An annuity is an insurance product you can buy with your pension pot which guarantees you an income. This is normally for the rest of your life, (the exception being short/fixed term annuities).   

Usually, the money to buy an annuity comes from your pension pot, but you can use money from any source, such as savings or investments. Your pension will most likely be the most effective way to save up the required sum, as it benefits from tax relief.

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.

Annuity is paid monthly, quarterly, bi-annually or annually this can be in advance or in arrears.

You’ll need to consider your circumstances, such as your health, whether you want to receive an annuity income over a short or long term, and whether you want to leave an income to a partner after your death.

Different types

Level Annuities

A level annuity will pay you the same income each year. They have a higher starting income than an escalating annuity, but they can leave you vulnerable to inflation, which might make your annuity income worth less over time.

Escalating annuities

An escalating annuity will rise each year at a fixed rate. It may start lower than a level annuity, but the amount it pays you will increase at a fixed rate each year (for example, by 3%).

Inflation-linked annuities

An inflation-linked annuity will rise each year in line with the retail price index. This protects your annuity against inflation, but it will start at a much lower rate and are usually capped.

Impaired or enhanced annuities

These pay out a higher income if your health or lifestyle may shorten your lifespan – for example, if you have an existing health condition.

Joint life annuities

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

Short-term or fixed-term annuities

You might choose a short-term annuity if you don’t want to commit your pension fund to a life annuity as you believe rates might get better in the future.

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

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 growth, minus the income payments made to you. 

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.