 
• An annuity guarantee period pays your beneficiary an income for a set term should you pass away. 
• Adding value protection to your annuity means your beneficiary will receive a lump sum of your remaining fund when you pass away.

Your beneficiary doesn’t normally need to have a spouse or civil partner. For example, you can generally take out a joint life annuity with any financial dependent aged 40+.

Choosing one of these death benefits will typically reduce your own annuity income payments. To maximise your annuity income, you can elect to have no death benefits in place. This would mean that when you pass away, your annuity payments stop and nobody continues to benefit from your pension fund.

How does an annuity work in terms of taxation?

Before setting up your annuity, you can take up to 25% of your pension fund as a tax-free lump sum. Any lump sum or income you then receive from the annuity is treated as taxable income in line with UK tax laws.

There are specific ways that a fixed term annuity may potentially help you to minimise your tax burden; read more about fixed term annuities.

The death benefits mentioned above will normally be paid tax free to your nominated beneficiary if you die before age 75, but will be treated as their taxable income if you die at 75 or over.

Update – October 2024 Autumn Budget: 

In the Budget of 30 October 2024, the government announced that pension savings will be considered part of someone’s estate and liable to inheritance tax (IHT) from April 2027. This will be within existing IHT rules: IHT is not payable by a person’s spouse or civil partner, and is only typically payable on estates over relevant IHT thresholds.

Another aspect of inherited pensions is income tax. Currently, if you pass away before age 75 any pension funds or annuity income your beneficiaries receive is free of income tax, whereas they are liable for income tax at their marginal rate if you die after age 75. Retirement Line’s understanding is that beneficiaries may still be liable for income tax on inherited pension income from April 2027, although it isn’t clear whether the ‘age 75’ rule will remain.

More information will be available following a government consultation period that will run until early 2025. We are monitoring this issue and will report on it once the matter is clarified. Please see our Budget report for more information: Budget 2024 – pensions brought into inheritance tax from 2027.

Examples of annuity income levels (December 2024)

To illustrate how much annuity income your pension savings could generate, below are some examples. These show the income that pension pots of six different sizes would generate, based on the best available annuity rate available for a 65-year-old male on 2nd December 2024.

Please remember to think about the total income you might receive when choosing between a lifetime and fixed term annuity. A lifetime annuity could pay greater total income than a fixed term annuity, depending on how long you live. Based on current data from the Office of National Statistics, the average life expectancy of a 65-year old male would be an additional 18.5 years; for a female it would be an additional 21 years.

Note:

• The above amounts are for a 65-year-old male taking a single-life level annuity paid monthly in arrears.
• The lifetime annuities include a guarantee period of five years. 
• Higher income levels from lifetime annuities may be available for people qualifying for enhanced rates based on health conditions or lifestyle factors.
• The fixed term annuity rates are based on taking all of your money by the end of the fixed term. However, most people in our experience choose a ‘Guaranteed Maturity Amount’ option where you leave some of your pension savings untouched. This will mean you have money left at the end of the term, but it will lessen how much regular income you receive during the term.

Annuity rates change daily, so these figures may not reflect the latest annuity rate and the annuity income that your pension savings could achieve. 

Click here for your free, no-obligation annuity quote

What are the benefits and risks of annuities?

As with most financial decisions, choosing a pension annuity brings certain risks as well as benefits, which we explain below. 

Risks of a pension annuity:

❌ Inflation will reduce a level annuity over time, in real terms. You can, however, opt for an escalating annuity that pays you an increasing income each year. You can opt to increase your payments by a fixed amount, or in line with the Retail Prices Index.

❌ With a single life annuity with no death benefits, income will cease on your death. However, there are options that will pay your beneficiary an income or lump sum when you pass away.

❌ You won’t have the opportunity to participate in future investment returns, unlike some alternative retirement income options.

❌ Once in force, you cannot change or amend an annuity contract.

Benefits of a pension annuity:

✔️ A pension annuity provides a secure level of income for life or a fixed term. It’s normally not dependent on the performance of investments, so you don’t need to worry about investment risk.

✔️ You can opt to include death benefits for your spouse or any nominated beneficiary.

✔️ Pension annuities can also offer enhanced terms if you have certain qualifying medical conditions or lifestyle choices. This means you could get a higher income.

Pension annuity features

You can shape your annuity to fit your circumstances and needs, with a number of flexible options. Here is a summary of the main features available when choosing an annuity, with links to further information:

Considerations when taking an annuity

If you decide that an annuity is right for you, here are some issues to consider when deciding on the type and configuration of the annuity product you take.

Will you have other sources of retirement income? 

You may decide to choose an annuity that fits with other income sources you have now, or expect in the future. For example, if you are 60 and wish to semi-retire, you may choose to take a fixed-term annuity that pays you an income until you are 66 (for example) when your State Pension and other private pensions may begin. 

Is inflation protection important to you? 

Choosing an escalating annuity will mean that your annuity income increases each year, but it will start at a lower amount than a level annuity. Think about how much income you need now compared to your likely future needs when choosing between a level or escalating annuity.

Is leaving money for loved ones important to you? 

You can add death benefits to your annuity so that a beneficiary benefits from your pension fund should you pass away before them. But remember that adding death benefits will lower your own regular income from the annuity.

Do you want future flexibility? 

A lifetime annuity locks in your annuity income until you pass away. A fixed term annuity can be set up so that some of your pension fund is still available at the end of the term, and you will have options available in terms of what to do with it.

Comparing annuities with other retirement income products

As well as annuities, one of the other options for drawing money from your pension savings is flexi access drawdown. This table illustrates some of the main similarities and differences between these two options:

This annuity/drawdown comparison article is for information only – please seek further guidance or advice before taking any action.

Click here for your free, no-obligation annuity quote

Speak with an annuity specialist today

As the UK’s leading annuity broker*, Retirement Line is well placed to provide you with thorough and factual annuity information to help you determine whether a pension annuity is the right retirement income option for you.

Our team of Annuity Specialists will be able to provide you with market leading quotes and annuity rates from the top annuity providers in the UK.

For a free, no-obligation annuity quote, get in touch with our team today by calling 0800 652 1316 or email us at [email protected]. 

What Our Customers Say

Annuity FAQ's

What does Martin Lewis say about a pension annuity?

He is the UK’s most famous personal finance broadcaster, so it’s interesting to see what Martin Lewis says about annuities. In his April 2023 article titled “Martin's 18 pension pumpers:  Need-to-knows to protect & boost savings for, and in, retirement”, he included specific information about the importance of shopping around to secure the best annuity rate.

He wrote: “DON'T just get an annuity from your pension provider without checking elsewhere (start with a quick annuity comparison), as you could be locking in many £1,000s less each year for life.”

Martin also mentioned the way that an enhanced annuity can pay income: “DO remember if you've health issues, or are a smoker, you may be able to get a special higher rate.”

What is the difference between a pension annuity and drawdown?

When you are looking at ways to turn your pension savings into an income, often two of the main choices you will consider are an annuity or pension drawdown. 

In summary:

An annuity converts the money in your pension savings into guaranteed retirement income for your choice of either your lifetime or a fixed term. Your income for the duration of the annuity is unaffected by future changes in interest rates or stock market performance although generally once the annuity is purchased the terms cannot be changed. This provides a guarantee of income, but does of course mean you wouldn’t benefit from investment growth.

Pension drawdown (flexi-access drawdown) on the other hand is where your fund remains invested and gives you the flexibility to draw an income from it as you need it. You could therefore benefit from good investment performance. But you also run the risk of seeing your fund value fall, potentially meaning that it cannot sustain the amount of future income you need. You can ofcourse vary the income you take in order to suit your requirements.

Please see the table above (‘comparing annuities and drawdown’) for a more detailed look at the pros and cons of each of these pension income options. 

More about annuities