When you approach retirement, you’ll need to decide how best to use the money you’ve built up in your pension pot to give you a stable and regular income for the rest of your life. One option is to buy an annuity.

In return for a lump sum (usually your pension fund, minus any tax-free cash), an annuity provider will pay you an income for as long as you live, or for a fixed period depending on the policy.

The income from an annuity is guaranteed. So, if you buy a lifetime annuity and live for longer than expected, it’s possible you’ll get more back than you paid.

The main benefit to buying an annuity is that it provides peace of mind – you’ll have a guaranteed income for life, or the period agreed. One of their main downsides is that they’re not flexible – once you set the terms of your annuity, they can’t be changed.

Annuity income depends on a number of factors, like the size of your pension pot, your age, the annuity rate, and even your postcode

How much income will I get from an annuity?

The income you receive from an annuity will depend on a number of factors, like the size of your pension pot, your age, the annuity rate, and even your postcode.

The state of your health is a major factor too. If the insurance underwriter predicts that you’re unlikely to live as long as someone in better health, you will probably receive an increased rate and a higher income.

The total income you’ll get from an annuity can vary significantly, depending on the size of your pension pot. It’s important to seek professional advice before making any decisions about what to do with your pension fund at retirement, as you may discover there’s a better option for your particular circumstances.

Do I pay tax on my annuity?

Annuity income isn’t tax-free.

If you’re using money from a pension to buy an annuity, you can take 25% of the overall pension fund value as a tax-free lump sum. For most people considering buying an annuity, it’s best to take the tax-free element as a lump sum and then use the rest to purchase an annuity or pension drawdown plan.

Whether you’re funding your retirement with an annuity or have a pension drawdown plan in place, all income is classed as ‘earned’ income and therefore subject to income tax, exactly the same as if you were employed.

As with a salary, the amount of tax you pay depends on how much income you receive. The current tax-free allowance is £12,570, with incremental rises of 20%, 40% and 45% if your overall income exceeds £150,000. It’s relatively common for retired people to have several sources of income, such as an annuity, other pension income and part-time work. You will be required to pay tax on all sources of income, not just your annuity.

Most lifetime annuity policies stop paying out when the policyholder dies

What happens to my annuity when I die?

Most lifetime annuity policies stop paying out when the policyholder dies. If you were to die soon after you purchased a policy, you could receive significantly less than the policy cost you, and you may not be able to pass any of that money on to your loved ones.

There are ways around this. You could buy a ‘joint-life’ policy, which will keep paying out until you and your partner die. You can also structure some annuity policies to include a death benefit. This will ensure the policy continues to pay an income or lump sum to a named beneficiary after your death. However, these additions are likely to significantly reduce the income payments you receive.

Do I need a pension to buy an annuity?

Annuities are typically purchased with all or part of a pension pot. However, it’s essentially an insurance product, separate from a pension, so you can buy one with other savings and investments. But speak to an independent financial adviser before you make any decisions – they will review your circumstances to consider all suitable options before making a recommendation.

When should I buy an annuity?

You can buy an annuity after the age of 55, but the younger you are, the lower the rate you’ll be offered. If you buy a policy at age 55, you’ll need to pay more for the policy to receive the same income level you’d get from age 65.

If you’re fit and healthy, you may find it’s better to wait until you’re older before buying an annuity and, in the meantime, rely on a pension or other sources of income.

An ‘Immediate Needs Annuity’ will continue to pay your care provider for as long as you need

Will my annuity increase with inflation?

If you’re concerned about inflation, you can choose to buy an increasing or escalating annuity, which increases your income every year. The annual increase can either be index-linked, so it rises and falls in line with inflation, or a set percentage rate.

If you’re thinking of buying an annuity early on in your retirement, your financial adviser may recommend an ‘increasing annuity’ because you are likely to live for many more years. But it will mean that your income payments will initially be lower than if you were to buy an annuity with a fixed income.

Can I buy an annuity to cover the cost of my care?

Yes, you can buy an ‘Immediate Needs Annuity’ when you go into care, which will continue to pay your care provider for as long as you need. One of the problems with planning later life care is predicting how long you’ll need to keep paying for it. That’s why many people choose to take out an immediate needs annuity – it takes away the worry of running out of money if you were to need care for many years.

There are significant tax benefits for annuities of this type. That’s because income is paid directly to the care provider, therefore it doesn’t count as personal income and is not subject to income tax, unlike a standard annuity or pension drawdown.

Will my annuity pay more if I’m suffering from a health problem?

If you’re thinking about buying an annuity and you have a health problem, you may find you’re able to get an ‘enhanced’ annuity. This means you’ll receive a higher income if you have a qualifying condition such as cancer, asthma, high blood pressure, diabetes or heart disease.

It’s estimated that up to 60% of annuity customers are eligible for an enhanced annuity. This could mean an increased annuity income of around 30% for diabetes or a heart condition, depending on the provider

Do I need to commit to an annuity for life?

Most annuities are a lifetime commitment, and once you’ve purchased the policy, you can’t change your mind. However, you can buy a fixed-term annuity, which means you won’t be committed for life.

A fixed-term annuity will pay you a guaranteed income for a set period, with a lump sum paid at the end of the policy. The lump sum is the amount you initially paid for the policy, plus growth, minus the income the policy has already paid you. You can then choose to buy another annuity or invest your money elsewhere. The main advantage is that it gives you flexibility, although the annuity rate may be low.

There have been significant changes to pension savings in the Spring Budget 2023 that may impact your retirement planning. To find out more, see: How does the 2023 Budget affect your pension and retirement planning?

Amber River Financial Planning

An annuity offers many advantages, including the security of a guaranteed income for the rest of your life. However, you may find that the annuity rates appear relatively low compared to other retirement income options, like pension drawdown.

An Amber River financial planner will take time to understand your unique needs and circumstances, explain and discuss the options open to you, and make an appropriate recommendation for drawing an income in your retirement.

Get in touch

To speak to one of our team, arrange an appointment or find out more, call 0800 915 0000, or alternatively use our contact form here.