What is a pension annuity and how does it work?

Published 29th January 2024

Pension annuities can play an important role in ensuring your financial security during your golden years. Let's break down the basics of what a pension annuity is and how it works.

What is a pension annuity?

A pension annuity is a financial product that provides a steady income stream during your retirement. It's a payment that you receive on a monthly, quarterly, six monthly, or annual basis, helping you cover living expenses after you stop working.

How does it work?

Paying in
While working, you contribute money to your workplace pension fund. This fund grows over time, thanks to contributions from both you and your employer. You may also have a private pension(s) you contribute to.

Retirement decision
When you're ready to retire, you need to decide how to use the money you've saved in your pension(s). You can leave your funds invested and draw an income (known as pension drawdown) or take a lump sum. Alternatively, you can opt for a pension annuity for a regular guaranteed income. You can also take a combination of these options.

Purchasing the annuity
For those choosing to receive a regular guaranteed income, you can use some or all of your pension fund to buy a pension annuity. You will have the option of taking up to 25% of your pension fund(s) (or the amount you’re using to buy an annuity) as a tax-free lump sum. You can spend this as you like. You should keep in mind that any tax-free cash taken will reduce the amount of money left to buy your annuity. In turn, this will reduce your income payments. Annuity rates can vary, and that will also affect the income you receive.

“A lifetime annuity is just one of the retirement options available. It provides a guaranteed income for life."

Sarah Lloyd, Commercial Director at Annuity Ready

Types of pension annuity
There are several different types of pension annuities:

  • Lifetime annuities – An insurance policy that pays you a guaranteed income for the rest of your life in exchange for some, or all of, the money in your pension pot.
  • Fixed term annuities - Like a lifetime annuity but pays an income for a fixed period of time, or until you die, if this is earlier. When the fixed term comes to an end, you'll usually receive a ‘maturity amount’. This lump sum is the money you paid into the annuity, plus any investment growth but minus any income you've already received. The amount you get will depend on how much income you took over the term and how much you paid for the annuity at the outset.
  • Enhanced annuities - A type of lifetime annuity that will provide you with an increased income. You may be eligible for an enhanced annuity if you have been diagnosed with an illness that could reduce your life expectancy, and/or you are overweight or smoke.
  • Investment-linked annuities - Another type of lifetime annuity. With an investment-linked annuity you can benefit from growth in the stock market. But, your income could also fall in times of poor stock market performance.

Death benefits
Annuities can include death benefits that allow you to pass on remaining funds to your beneficiaries. These can ensure your loved ones receive financial support even if you pass away. You can add a guaranteed minimum payment period or value protection when you buy an annuity. Selecting either option will reduce the annuity income you are offered.

Paying tax
You can normally only take up to 25% of your total pension fund(s) as a tax-free lump sum when you access your pension. After that, you’ll pay tax on your income like you would on your salary. This is the same whether you take a pension drawdown, lump sum or buy an annuity.

After 6th April 2024, the tax-free lump sum allowance has been set at 25% of the pension up to a limit of £268,274. There is an overall limit, which is tested on death of £1,073,000 which is known as the lump sum and death benefit allowance. This replaces the Lifetime Allowance.

Despite being an important option to consider, research from our Get Britain Pension Ready campaign found that 43% of those surveyed were baffled by the term ‘annuity’.

Before choosing a pension annuity

Shop around
Different insurance companies offer various annuity products. It's essential to compare rates, fees, and contract terms before making a decision. Doing so will help you find the best annuity rate for you.

Annuity Ready allows you to compare guaranteed lifetime quotes from all providers in the annuity open market, to see if you can get a higher income from your pension savings.

Get professional guidance
If you are aged 50 or over you are entitled to free and impartial guidance from Pension Wise, a government service from MoneyHelper. You can receive tailored guidance online or over the phone to help you understand your retirement options.

If you need further help, you may wish to get in touch with an independent financial adviser. You can find a local financial adviser on the MoneyHelper site.