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What is an annuity?

When you retire, the pension pot that you've been paying into needs to be converted into a regular income. You can do this in several ways, including purchasing an annuity.

Annuity definition

An annuity is an insurance product which, in exchange for a one-off lump sum (usually taken from your pension pot) provides you with a regular annual income, for a fixed term or for life.

Annuities facts

There are a few different types of annuity to choose from, where the income is paid out in different ways. It's important that you get the right one for you.

The level of income you receive is referred to as the 'annuity rate'.

The annuity rate you are offered by providers will depend on factors such as your health and age (because an annuity is a type of insurance policy).

As a general principle, the shorter your perceived life expectancy, the higher your annual income is likely to be.

There is now no maximum age by which you must take out an annuity (it used to be 75).

Open market option – shop around for annuities

Important: If you decide an annuity is right for you, you don't have to buy it from your pension provider. Not all pension schemes offer all options and you don't have to stay with the scheme you paid into. You can shop around to find the offer that best suits you.

You can often get a better rate by looking at all the deals available on the market. It really is worth shopping around, because choosing the right annuity can be one of the biggest financial decisions you'll ever make.

Delaying your annuity

Alternatively, you might decide to leave your pension pot untouched for a while. You can read about whether or not to delay buying an annuity here.

Different types of annuity

  • Life: this is the most common type of annuity and will provide an income for the rest of your life, in exchange for an upfront fee. These can be fixed, escalating or enhanced (see below)
  • Immediate life: the same as a 'life' annuity, except you can purchase it with a lump sum from sources other than your pension
  • Enhanced: if you suffer from a health condition or make certain lifestyle choices — for example if you smoke — you may be able to get a better deal with an enhanced annuity. This type of annuity offers a higher rate based on your lower perceived life expectancy
  • Guaranteed: the income is paid for the annuitant's life (the annuitant is the person who buys the annuity), but in the event of early death within a predetermined period — usually 5-10 years — the income is paid to the people you nominate for the guaranteed period
  • Deferred: you make a single payment or regular payments to the annuity provider, but you don't start receiving the income for a number of months or years
  • Fixed term: you receive the income for a set period of time, such as 5 years. Payments end once this period is over or if you die during the term
  • Level: the income you receive stays level at all times and doesn't keep pace with inflation
  • Increasing/escalating: the income you receive increases by a certain amount each year. This percentage is either linked to inflation, or chosen by you when you purchase the annuity
  • Investment linked annuities (also called variable annuities): Some providers also offer annuities where the size of the payout is linked to the performance of an investment fund, in the hope of generating better returns. However, beware that investment linked annuities will carry an increased level of risk.

Single or joint annuity?

If you have a partner, you can each take out single annuities that will pay out two separate incomes, or you can take out a joint annuity that pays out a single income.

Single annuity

A single annuity will generally pay out a higher level of income than a joint annuity (because the annuity provider only needs to pay out until the end of one life) but will not provide any income for your partner when you die.

Joint annuity

A joint annuity will generally pay out a lower level of income (equivalent per person) but it will usually continue to pay out even when one of you dies, although the income that the surviving partner receives would be a percentage of the income you both received beforehand.

Important: When you purchase a joint annuity, you set the level of income you'd like the annuity provider to continue paying out after the first partner has passed away. For more information, read our guide Joint vs Single Annuity.

Can I sell my annuity?

If you have only just bought your annuity, there is a short 'cooling off' period when you can still change your mind without incurring any losses (in most cases 30 days). After that, your rate will be fixed and as it stands, you can't change the decision.

However, the government has said that from April 2016 there is a possibility that you might be able to sell an annuity you own.

Alternatives to annuities

Buying an annuity has long been the most popular form of drawing retirement income but, from April 2015, we've all been given more freedom over how we take money from our pension pots. It is likely that annuities will remain the most popular form of taking a retirement income for the foreseeable future but there several alternatives to annuities that you should explore.

When you reach the age of 55, you have the option to withdraw up to 25% of your pension pot as a tax-free lump sum. The remaining amount can be used to:

  • Buy an annuity — which gives you an income for the rest of your life
  • Retain flexible control — which allows you to choose to keep some of your pot invested while you take some money from it
  • Draw down one cash sum — which means taking your whole pot in one go
  • Draw down phased cash sums — which means taking fixed sums from your pot at planned retirement phases

Next steps

If you think an annuity may be right for you, or just want to explore your options, consider taking financial advice to help you make the most of your pension pot.

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Last updated: 31 May 2015

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