What is a pension annuity?

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An annuity is a type of retirement product you can purchase using some or most of the pension pot you’ve saved for your retirement. It usually pays a regular fixed income that can either last your lifetime or for a set period.

On this page, you’ll learn more about pension annuities, how they work and the different types available. We also consider the alternatives to a pension annuity and explain how you can use a high-interest savings account to help supplement your retirement income.

Key takeaways
  • Regular income: An annuity allows you to convert your pension pot into a guaranteed regular income that you’ll receive for life

  • Pension: Pensions and annuities are different, but the connection between them is that an annuity is purchased using your pension

  • Shop around: Pension annuity rates can vary significantly between providers, so be sure to shop around to find the best deal

What are pension annuities?

An annuity is a financial retirement product that allows you to convert your pension pot into a regular, fixed pension payment. It guarantees that you’ll receive a stable income for the rest of your life.

There are different types of annuities available (more on that below). Some annuities are available for a set period, and each has its advantages and disadvantages.

The amount you’ll receive from an annuity will depend on your life expectancy, health and the amount you pay. Depending on the type of annuity you choose, the annuity provider may pay out other insurances such as principal protection, long-term care costs, legacy planning and more.

How does a pension annuity work?

Once you’ve reached the age of retirement or want to stop working, you can use your pension pot to purchase an annuity, giving you a guaranteed fixed income for the rest of your life or for a set time period. For example, you could take 25% of your pension pot as a tax-free lump sum, then buy an annuity with the remaining 75% of your pot.

Insurance companies typically sell annuities, and you’ll pay income tax on your annuity income. The amount of income tax you’ll pay will depend on the income tax band you’re in.

Pension annuities explained

An annuity is usually purchased using the pension pot you’ve saved while you were working. The only way to get an annuity is by using your pension pot, and this is probably why you’ll also hear an annuity referred to as a pension annuity.

What’s the difference between an annuity and a pension?

The following table shows the main differences between an annuity and a pension:

You purchase an annuity by using your pension to provide you with a guaranteed fixed income.You save into a pension pot, and once you retire, you’ll usually take small sums out of your pot in the form of a regular income.
Purchasing an annuity provides security for your finances but isn’t flexible.You can access a large sum of your money from your pension if you need to.
Annuities only offer a guaranteed income based on how much of your pension pot is used to purchase it.Leaving your money in a pension may give you the chance to access high-yield investments that can help increase your pension pot.

What are the different types of pension annuities?

There are many different types of pension annuities, so it’s important to shop around and choose an annuity that offers the best annuity rates and suits your needs. The different types of annuities include the following:

  • Single life: This type of annuity makes payments solely to you for life or a fixed number of years.
  • Joint life: With a joint-life annuity, your spouse or partner can receive payments after you pass away.
  • Fixed-term annuity: This type of annuity pays an income for a set number of years, as well as a guaranteed sum you can use to purchase another annuity.
  • Short-term annuity: This type of annuity pays out for a set number of years, often less than five years, after which time payments cease. Payments from this type of annuity will also stop if you pass away.
  • Guaranteed period: This is a guarantee that you’ll receive your pension for a set term, even if you die. For example, if you have a 10-year guaranteed period annuity, but pass away after six years, your spouse or partner will receive your annuity for the remaining four years.
  • Enhanced or impaired annuity: This type of annuity may pay more than a standard annuity if you smoke or have certain medical conditions.
  • Escalating: Escalating annuities increase the amount you receive each year to reduce the effects of inflation.
  • Level annuities: A level annuity pays a flat amount of income every year.
  • Investment-linked: This type of annuity is linked to the stock market, and the amount you’ll receive will depend on the performance of the annuity’s investments.
  • Capital protected annuities: With this type of annuity, a nominated person will receive your pot if you die within a set period of time.

How are pension annuities calculated?

The annuity rate you’ll receive will depend on the following factors:

  • The younger you are when you purchase the annuity, the less income you’ll receive
  • Men typically receive a better annuity rate, because they have a lower life expectancy than women
  • Health and lifestyle will also be a factor. If you have certain medical conditions, you may be able to purchase an annuity that offers higher payments

Annuity rates can vary significantly between providers so it pays to do your research. According to a report by Which?, shopping around for an annuity could increase your retirement income by as much as 20%.

What are the tax implications on annuities?

Under the current rules, you can take up to 25% of your pension pot as a tax-free lump sum and then buy an annuity (if you choose this option) with the remaining 75%.

You’ll pay tax on income from an annuity, just like you do when you receive a salary because when you save into a pension, you get tax relief from the government on your contributions.

Alternative strategies to fund your retirement

Of course, buying a pension annuity is just one option. There are various other ways you can fund your retirement, such as income drawdown or taking a lump sum from your pension. Each one has its own rules and tax implications, so you’ll need to think carefully before making a decision. The best option will also depend on your individual circumstances, so speak to an independent financial advisor if you’re unsure about anything.

Your pension pot might be your main source of income in retirement, but it’s possible to generate income from other sources too. One strategy is to put some of your money into a high-interest savings account, such as a fixed rate bond. These types of accounts tend to pay higher interest rates than other savings accounts and, unlike investing, there’s no risk involved. Provided you’re happy to lock away your money for a fixed period, you can use the interest earned to supplement your pension and enjoy a more comfortable lifestyle in retirement.

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