Pension Annuity
Written by
David
Reviewed by
Richard
Date
March 2025
What is pension annuity?
How does an annuity work?
What affects the income from an annuity?
Key features of annuities
Will annuity payments rise over time?
Frequency of payments
Annuity death benefits
Tax considerations
Annuity pros and cons
Annuities vs drawdown: A comparison
Points to consider before choosing an annuity
Common questions
Next steps
What is pension annuity?
A pension annuity allows individuals with defined contribution pensions to convert their savings into a regular income during retirement.
From the age of 55 (rising to 57 in April 2028), it is possible to use pension funds to purchase an annuity from an authorised provider, most commonly an insurance company.
In return for a lump sum from your pension savings, the provider commits to paying a series of income payments, which can either last for the rest of your life or a set number of years.
This income is guaranteed and not tied to investment performance or interest rate movements.
How does an annuity work?
When reaching retirement age, or from age 55 (57 from 2028), individuals with defined contribution or money purchase pensions can choose to exchange their savings for a guaranteed income through an annuity.
Annuity providers offer varying rates and terms, and shopping around is often recommended.
Annuities are suited to those seeking predictable income without exposure to investment risk. Once established, the terms are fixed and there are no ongoing management charges.
Additional features, such as income for a partner or beneficiary after death, can also be incorporated, depending on the annuity structure selected.
What affects the income from an annuity?
Annuity income is determined by several factors. Providers assess these when calculating the rate they are prepared to offer. Key factors include:
Size of the pension fund
The amount of pension savings directly influences the income available. A larger pension pot typically translates to higher annuity payments. Up to 25% of the pension can usually be withdrawn as a tax-free lump sum prior to purchasing an annuity. Opting not to take this lump sum may result in higher regular income, though this income is subject to income tax.
Age at purchase
Generally, the younger you are when you take out an annuity, the lower your income will be, since payments are expected to last longer. However, delaying an annuity may not necessarily yield higher income over the long term.
Type of annuity selected
- Lifetime annuity: Provides income for the rest of your life. Payments continue regardless of how long you live.
- Fixed term annuity: Offers income for a specific period. This can appeal to those wanting to retain flexibility for the future.
Enhanced annuities
Individuals with certain health conditions or lifestyle factors (such as smoking) may qualify for an enhanced annuity. These products offer higher income based on the assumption of a reduced life expectancy.
Over 1,500 health and lifestyle factors may influence eligibility. In some cases, enhanced annuity income can be significantly higher than standard rates, although this is only available for lifetime annuities.
Gilt yields and annuity pricing
Annuity rates are influenced by the yields on long-term government bonds (gilts). These yields often track the Bank of England base rate. When gilt yields rise, annuity rates tend to increase, and vice versa.
Key features of annuities
| Feature | Details |
|---|---|
| Tax-free lump sum | Up to 25% of the pension fund can be taken before purchasing the annuity. |
| Payment frequency | Income can be paid monthly, quarterly, half-yearly or annually. |
| Death benefits | Options available to provide income or a lump sum to beneficiaries. |
| Inflation protection | Payments can rise annually by a fixed rate or in line with inflation. |
| Fixed term annuities | Offer income for a specific period, allowing for future flexibility. |
Will annuity payments rise over time?
Unlike the State Pension, which increases each year under the triple lock system, annuity income only rises if you choose an escalating annuity.
- Level annuity: Pays a fixed amount each year. While the income is predictable, its purchasing power diminishes over time due to inflation.
- Escalating annuity: Starts with lower payments but increases annually, either by a fixed percentage or in line with inflation. Over time, it can surpass the payments from a level annuity.
The right choice depends on your current financial needs and long-term expectations.
Frequency of payments
You can usually choose how often you receive your annuity income—monthly, quarterly, bi-annually or annually. Payments can be made in advance (at the start of each period) or in arrears (at the end).
Choosing payments in arrears typically results in slightly higher income overall, although some prefer more frequent payments to manage household budgeting.
Annuity death benefits
Several features allow for income or lump sum payments to be made to beneficiaries after death:
- Joint life annuity: Continues payments to a nominated beneficiary for their lifetime.
- Guarantee period: Ensures income is paid for a minimum period, even if the annuitant dies during that time.
- Value protection: Pays out any remaining value of the original pension pot as a lump sum to a beneficiary.
Selecting these features usually reduces the income received during your lifetime but can provide financial support for others after your death.
Tax considerations
Before setting up an annuity, up to 25% of the pension fund can be taken as a tax-free lump sum. The remainder, whether paid as a lump sum or regular income, is subject to UK income tax.
If the annuitant dies before age 75, death benefits from the annuity are typically paid tax-free. If death occurs at 75 or later, any beneficiary income or lump sum is taxed according to their marginal rate.
Annuity pros and cons
Potential drawbacks:
- Inflation: Fixed income can lose value over time unless inflation protection is included.
- Lack of flexibility: Once set up, annuities generally cannot be amended.
- No investment growth: Unlike drawdown, annuities do not benefit from market gains.
- Death benefits may reduce income: Including protection for beneficiaries usually lowers the annuitant’s income.
Potential advantages:
- Security: Income is guaranteed and unaffected by investment risk.
- No ongoing fees: Costs are built into the annuity rate.
- Enhanced options: Some individuals may receive higher income due to health or lifestyle factors.
- Customisation: Various features can be added to meet personal circumstances.
The right choice depends on your current financial needs and long-term expectations.
Annuities vs drawdown: A comparison
| Feature | Annuity | Flexi-Access Drawdown |
|---|---|---|
| Available from age 55 (57 from 2028) | Yes | Yes |
| 25% tax-free lump sum | Yes | Yes |
| Guaranteed income | Yes (for life or term) | No (subject to investment performance) |
| Inflation protection | Optional | Not guaranteed |
| Ongoing flexibility | No | Yes |
| Health/lifestyle enhancements | Yes (enhanced annuity) | No |
| Ongoing charges | No | Yes |
| Inheritance options | Optional death benefits | Remaining fund passed to beneficiaries |
Annuities offer certainty, while drawdown allows flexibility. The right choice depends on individual preferences and financial circumstances.
Points to consider before choosing an annuity
- Other income sources: Consider coordinating annuity income with other pensions or benefits.
- Inflation: Decide whether escalating income is needed to help offset rising living costs.
- Legacy planning: Death benefits can support loved ones but may reduce your income.
- Flexibility: Lifetime annuities are permanent. Fixed-term options may allow for reassessment later on.
Common questions
What has Martin Lewis said about annuities?
In April 2023, Martin Lewis advised those approaching retirement to compare annuity rates before purchasing, noting that better deals are often available away from one’s pension provider. He also highlighted that enhanced annuity rates may be available for those with certain health conditions or lifestyle factors.
What is the difference between annuities and drawdown?
An annuity converts pension savings into a guaranteed income, while drawdown keeps funds invested, allowing flexible withdrawals. Annuities offer stability and security; drawdown offers the potential for growth but comes with market risk.
What happens to an annuity when someone dies?
This depends on the options chosen. Without death benefits, payments usually stop upon death. If features like joint life, guarantee periods or value protection are selected, income or a lump sum may continue to a named beneficiary.
Next steps
Want to see how much income you could really get?
Check the latest annuity rates or get a personalised quote now through Legal & General, Aviva, or use Retirement Line’s annuity calculator to get an up-to-date forecast — it only takes a minute to get started.
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