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Nearly one in three over-50s find annuities too difficult to understand, making it harder for them to decide how best to turn their pension savings into a retirement income.
Research from insurer Legal & General (L&G), based on a survey of 2,000 UK adults aged 50 and over, found that 30% struggle to understand how annuities work. Women were more likely than men to feel unsure, with 34% saying they didn’t know enough about annuities, compared with 21% of men.
The research also uncovered several common misconceptions. For example, 17% of people mistakenly believe that annuity money cannot be passed on after death, while one in five (20%) think you can only buy an annuity once you’ve completely stopped working.
Annuities can provide an important role in retirement planning, especially for people who want the reassurance of knowing they’ll receive a regular guaranteed income. Here’s what you need to know about how they work, and five common myths explained.
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. 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 2,600 reviews on VouchedFor, the review site for financial advisers.
What is an annuity and how does it work?
An annuity is a financial product that allows you to exchange some or all of your pension savings for a guaranteed income. You buy it from an insurance company, which then pays you an agreed amount, either for the rest of your life or for a set period of time.
There are two main types of annuity:
- Lifetime annuity: This type of annuity pays you a guaranteed income for the rest of your life, however long you live. This can provide reassurance that you won’t run out of money in retirement.
- Fixed-term annuity: This kind of annuity pays you a guaranteed income for a fixed period, such as five or 10 years. At the end of the term, you may receive a guaranteed maturity amount, made up of any remaining fund. You can then use this to either buy another fixed-term annuity, switch to a lifetime annuity, move into flexi-access drawdown, or withdraw the cash.
You don’t have to use your entire pension pot to buy an annuity. For example, you might decide to use some of your pension to secure an income to cover essential bills, while leaving the rest invested so you have more flexibility over how and when you access it. You can find out more in our guide to annuities explained.
Five common annuity myths busted
There are several common misconceptions about annuities. Here, we debunk five of the most widespread myths to help you understand how they work.
1. Myth: Annuities don't provide a reliable retirement income
The reality: A lifetime annuity can provide a guaranteed income for the rest of your life.
Just 35% of people surveyed by L&G correctly identified a lifetime annuity as a retirement option that guarantees an income for life.
One of the biggest advantages of a lifetime annuity is that you know how much money you’ll receive, making it easier to budget and plan for your retirement. Unlike pension drawdown, where your savings remain invested and their value can rise and fall, a lifetime annuity provides an agreed income regardless of how long you live.
You can also choose whether you want your income to stay the same or increase over time to help keep pace with inflation. However, an inflation-linked annuity will generally pay a lower starting income than one that pays a fixed amount.
It’s worth remembering that you don’t have to choose between an annuity and drawdown. You could use part of your pension to buy an annuity and leave the remainder invested in a drawdown plan.
Find out more in our guide to pension drawdown and how it works.
2. Myth: Annuities are too complicated to understand
The reality: Although there are different types of annuity and features to consider, the basic principle is relatively straightforward.
You exchange some or all of your pension savings for a guaranteed income from an insurance company. You then receive payments according to the terms you’ve agreed. Importantly, once you’ve bought an annuity, you generally cannot change your mind or get your pension savings back, so it’s essential to compare your options carefully before committing.
The amount you’ll bet from annuity depends on several factors, including:
- Your age: As a general rule, the older you are when you buy an annuity, the higher the income you’re likely to receive, as the insurer expects to pay it for a shorter period.
- Your health and lifestyle: If you have certain medical conditions or lifestyle factors that could affect your life expectancy, you may qualify for an enhanced annuity offering a higher income.
- Whether you want your income to increase in line with living costs: An annuity that increases with inflation will usually start at a lower level than one paying a fixed amount.
- Whether you want to provide for someone else: Choosing an annuity that continues paying an income to your spouse or partner after your death can reduce the amount you initially receive.
3. Myth: You can only buy an annuity once you've retired
The reality: You don’t necessarily have to stop working before buying an annuity.
One in five (20%) of those surveyed by L&G wrongly believed annuities were only available once someone had completely stopped working.
In fact, you can potentially buy an annuity while you’re still earning a salary, provided you’ve reached the minimum pension age and meet the provider’s eligibility requirements.
For example, some people might want to reduce their working hours gradually rather than stop work altogether. A fixed-term annuity could potentially provide a guaranteed income to supplement their earnings during this transition. Find out more in our article Can I take my pension and still work?
It could also help bridge the gap between finishing work and starting to receive your State Pension.
Under current rules, most people can access their private pension from age 55, although this minimum pension age is due to rise to 57 from April 2028. Some people have protected pension ages that allow them to access their savings earlier. Lear more about changes to the pension access age in our article Will the pension access age rising to 57 affect you?
If you’re thinking about retiring gradually, our guide to phased retirement explains some of the options available.
4. Myth: You lose your annuity when you die
The reality: Although some annuities stop paying out when you die, there are options that can continue to provide financial support for your loved ones after your death.
Yet around 17% of people surveyed by L&G mistakenly believed that money held in an annuity couldn’t be passed on after death.
There are several ways to ensure payments continue to your spouse, partner or another beneficiary when you die:
- Joint-life annuity: This continues paying an agreed proportion of your income to your spouse or partner after you die. Payments usually stop when they subsequently die.
- Guaranteed payment period: You can choose for your annuity to pay out for a minimum period, such as five or 10 years. If you die before this period ends, the remaining payments can go to your beneficiaries.
- Value protection: Some annuities offer an option that pays a lump sum to your nominated beneficiary if you die before you’ve received a set amount of your original investment back.
These options can help protect your loved ones financially, but they do come at a cost. For example, choosing a joint-life annuity or adding a guarantee period will usually reduce the income you receive initially.
It’s important to check exactly what happens to your annuity when you die before buying it, as you cannot normally add these features later.
5. Myth: Annuities offer poor value for money
The reality: Whether an annuity represents good value depends on your circumstances, the rates available and what you’re hoping to achieve from your retirement savings.
Around one in five (21%) of people surveyed by L&G said they thought annuities were expensive.
However, an annuity isn’t necessarily about getting back more money than you paid in. Instead, you’re effectively paying an insurer to take on the risk of providing you with a guaranteed income for the rest of your life. For someone who lives for many years after retiring, a lifetime annuity could provide a valuable source of financial security, particularly if they are worried about running out of money.
On the other hand, if you die relatively soon after buying an annuity without any death benefit protection, you or your beneficiaries could receive considerably less than the amount originally used to purchase it.
It’s also important to remember that annuity rates can vary between providers, so you shouldn’t automatically accept the deal offered by your existing pension provider. Rates are usually closely linked to 15-year gilt yields which have risen sharply this year, boosting the guaranteed incomes on offer
Andrew King, pension technical specialist at wealth management firm Evelyn Partners, says: “Annuities are definitely back on the radar of many retirees as annuity rates were at their highest levels for more than 10 years, even before this latest spike in bond yields. That means the guaranteed annual income that someone can buy with all or part of their pot is better than it has been at any point since pension freedoms arrived.
“A healthy 65-year-old buying a single-life level annuity with a five-year guarantee can currently secure just over £8,000 of income with £100,000 in pension savings, compared with well below £5,000 at the market lows seen a decade ago. Annuity rates can, however, vary dramatically with the individual’s age, health and address, as well as the type of product chosen – with options for inflation protection, periods of guaranteed pay-outs, and joint-life death benefits.”
Shopping around could help you secure a higher income. You may also qualify for an enhanced annuity if your health or lifestyle means you have a shorter life expectancy.
You can read more in our guide to five steps to choosing an annuity.
Should you buy an annuity or use pension drawdown?
An annuity won’t be the right option for everyone, and it’s important to weigh up the benefits against the potential drawbacks before making a decision.
The main advantage is certainty. With a lifetime annuity, you’ll receive a guaranteed income for the rest of your life, which can make budgeting easier and provide peace of mind that you won’t run out of money in retirement.
However, the downside is that you generally give up access to the money used to buy it. You also won’t benefit from any potential investment growth on those savings.
Pension drawdown offers greater flexibility because you leave your pension invested and decide how much money to withdraw and when. However, your investments could fall in value, and there’s a risk you could withdraw too much too soon.
Some people choose a combination of both. For example, you might use an annuity to cover essential expenses such as household bills and food shopping, while keeping the remainder of your pension invested to provide additional income when needed.
There’s no single approach that will suit everyone. Your decision will depend on factors such as your other sources of retirement income, how much flexibility you want and whether leaving money to loved ones is important to you. Read our guide to annuity versus drawdown: which is right for you?.
Where can you get help with annuity decisions?
Choosing how to turn your pension savings into an income is a significant financial decision, so it’s worth taking time to understand the options before committing.
You can get free, impartial guidance from Pension Wise, a government-backed service for people aged 50 and over with defined contribution pensions. It can explain your retirement income options, although it won’t recommend a particular product.
You may also want to speak to a regulated financial adviser if you’re unsure whether an annuity, drawdown or a combination of the two would be most suitable for your circumstances.
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. 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 2,600 reviews on VouchedFor, the review site for financial advisers.
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