What is an annuity pension? The pros and cons

You can choose an annuity when planning how to use your pension savings in retirement.

If you’re planning for your retirement or want to know more about your different options when saving for the future, it’s important to consider whether an annuity pension is right for you.

Here’s everything you need to know about an annuity, including how it works, and the pros and cons.

What is an annuity?

An annuity is a type of insurance product. You pay a lump sum to a provider, who in turn agrees to pay you a regular income for the rest of your life or a set period.

This income is guaranteed and does not depend on a limited pot of money, so if you live a long time you may get back more than you paid.

A big advantage of an annuity is its reliability: you will always have an income. The main disadvantage is this income may be smaller than you could achieve by accessing your pension another way. 

It’s important to note once you purchase an annuity, your decision is irreversible, and you cannot reclaim the lump sum, even if your circumstances change.

How much does an annuity pay?

The income paid to you by your annuity provider will depend on a number of things.

The main factors are:

• How much you pay for it
• Your age
• The provider’s annuity rates at the time
• Your state of health

Other factors include whether or not you want the annuity to include guarantees or cover your spouse as well, or whether you want the income to increase with time. Even your postcode can be a factor.

Annuity rates can also vary a lot between providers, meaning some may give you tens of thousands more than others over the course of your retirement.

It's hard to estimate how much you might receive each year without first speaking to a financial adviser.

An adviser can assess all your circumstances and search the whole of the market to find the best deal for you – as well as seeing if you qualify for an enhanced annuity or any guaranteed annuity rates.

Other questions you might want to ask include:

• Do I get a better annuity if I’m in poor health?
• Will my annuity cover my spouse if I die first?
• Can my annuity increase with inflation?
• Could I get a temporary annuity and switch to another product later?
• Can I get a deferred annuity (one that starts later in my life)?
• Is there a special annuity that can held with care costs?
• How do I go about buying an annuity?

What is an enhanced annuity?

An annuity that pays you more money due to health and/or lifestyle factors is called an enhanced annuity.

If you’re considering an annuity, then for once it can be an advantage to have a health condition.

There are a range of medical conditions that can qualify you for an enhanced annuity – meaning you’ll receive a higher annual income for the same money.

Qualifying conditions include cancer, high blood pressure, heart disease, diabetes and a long list of others. Lifestyle factors may also apply, such as being a long-term smoker. Even if you don’t think you’d qualify, ask your adviser to check for you – as many as 60 per cent of annuity customers could be eligible.

Find out more about enhanced annuities.

What is a joint-life annuity?

A standard annuity will stop paying out as soon as you die. However, you can select a joint-life annuity, which means it covers both you and one other person (usually your spouse).

This annuity will continue paying out a smaller income (usually 50% of the original amount) to your spouse until they die.

You can also choose an annuity with a guarantee, which means the annuity will pay out for a minimum time period (e.g., five years), even if you die sooner.

What is an increasing annuity?

When buying an annuity, you can opt for an increasing annuity (sometimes called an ‘escalating annuity’) that pays out a higher income each year.

This means if inflation rises, your buying power won’t be reduced (or won’t be reduced so badly).

Some types of increasing annuity will raise your income by a set amount each year. Others can be index-linked so that they rise in line with one of the measures of inflation. However, there is usually a limit to how much they can increase, so they may not keep pace with runaway inflation.

Protecting your buying power in this way is an advantage. The downside is these annuities are more expensive, so your initial income may be lower.

It may, therefore, be several years before an increasing annuity starts to return value for money.

What is a fixed-term annuity?

A fixed-term annuity will pay you a regular income for a limited period, followed by a lump sum at the end of this period. Sometimes called short-term annuities, these products last from anything between one to 20 years, though five to 10 years is a typical length.

When the period of cover ends, your provider will pay you a maturity sum, which is the amount you originally paid for the annuity plus investment growth minus the income payments made to you.

You can then use the maturity sum to buy another product, such as another annuity or a drawdown scheme.

The advantage of fixed-term annuities is they offer some of the stability of standard annuities without committing to a product for the rest of your life. This places them somewhere between annuities and drawdown in terms of security versus flexibility.

The disadvantage is that returns on fixed-term annuities may be low, and you might get better returns from other forms of saving or investment.

Find out more about fixed-term annuities.

What is a deferred annuity?

A deferred annuity is one you set up to pay out from a chosen date in the future. For example, a person retiring at 65 might buy a deferred annuity that is due to start paying out when they reach 80 and live off other income (such as a drawdown scheme) in the meantime.

The potential advantage of doing this is an annuity paying out from age 80 will be much more generous than one paying out from 65. The disadvantage is that a person may die before the annuity is due to pay out, but some products may have safeguards or guarantees against this.

You can buy a deferred annuity with a lump sum or via several payments. Your policy then starts to pay out from your chosen date. Alternatively, it may pay out a lump sum that you could use to buy an annuity elsewhere.

Deferred annuities are not widely used in the UK, but ask a financial adviser if you’re interested.

What is an immediate needs annuity?

An immediate needs annuity (also called an immediate care annuity or a care fee plan) works in a similar way to an ordinary annuity, except the income goes directly towards the cost of your care.

The advantage of doing this is that it then doesn’t count as your income, so is not subject to income tax. In this way, it can deliver higher sums to pay for your care than you might be able to achieve with an ordinary annuity.

Find out more about immediate needs annuities.

How do I buy an annuity?

Buying an annuity is usually fairly straightforward, but there are a few pitfalls to be aware of and some things that you may need to know about.

For a clear idea of what you need to do, see our Step-by-step guide to buying an annuity.

Do I pay tax on my annuity pension? 

An annuity pension is classed as earned income, so it can be taxed. The exact amount of tax you pay will depend on your other earned income and how much you draw from your pension, but you will be taxed in line with income tax thresholds.

This means you will pay no tax up to your personal allowance of £12,570 (in the 2024/25 tax year), with everything over this being taxed at the basic, higher, or additional rates, depending on your income.

What happens to my annuity pension when I die?  

What happens to your annuity after you die will depend on the type of annuity you have, so it’s important to ask your chosen provider what their afterlife policy is.

When you die, most annuities stop paying out. While there are additional policies such as value protection and guaranteed term policies that can extend your annuity to your next of kin, this is normally something you need to buy on top of your annuity.  

One exception to this is the joint-life annuity which will cover your spouse or other designated family member in case you die first. 

Should I always shop around for the best annuity?

Usually, you can achieve better value from an annuity by looking beyond your existing pension provider. Finding a better product can often give you a significantly bigger income over the course of your retirement. 

However, always check with your adviser before switching to a new provider. Some pension pots come with a guaranteed annuity rate (GAR), which may entitle you to a very favourable annuity rate (some are worth many thousands more per year than standard annuities).

Often it isn’t easy to tell if your pension has a GAR as not every provider will draw your attention to this. Ask an adviser if you have one.

Is an annuity right for me?

There are many advantages to having an annuity, including predictability, security, and simplicity. 

However, your income may not be as much as you hope for, and you won’t have the option of varying it if you suddenly find you need more money. You may want to ask your adviser to help you compare annuities with more flexible options.

Find out about other options for drawing your pension as well as the key differences between drawdowns and annuities.

Get expert financial advice

An annuity can provide peace of mind with a guaranteed income for life, making it an appealing choice for those seeking financial stability in retirement.

However, the right choice depends on your individual needs and circumstances, such as whether you prioritise security over flexibility or if you need to cover specific costs like long-term care.

 Carefully compare your options, and consider factors like annuity rates, your health, and potential future needs, to determine whether an annuity is the best fit for your retirement strategy.

Unbiased can quickly match you with a financial adviser for expert financial advice to help you navigate the complexities of annuities and find the best option tailored to your retirement needs.