Annuities guide: what they are, types, how to buy them

Rates for annuities have been steadily increasing in recent years, with annuity sales hitting record levels in 2023, according to the Association of British Insurers (ABI). If you are close to retiring, deciding whether to get an annuity or not is probably the most important financial task you have to think about. But far too many people don't actually understand what they are. 

At its simplest level, an annuity is a contract between you and an insurer. You buy an annuity from an insurer with some or all of your pension savings. In return for your pension savings, the insurer agrees to pay you an annual income for life or for a fixed term. And that's it. If you understand that, then you understand the basics of annuities.

With the introduction of pension freedoms in April 2015, new rules gave the over-55s much more flexibility with their pension savings. Since then, you have more options for what to do with your pension pot, including taking a tax-free lump sum of up to 25% of your pot and flexible drawdowns. Alongside those changes, more providers now offer annuities further expanding people's choices.

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If you want the peace of mind that comes with some secure income in retirement, an annuity may be the right option for you. It's a once-in-a-lifetime purchase, so with that in mind, here’s everything you need to know about annuities, how they work and how to choose the right one for you. 

Types of annuities

1. Lifetime annuity

A lifetime annuity provides a guaranteed income for the remainder of your life. The amount you receive depends on how much you spend, your age, health and current annuity rates. One benefit is that the amount you receive is fixed. It could be a sensible option if you expect your living costs to remain roughly the same over the coming years, or if you are concerned about your pension income lasting as long as you do. This option also has no investment risk, so you don’t need to worry about the value of your money going up or down.

The downside is that you could get less than you paid for a lifetime annuity if you don’t live as long as expected. Payments usually stop when you die, although some providers offer an ongoing income or a lump sum to your loved ones and beneficiaries. This will very much depend on the provider you choose, so check the small print.

2. Level and escalating annuities

Level annuities do what they say on the tin. They provide the same level of income throughout the annuity’s term. This might suit you if your outgoings aren’t expected to rise much over this period.

Alternatively, you can buy an escalating annuity, which provides an income that rises each year at a fixed rate.  

3. Inflation-linked annuity

Living on a fixed income can be a frightening prospect when you consider the ongoing impact of inflation. If you buy an inflation-linked annuity, your income is tied to the rising cost of living. Be aware however that you will pay extra for this pension income protection and initially your income will be much lower with an inflation-linked annuity than with a standard one.

4. Fixed-term annuity

This type of annuity guarantees you a fixed income for a set period, usually between five and 10 years, but they can stretch up to 40. When you take out a fixed-term annuity, the provider will take your money and invest it on your behalf. This sum is then returned to you with the added investment growth, but minus the money you’ve been paid throughout the fixed period.

They can be a good way to produce an income until you reach state pension age. For example, you may choose to buy a fixed-term annuity at age 57 to provide an income until you reach age 67 and can claim your state pension. You may then choose to buy another annuity or use your savings to generate retirement income another way.

The maturity amount you receive at the end of the term is set when you take out the product. A lower annuity income will result in a higher maturity sum and the end, and vice versa, and the money can usually go to a nominated beneficiary should you die before the term is up. 

5. Investment-linked annuity

These products introduce a degree of risk to the decision-making process. Here, part of your income is guaranteed, much like a regular annuity, while part is linked to investment performance. You get to decide what level of guaranteed income you’re happy with, and the remainder of your pension pot is invested, paying additional income based on the returns. This means you may receive extra income when markets are performing well, but you could also lose money if your investments perform poorly.  

6. Enhanced annuity

 If you’ve got a health condition or lifestyle that may reduce your life expectancy, you could qualify for an enhanced annuity, which provides a higher income. These annuities can pay up to 20% more than a standard annuity if you’ve got a condition including diabetes, high blood pressure, or if you smoke, for example. 

If you choose this product you'll undergo extensive medical screening, and may have to provide evidence that you qualify for this type of annuity.

7. Single-life or joint annuities

If you buy a single-life annuity, your income stops when you die. But if you’re married or have a partner, this could leave them short on money when you die. 

You might opt for a joint annuity instead that continues to provide income to your surviving partner when you’re no longer around. Joint annuities typically pay a lower income because the provider expects to pay out over a longer period.

What is the annuity rate?

As well as being clear on the type of annuity that you need, it’s important to compare those on offer and shop around for the best rates. Annuity rates and the retirement income you receive vary widely.

The annuity rate is the amount of money you will get each year as a percentage of your total pension pot. For example, if you get a rate of 5% for your annuity, each year you will receive back 5% of your savings. So, someone with a £100,000 pot would get an annual income of £5,000 a year.

Factors that affect the annuity rate

Several factors affect the annuity rate you’re offered and the income you receive. Insurers calculate annuity rates based on life expectancy, so the shorter your expected lifespan, the higher the income you’ll receive.

Annuity rates also depend on government and corporate bond rates. Insurers typically invest pension funds in bonds and pay you from the returns they receive. When bond yields are low, insurers are getting less money so they offer new annuities at lower rates.

How to buy an annuity

As you approach retirement, your pension provider will contact you with options on how you can use your pension pot, including buying an annuity. But you don’t have to go with your existing provider – you’re free to shop around for the best deal. 

In 2023, 64% of annuity buyers bought an annuity from a different provider, according to the ABI. And, since annuity rates can vary by as much as 20%, according to Which?, checking to see if you can find a better deal elsewhere could make a real difference to your retirement income. The government’s MoneyHelper scheme has an online comparison tool for annuities, allowing you to compare the rates other providers are offering.

Claire Reed, head of individual annuities at Aviva, said: “You could speak to a financial adviser or a non-advised intermediary, sometimes referred to as an ‘annuity bureau’ or ‘annuity broking service’ about options. An annuity bureau will not say if an annuity is the right option, but they can help find the provider who offers the best annuity rate.  

“A regulated financial adviser will consider the full range of retirement options and the specific type of annuity that fits your personal circumstances. This is important, as one of the things to be aware of with an annuity is that the purchase can’t usually be undone if your circumstances change in the future.”

An adviser will also consider how much income you need, and your retirement goals. While you’ll pay for professional help, chances are, you’ll make up for this outgoing in retirement. 

You may decide on a mix-and-match approach. So, you could buy an annuity with some of your pension and leave the remainder invested in a flexible pension drawdown plan. An annuity income may cover your regular bills, for example, while you take a flexible income from the rest of your pension savings. 

When to buy an annuity  

Think about the timing of an annuity purchase carefully. You don’t have to buy an annuity when you retire. Buying an annuity early in retirement could mean you miss out on future investment returns on your pension savings. For example, you might buy a small annuity at age 60 to cover you until you reach state pension age. Later, you might buy another annuity to benefit from a higher rate as the income you receive from an annuity typically rises as you age.  

Remember, once you buy an annuity it’s usually an irreversible decision, so it pays to think carefully before buying one.