Most people use a lump sum from their pension pot to buy an annuity from an insurer who, in return, guarantees to pay a fixed income for life or the term of the policy. Alternatively, you can choose to purchase an ‘index-linked’ annuity, so your income increases each month in line with inflation.

For more information about the different types of annuity, go to What is an annuity?

An annuity offers stability, security and peace of mind. But it does come at the cost of flexibility and, potentially, a lower monthly income compared to other income options.

You won’t run out of money

Many people worry about running out of money, especially as they get older and are less able to manage their investments. A lifetime annuity will do just what it says: give you a guaranteed income for the rest of your life, whatever happens.

Of course, if you choose a fixed-term annuity then your income will end after a specified period, but this will be agreed upfront when you buy the product.

Enjoy a reliable, stable income

An annuity can offer you stress-free living (from a financial perspective, at least) for the rest of your life. You know exactly how much money you’ll receive every month life and, unlike a pension drawdown plan, your investments won’t be dependent on the markets’ highs and lows. Your income will remain constant, even if the economy takes a tumble, so you can plan your spending with confidence.

Protect yourself against inflation

You can buy an ‘increasing annuity’ that is either index-linked, so it rises and falls in line with inflation, or increases by a set percentage every year.

This means that for however long you live, your monthly income will remain the same in terms of spending power. However, it’s essential to understand this type of annuity will cost more to purchase initially – or may give you a lower monthly income in the first few years. A financial adviser will help you understand the options available to you.

Your family could receive income when you die

One of the reasons people dislike annuities is that when they die, the annuity dies with them. But this doesn’t have to be the case.

It’s possible to purchase a ‘joint-life’ policy, which will continue to give your partner a monthly income until they die. Or you can structure the policy to include a Value Protected Annuity (VPA). If you were to die before receiving the amount you paid for the policy, a VPA would ensure the remaining payments continue to pay out to your partner or a named beneficiary.

But remember, an annuity is an insurance product. Any extra benefits written into the policy will likely increase the cost, or reduce the level of income you receive.

You may receive less income than you put in

An annuity is an insurance policy – and there are winners and losers by its very nature. If you die earlier than expected and haven’t included a VPA or purchased a joint annuity, your money will die with you. This means you may receive less than you paid for the annuity.

However, if you live longer than expected, you could receive far more than you put in.

You won’t benefit if future annuity rates rise

Annuity rates change all the time, and your monthly income will depend on the market rate at the time you purchased your annuity. If the rates are low when you retire, you might initially choose a different option – such as a pension drawdown plan – and hope that annuity rates recover.

Alternatively, you could purchase a fixed-term annuity (which might end after five to ten years) in the hope that you can buy a lifetime annuity at a higher rate in the future.

You’re locked-in until the end of the policy

Once you’ve purchased an annuity, you are locked in for a fixed term – or for life. You won’t have the option of switching to a higher-yield annuity or withdrawing a cash lump sum until the end of the policy.

This is why many people choose to use a percentage of their pension pot to buy an annuity rather than the whole amount. It enables you to keep some of your money invested, taking advantage of future market rises and allowing instant cash access if needed. It gives you a mix of a stable income whilst retaining some flexibility for the future.

If you’re approaching retirement and need advice on generating a monthly income from your pension pot, speak to an independent financial adviser. They will present you with different scenarios based on your circumstances, retirement goals and financial situation, so you can make an informed decision about your future.