3.8 Understanding Annuities

3.8 Understanding Annuities

Annuities offer guaranteed income for life — but are they still relevant? With pension freedoms offering flexibility, many people overlook annuities. This chapter explains what they are, when to consider them, and how to shop for one that suits your needs.

What Is an Annuity?

An annuity is a financial product you can buy with some or all of your pension pot. In return, it pays you a guaranteed income, usually for life.

Once purchased, the terms are fixed — you can’t change your mind or access the money again.

There are two main types:

• Lifetime annuity – Pays income for as long as you live
• Fixed-term annuity – Pays income for a set number of years

You don’t have to buy an annuity, but they may be suitable for some people — particularly in later retirement.

How Annuities Work

• You choose how much of your pension pot to use (typically after taking a 25% tax-free lump sum)
• You choose options like:
  • Single or joint life
  • Guarantee period (e.g. minimum 10 years even if you die early)
  • Inflation protection (index-linked)
• The provider calculates your income based on:
  • Your age
  • Health
  • Current interest (gilt) rates
  • Selected options and features

Once agreed, the income is fixed (or increases annually if inflation-linked), and usually paid monthly for life.

When Annuities Make Sense

While annuities have fallen out of favour since pension freedoms, they can be valuable in certain scenarios:

Pros and Cons of Annuities

Options to Customise Your Annuity

You can combine features — but every option reduces the starting income you receive.

Example: Lifetime Annuity Purchase

Steve, age 67, buys a lifetime annuity with £100,000 from his DC pot.

He selects:

• 25% tax-free lump sum (£25,000)
• Single-life annuity with no escalation
• No guarantee period

Result:

• Receives ~£6,800/year (approximate rate as of mid-2024)
• Income is taxable but guaranteed for life
• If he dies early, payments stop

If Steve had added inflation-linking or a spouse’s pension, the starting income would be lower.

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When to Buy an Annuity

• Annuities usually suit later retirement — e.g. age 70+
• They can complement drawdown, not replace it
• Best bought after taking tax-free cash, using just part of your pot

You don’t have to annuitise all at once. You can use phased annuities, buying small annuities gradually.

Shopping Around for the Best Rate

Never buy an annuity directly from your pension provider without checking the market. Use:

• Financial advisers
• Online annuity brokers
• Comparison services
• Guaranteed annuity rate quotes from insurers

Factors that can increase your annuity rate:

• Poor health or medical conditions
• Smoking history
• Location (postcode)
• Larger pot size

🔗 The “open market option” gives you the legal right to buy your annuity from any provider — not just the one holding your pension.

Summary: Should You Buy an Annuity?

You Might Consider an Annuity If…

You want a guaranteed, low-maintenance income

You’re concerned about living a long time

You want to cover fixed, essential expenses

You are in poor health and qualify for a better rate

You don’t want to manage pension investments

Next Chapter Preview:

We’ll explore phased retirement — combining part-time work, gradual drawdown, and lifestyle choices to ease into retirement on your terms.