What is an annuity?

last updated 24 July 2024

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 it 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 what you need to know about annuities.

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.

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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.

Types of annuity

There are four main types of annuity. Various insurers and advisers may have slightly different names for each, so make sure that you inspect the details carefully when you're considering a purchase.

Lifetime annuity: provides you with a set income for the remainder of your life
Fixed-term annuity: provides you with fixed income for a set period, usually around 5-10 years
Investment-linked annuity: provides you with some guaranteed income, but the rest is linked to investments – introducing a level of risk to your income in retirement
Enhanced annuity: provides you with a higher income, based on your life expectancy (as estimated by the annuity insurance provider)

Annuity rates

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.

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.