If you’re planning to buy an annuity, it isn’t a case of ‘one size fits all’, so you’ll need to get to grips with the different types of annuities before you take the plunge.
In this article we break down what annuities are, how they work, all the different types of annuity, some of the pros and cons of buying an annuity, and more.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
What are annuities?
An annuity is essentially a contract with an insurance company. In return for handing over some, or all your pension savings, you’ll be paid a guaranteed income for life, or a fixed term.
How much retirement income will I get from an annuity?
The amount of income you’ll get will depend on a range of factors including how much of your pension you’re using to buy an annuity, how old you are, whether you want the income you get to increase each year, your health, and whether you want the annuity to pay out to your spouse, partner, or someone else after you die.
Example of annuity
For example, according to calculations by Hargreaves Lansdown, in the aftermath of the mini-Budget in 2022, a 65-year-old with a £100,000 pension could get up to £7,586 per year from a single life level annuity with a five-year guarantee. This is 52% higher than the £4,979 per year someone in the same position could get back in July 2021. As interest rates have been held, annuity incomes have settled, with the same person currently able to get up to £7,217 in July 2024. However, with reductions in interest rates expected in the next few months, annuity rates could start to drift downwards.
How to calculate annuity income
Each provider will have their own methods for calculating annuity payments, taking the above factors into account. Some providers may include a calculator on their website to help you get a sense of the rates they will typically offer, so it’s worth using one of these to work out how much you could get. Sites offering annuity calculators include Age Partnership, Aviva, LV= and Legal & General.
What are the different types of annuity?
Here’s a rundown of some of the available annuity options. Remember that you don’t have to go for the annuity offered to you by your pension provider. In fact, it’s essential you compare annuities from a wide range of providers, as the annuity rates (and therefore the retirement income) you’ll be offered can vary widely.
Lifetime annuity
As its name suggests, a lifetime annuity will provide you with an income for the rest of your life. The income you’ll be offered will depend on your life expectancy and the expected returns the annuity provider thinks they can make from their investments (usually government bonds, otherwise known as gilts).
Joint life annuity
A joint life annuity is an annuity which pays you an income until you die, at which point it transfers to your partner or spouse and will pay them an income until they die.
Alternatively you can arrange it so that it pays a regular income to another beneficiary, such as a dependent child after you die – although in this case the annuity would typically only pay out until they reach a certain age, typically 23, at which stage they’ll hopefully be financially independent.
Temporary or fixed term annuity
When you take out a temporary or fixed term annuity, the income you receive will only be paid for a set period, for example, two or three years. Since you’ll only receive an income for a relatively short period of time, you’ll need to use less of your pension than you would if you wanted an income that lasts your lifetime. This type of annuity might suit someone who thinks their circumstances could change in future. For example, if you plan to downsize in a few years and release cash from your property, this may mean at that point you’d no longer need income from an annuity.
Enhanced annuity
If you’re a smoker, are overweight, or there are other factors which might shorten your life expectancy, you might be eligible for an enhanced annuity. This type of annuity will typically offer you a higher income than other lifetime annuities, as the provider assumes that with a shorter expected lifespan, they will need to make payments for a shorter period of time.
Impaired life annuity
An impaired life annuity works in a similar way to an enhanced annuity, in that you’ll typically be offered a higher rate of income because your life expectancy is shorter due to a medical condition. For example, you may have diabetes or heart disease that may reduce your life expectancy. Before you’re offered an impaired life annuity, you’ll usually be required to complete a medical questionnaire, and some providers may require your medical records, or for you to undergo an examination.
Investment-linked annuity
Investment-linked annuities are an example of what are known as variable annuities, meaning that a portion of your income will be decided by certain investments your insurer makes. When you buy an investment-linked annuity, you’re guaranteed to receive a minimum income, but the total amount you receive can vary depending on changes in the value of investments that your annuity is linked to.
The advantage of this is that if the investments do well, your income could rise over time. However, if they underperform, your income could fall, so if you’re considering this option then you’ll need to be comfortable accepting this risk. Depending on what your requirements are, following the pension freedoms, it’s worth considering that flexi-access drawdown (where you can take an income from your pension as and when you need it whilst leaving your savings invested) may be a more flexible way to take your retirement income than an investment-linked annuity.
Inflation or index-linked annuity
An inflation or index-linked annuity is designed to provide an income that will keep pace with rising living costs. The income you receive is typically linked to the Retail Prices Index, which is a measure of inflation that looks at the prices of consumer goods we spend our money on, such as food, drink, clothing and other essentials, and also includes housing costs such as mortgage interest payments and council tax. Initially your payments will typically be lower than the amount you’d get from a standard lifetime annuity (which provides a fixed level of income), but over time as inflation rises, the aim is that you should end up with a higher level of income.
Deferred annuity
Though they are not widely used in the UK, a deferred annuity means that you pick a chosen point in the future for your payments to start, with the expectation that you can live off other income until then. For example, at age 66 you might set up your annuity payments to begin at age 80, as annuity payments tend to be more generous the older you are.
What happens to my annuity when I die?
It’s important to note that annuities do not form part of your estate by default. This means that, unless you have taken specific measures, your provider will keep your pension funds when you die.
How do I pass on an annuity to my beneficiary?
If you wish to pass your annuity onto a beneficiary then there are a few ways to do this. A joint life annuity is one option, as this will ensure that your spouse, partner, or other named beneficiary will receive the income.
You can also opt to purchase what’s known as Value Protection when you buy your annuity, which will ensure that your chosen beneficiary will receive up to 100% of your remaining pot as a lump sum should you die. Some providers will include Value Protection for 90 days after the start period, but you’ll have to specifically buy it as a feature if you want the protection to extend beyond that.
Alternatively, if your annuity is for a fixed term, then payments will continue to be made to your estate until the term is up, even if you die before this. This way, your beneficiaries would still be able to access your payments.
Will my annuity be taxed after I pass away?
How your annuity is taxed after you die depends on how old you are when you pass away. If you die before you reach the age of 75, your beneficiaries should be able to receive your leftover annuity tax-free.
If you’re aged 75 or over when you die, however, your beneficiaries will need to pay tax at their marginal rate on any continuing annuity income. That means if they are a basic rate taxpayer, they must pay tax at 20% on any annuity income, whilst higher rate payers pay tax at 40%, and additional rate individuals pay tax at 45%.
How are annuity death benefits passed on to beneficiaries?
As long as you’ve provided the insurer you bought your annuity from with details of your nominated beneficiary, then when you die, your insurance company should distribute any remaining payments to them, either in the form of a lump sum or regular payments.
How do annuities get taxed?
Only 25% of your retirement savings can be accessed tax-free.
Whether you use the remaining funds to purchase an annuity or use a drawdown plan to provide yourself with a retirement income, any payments you receive will be considered income, so will be subject to income tax.
Should I drawdown my pension or buy an annuity?
There are many factors to consider when deciding whether to go for an annuity or drawdown plan, or a combination of the two. Here are a few things to keep in mind.
With a drawdown plan, when you die, all of the money in your pension pot will pass into your estate automatically. However, this is not the case with annuities, so you will have to take specific action in order to ensure that your beneficiaries receive any money after your death.
With an annuity, the level of income you’ll receive is decided by your provider, which will take your age, your health, the size of your fund and various other factors into account. This is not the case with a drawdown plan, where you are free to adjust the size and frequency of your payments as you wish. Drawdown plans offer a lot of flexibility and the option to switch to an annuity later on, but once you purchase an annuity, you are committed to it.
One major advantage of annuities, however, is that they can guarantee your retirement income for a longer period than a drawdown plan. If you are hoping to have a long retirement and aren’t sure whether the money in your pot will cover it, then you could use this money to purchase a lifetime or long-term annuity, so you won’t have to worry about your funds running out.
Another advantage of an annuity is that there is no investment risk. Under a drawdown plan, your funds will be invested and your income will vary depending on how well your investments perform. With an annuity, on the other hand, your income will be guaranteed, unless you have specifically chosen an investment-linked annuity.
How to get advice on buying an annuity
Buying an annuity is a significant financial decision that could have a long term impact on your retirement income. Not all providers will offer you the same monthly income from any given pot of money, so it’s crucial to shop around and get the best deal for your circumstances. It’s also important to note that since the pension reforms in 2015, you are no longer compelled to buy an annuity – so it may not be the best way for you to choose to take your retirement income.
If you aren’t sure which annuity to go for, or whether an annuity product is even right for you in the first place, always seek professional financial advice on your specific circumstances.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
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