Understanding Pension Annuity
What is a pension annuity?
A pension annuity is a product that turns your defined contribution pension pot into a regular income. It’s bought from an insurance company using some or all of your pension savings. Once set up, it provides an income based on terms agreed at the outset. These terms are fixed and usually cannot be changed.
How to buy an annuity
You buy an annuity by choosing a provider and using a portion of your pension pot to generate a guaranteed income. The insurer sets an annuity rate, which determines how much income you’ll receive based on the amount you invest. This rate is influenced by interest rates, the provider’s pricing, and your personal circumstances.
You can choose how often you’re paid — monthly, quarterly or annually. The start date, payment frequency and any additional features must all be agreed in advance. Most annuities pay out for life, but fixed-term options are available.
Common features to consider
Annuities often include optional features that affect how income is paid:
- Guarantee periods, where payments continue for a set time even if you die early
- Joint life cover, so payments continue to a spouse or partner after your death
- Inflation protection, so income increases each year to help maintain its value
Once an annuity is in place, you usually can’t make changes, switch providers or access the capital.
Comparing the main types of annuities
Lifetime annuities
A lifetime annuity pays a guaranteed income for the rest of your life. It provides long-term financial security, especially if you’re concerned about running out of money.
You can include features such as:
- Income that rises by a fixed rate or in line with inflation
- Joint life cover to continue income for a spouse or partner
- Value protection to return unused funds if you die early
For example, a 65-year-old with a £100,000 pension pot might receive around £6,500 a year with a basic single-life annuity. If they add inflation protection and joint cover, the starting income could fall to around £4,800.
Fixed term annuities
A fixed term annuity pays income for a set number of years (typically 5, 10 or 20). At the end of the term, a final payment is made, which can be taken as cash or used to buy another product, depending on the rules in place.
This type of annuity may suit someone who wants stable income early in retirement but prefers to keep future options open. For instance, a person retiring at 60 might buy a 10-year annuity to cover income needs until the State Pension starts at age 66 or 67.
Single life vs joint life annuities
A single life annuity pays income based on your own life. Payments stop when you die unless you’ve added features like a guarantee period. Because it only covers one person, it usually provides a higher starting income.
A joint life annuity continues to pay income to your spouse or partner after your death. The amount they receive is typically 50% or 100% of the original income. Because the provider may be paying for longer, the starting income is lower.
Level vs increasing annuities
A level annuity pays the same amount each year. While the income stays constant, its buying power falls over time due to inflation. For example, £6,000 a year will gradually buy less if prices rise by 3% annually.
An increasing annuity rises each year, either by a fixed percentage or in line with inflation. This helps protect your income over time, but the initial income is lower to account for the future increases.
Enhanced annuities
Enhanced annuities pay a higher income to people with health conditions or lifestyle factors that may shorten life expectancy.
This can include serious illnesses such as cancer or heart disease, and behaviours like smoking or heavy alcohol use.
The provider will assess your circumstances through a process called medical underwriting.
For example, someone who smokes and has high blood pressure might receive £7,200 a year from a £100,000 pot, compared with £6,000 for a non-smoker of the same age.
What affects annuity rates?
Annuity rates depend on both personal and economic factors.
Personal factors include:
- Age. Older buyers typically receive more because payments are expected to last for fewer years
- Health and lifestyle. Poorer health may lead to higher income through enhanced rates
- Product features. Adding inflation protection or joint life cover lowers the starting income
Other factors include:
- Interest rate. Higher rates allow providers to offer better returns
- Gilt yields. Providers invest in government bonds, and higher yields support better income
- Market competition. Rates vary, so comparing providers can make a significant difference
For instance, in a low interest rate environment, a £100,000 annuity might pay £4,800 a year. When rates rise, the same pot could generate £6,000 or more.
Choosing between annuities and drawdown
Pension drawdown allows you to take income directly from your invested pension pot. You can vary the amount and timing of withdrawals, but your fund remains exposed to market risk and could run out.
Annuities provide a secure, guaranteed income that doesn’t depend on investment performance. However, they are inflexible — once purchased, you cannot change the terms or access the money unless you selected specific features.
Some people combine both. For example, using £50,000 to buy an annuity for essential expenses, and keeping the rest in drawdown for discretionary spending or investment growth.
How annuity income is taxed
Annuity income is taxed as regular income under the PAYE system. Before you buy an annuity, you can usually take up to 25% of your pension pot as a tax-free lump sum. The remaining amount is used to generate taxable income.
The amount of tax you pay depends on your total income. For example, if you receive £10,000 from an annuity and earn £5,000 from part-time work, you’ll pay tax on anything above the personal allowance (currently £12,570).
The annuity provider deducts tax before paying you. If you have other income sources, HMRC may adjust your tax code to make sure the correct amount is collected.
Who might consider an annuity?
An annuity may suit people who want reliable, long-term income and don’t want to manage investments in retirement. It can be a good option for those without other guaranteed income sources, such as a defined benefit pension.
Enhanced annuities can be valuable for people with health conditions, offering more income without taking investment risk. On the other hand, those who want flexibility, access to capital, or the ability to leave money to family may prefer drawdown.
Someone who expects to live a long time and values certainty may benefit from a lifetime annuity with inflation protection. Someone who expects their needs to change, or who wants to keep future options open, might prefer a fixed-term annuity or drawdown.
Frequently asked questions
Can I use only part of my pension pot to buy an annuity?
Yes. You can use part of your pension to buy an annuity and leave the rest invested or available for drawdown. For example, using £50,000 from a £200,000 pot could provide a baseline income while keeping other options open.
Will my annuity income rise with inflation?
Only if you choose an increasing or inflation-linked annuity. If you don’t, your income will stay fixed and its real value will fall over time. This option must be selected when you buy the annuity.
Can I change my annuity after purchase?
No. Annuities are not designed to be changed once in place. You cannot cancel, amend or transfer the product, so it’s important to consider all options before committing.
Can I pass on any value to my family?
Only if specific features were chosen at the start. These include:
• A guarantee period (e.g. 10 years of payments even if you die earlier)
• A joint life annuity (ongoing income for a spouse or partner)
• Value protection (return of unused capital on early death)
Without these features, payments stop on death and no money is passed on.
Do interest rates affect annuity rates?
Yes. Higher interest rates usually result in better annuity rates because providers can generate more from your money. However, waiting for rates to rise also means delaying income and accepting the risk of market or health changes.
Where can I learn more?
More information is available from MoneyHelper’s annuity guidance and the FCA’s pension annuity overview.
