What is an annuity and how does it work? 

7 min Read Published: 30 Jun 2020

What is an annuity?

What is an annuity and how does it work?An annuity is an insurance product that will provide an income in retirement in exchange for a lump sum. This lump sum would typically have been built up over time by contributing to a pension product.

An annuity provider will calculate how long you are likely to live in retirement and set the income accordingly. If you live to a good age you will benefit from the continued income if, however, you die before your expected age then you lose out.

Prior to April 2015 buying an annuity was the only available course of action for anybody owning a defined benefit pension when they retired. In April 2015 the rules were changed to give individuals greater access to their pensions from the age of 55 which resulted in a decrease in the number of annuities purchased.

How do annuities work?

Simply put, an annuity provides a guaranteed income in exchange for a lump-sum payment. The amount of income provided will depend on an annuity provider's assessment of your life expectancy and the type of annuity purchased.

Annuities

There a range of annuities available as explained in the table below. The income generated will depend on the type of annuity purchased.

Types of annuities explained

Annuity Type Details
Single life Paid to an individual, either for life or a set number of years
Joint life Payments continue to your spouse or partner after you die
Fixed term Pays an income for a set number of years, then a guaranteed sum which you can invest or use to buy another annuity
Short term Stops paying at the end of a set number of years or when you die, whichever comes first
Guaranteed period Pays out for a set term even if you die within that term
Enhanced or Impaired May pay more than a standard annuity if you smoke or have a medical condition, eg diabetes or high blood pressure
Escalating The amount increases each year to reduce the effect of inflation
Level Pays a flat amount of income each year
Investment linked Tied to the stock market, the amount it pays can vary and depends on the success of the investments
Capital protected Capital protected annuity allows you to protect all or part of the fund used to buy your annuity if you die

How much income will I get from an annuity?

The table below shows a comparison of the single annuity income achieved on a £100,000 pension pot for a male aged 65 paid monthly in arrears.

£100,000 annuity comparison table

Provider Monthly Yearly
Scottish Widows £389 £4,673
Canada Life £386 £4,638
Legal & General £386 £4,634
Just £382 £4,590
Hodge £380 £4,571
Aviva £368 £4,425

The above are indicative of the best annuity rates available (June 2020)

Is annuity income taxed?

if you are using a pension pot to buy an annuity then you can withdraw 25% of your pension pot tax-free before you purchase the annuity. The income from an annuity is liable to income tax and this tax will be deducted at source, so you will receive the net amount.

Pros and cons of an annuity

Pros

  • Conventional annuity pays you an income which cannot go down in value
  • Income is paid until you die – not for a limited period
  • Income will never run out in your lifetime.
  • There’s no investment risk for conventional annuities
  • It can provide an income after your death to other family members
  • You can protect your income against inflation

Cons

  • Once an annuity is set up you cannot change it
  • Conventional annuity is set up on your life only, on your death it will stop
  • You must decide what income type you require at the outset
  • You must decide what additional benefits you are going to include from outset
  • Conventional annuity enjoys no further benefit from investment growth
  • Annuity rates fluctuate over time, therefore, if you buy when the rate is low your income is fixed at this rate

How to find the best annuity

If you already have a pension plan your pension provider will contact you approximately 6 months prior to your selected retirement date and provide you with the options available. They will also inform you of the benefit of shopping around for the best annuity and how to access your pension through pension drawdown.

Once you have selected the annuity provider and the type of annuity you require you can contact the provider directly and they will arrange the annuity for you. I would also recommend speaking to an independent financial adviser to discuss all your pension needs. If you don't currently have a financial adviser, then check out our article '10 tips on how to find a good financial adviser'.

Alternatives to an annuity

Since April 2015 the option to access your pension savings from the age of 55 was introduced which resulted in an increase in the number of people accessing their pension through what is known as 'pension drawdown' and a reduction in the number of annuities purchased.

One of the main attractions of income drawdown is that an individual can access their pension a little at a time rather than use their whole pension pot to purchase an annuity as previously was the case. Another benefit is that any of the pension pot not withdrawn can remain invested, giving it the potential to grow further. For more information on pension drawdown read our comprehensive article - What is pension drawdown and how does it work?

 

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