What is an annuity? 

An annuity is a type of insurance product that allows you to exchange some or all of your pension for a guaranteed, regular income once you reach the minimum pension retirement age (currently 55, rising to 57 in 2028) 

It is a popular option for savers who want a certain payout each month, removing the risk of leaving a portion of your pension pot invested.

The trade off is that you won’t benefit from any investment growth, and generally annuities can’t be changed once set up. 

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How does an annuity work? 

An annuity works by handing over a lump sum of pension savings to an insurance company. This provider will calculate and offer an ‘annuity rate’ based on your life expectancy and market interest rates.

For example, a rate of 6% would mean that for every £100,000 of your pension paid to the provider, they would pay you £6,000 a year for the rest of your life. 

• If you live to be 100 your insurer loses money but you would likely profit. However, if you passed away two years after buying your plan, the insurer usually keeps the rest of the pot, unless you purchased specific guarantees. 
• Once you purchase a lifetime plan, the decision is usually irreversible. You cannot change your mind or ask for your lump sum back. 

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The main types of annuity 

If you’ve decided an annuity is right for you, you can tailor it to suit your specific needs, but every feature you add will affect the rate you’re offered. 

• Lifetime annuity: This pays you a regular income for the rest of your life, no matter how long you live. This may be the best protection against the ‘longevity risk’ of living longer than your savings allow. 
• Fixed-term annuity: This pays you a fixed amount for a set period, like five or ten years. At the end of your term you may also get back a ‘maturity amount’, which you can use to buy another plan or move into drawdown. 
• Index-linked annuity: This type of plan will start with a lower payout, but increase each year to track inflation, and protect the purchasing power of your payments. 
• Single-life annuity: These are designed for a single person. When this person dies, payments are stopped and the plan ends. Typically these offer a higher starting rate, because the insurer expects to pay out for a shorter time. 
• Joint-life annuity: This continues to pay an income to your spouse or partner after you die. You usually choose what percentage they receive e.g. 50% or 100% of your income. Because the insurer expects to pay out for longer, the starting rate is lower than a single-life policy.
• Enhanced annuity: This is a type of lifetime annuity that pays a higher guaranteed income if you have certain health conditions or lifestyle factors (like smoking or high blood pressure) that may shorten your life expectancy. As the insurer expects to pay out for a shorter period they offer a more generous rate.
• Purchased life annuity (PLA): This provides a guaranteed income bought with cash savings rather than a pension pot. The primary benefit is tax efficiency, as the government treats a large portion of each payment as a tax-free ‘return of capital’. 

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How to buy an annuity? 

When buying an annuity, consider the following:

1. The most important rule of buying an annuity is to consider your options. The first offer you get may not necessarily be the best, and you can potentially boost your income for free!
2. Make sure you make accurate health declarations. When getting quotes, you’ll be asked health related questions, and it's important you're totally honest. If you smoke, are overweight, or have conditions like diabetes or high blood pressure, insurers may offer you an ‘enhanced annuity’. Lower life expectancy means they can afford to pay a higher income. 

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Annuity vs drawdown 

Choosing between annuity and flexible drawdown is a big decision, so consider the following factors:

• Income security: Annuities guarantee an income, whereas flexible drawdown accepts a degree of uncertainty because of investment performance.
• Flexibility: Annuities have low flexibility as income is fixed once set up. Drawdown is highly flexible as you can adjust your income whenever you like.
• Investment risk: Annuities carry no investment risk, this risk is transferred to your insurer. Drawdown can be a  higher risk as your investments can move up and down in value.
• Death benefits: Annuities generally have poor death benefits and income stops when you die (unless joint-life). If you choose to draw your own income, the remaining pot will be passed on to your beneficiaries.

Annuities are generally suited to people who want peace of mind and essential income covered. Flexible drawdown is better for people who want full control, and some potential growth at the expense of taking on some risk. 

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What happens to your pension when you die?

Historically, pensions have been one of the best vehicles for passing wealth down the generations because they aren’t included in your legal estate, meaning they’re usually not liable for inheritance tax. However, this is handled differently depending on what type of pension you have, and the age at which you die.

Note: from April 2027, unspent pension pots are expected to become subject to inheritance tax, this may affect how you think about drawdown vs annuity

Read our next guide for more understanding.

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Financial Advice

Chip does not provide financial advice, if you’re unsure what pension options are right for you, speak to a regulated financial adviser. They’ll be able to guide you through your options and give you advice based on your personal circumstances. 

You can find regulated and impartial advisers through the MoneyHelper website. Or, if you’re over 50 you can get free and impartial guidance through Pension Wise.