What is an annuity?

Annuity rates have been steadily increasing this year, and sales have also risen. But what is an annuity, what are the pros and cons, and should you buy one?

Pot of money with retirement label on it
(Image credit: Nora Carol Photography)

An annuity is a pension product that converts your retirement pot into a steady stream of guaranteed income. For many people, an annuity forms the backbone of their long-term retirement plans, but they may not suit every retiree.

Sales of annuities have been on the up in recent months, with sales surging 22% during the first quarter of 2023, according to data from the Association of British Insurers (ABI)

Rising interest rates have boosted annuity rates and therefore boosted the products’ popularity, but how do they work and why do many retirees rely on them?

Here’s everything you need to know about annuities. 

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What is an annuity?

An annuity is an insurance product that offers a guaranteed income in retirement. You can buy one with your defined contribution (DC) pension pot, such as a workplace scheme or a personal pension, either to cover the remainder of your life or for a set number of years.

Commonly, people opt to take 25% of their pension as tax-free cash, with some opting to use the remainder to purchase an annuity, typically from an insurer. How much they’ll offer to give you every month depends on a number of factors, including the size of your pension pot, any health problems and your age.

Annuities used to be mandated for most people with a DC pension, but the introduction of pension freedoms in 2015 meant retirees had more options, including using pension drawdown. But annuities still fill an important need within the retirement market, with a range of options available to cater to your needs.

There are four main types of annuity. Various insurers and advisers may have slightly different names for each, so make sure you always inspect the details carefully.

Lifetime annuity

A lifetime annuity will pay you a set income for the remainder of your life. 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 pensions lasting as long as you do. This option is void of any investment risk, so you don’t need to worry about the value of your money going up or down.

You can also buy an escalating annuity - it increases how much money you receive each year, which can be helpful in dealing with inflation.

The risk is you get less back than you paid for your annuity - and there is no money left for your beneficiaries - although some providers do offer a lump sum when you die. This value will depend on the provider you choose, so it’s well worth shopping around and comparing what deals are available. 

Fixed-term annuity

A fixed-term annuity offers a guaranteed income for a set period of time, typically 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.

This offers a good degree of flexibility down the line, as you can use the returned sum to buy another annuity, or any other form of retirement income. 

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. 

Investment-linked annuity

These products introduce a degree of investment 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.

In periods where markets are doing well, you stand to receive additional money on top of the guaranteed payment, but you could stand to lose money should markets perform poorly.  

Enhanced annuities

If you have an illness or health condition that may reduce your life expectancy, you could receive a higher retirement income through an enhanced annuity. This includes health conditions like diabetes, cancer, high blood pressure, as well as other factors like whether you are a smoker.

In this instance, insurers base the rate they offer on your personal life expectancy, so it requires a fair amount of medical questioning.

How can I buy an annuity?

Your pension provider will likely be eager to get in touch with you once you near retirement age, and they will present you with options on how you can use your pension pot, including buying an annuity. But you don’t have to take their offer - you’re free to shop around and find a better deal elsewhere. 

The government’s MoneyHelper scheme offers a comparison tool for annuity products, allowing you to take a look at what rates other providers are offering.

A financial adviser may also be able to help you secure a product that aligns with your financial circumstances and retirement ambitions. 

It could be that you buy an annuity with a small amount of your overall pension savings at say age 60, while you wait to claim your state pension. Later in retirement you can either choose to buy another annuity (the rate will be better the older you are), or to take cash flexibly out of your pensions using drawdown.

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

Tom Higgins

Tom is a journalist and writer with an interest in sustainability, economic policy and pensions, looking into how personal finances can be used to make a positive impact. He graduated from Goldsmiths, University of London, with a BA in journalism before moving to a financial content agency. 

His work has appeared in titles Investment Week and Money Marketing, as well as social media copy for Reuters and Bloomberg in addition to corporate content for financial giants including Mercer, State Street Global Advisors and the PLSA. He has also written for the  Financial Times Group.

When not working out of the Future’s Cardiff office, Tom can be found exploring the hills and coasts of South Wales but is sometimes east of the border supporting Bristol Rovers.