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GUIDE: Everything you need to know about pension annuities

Paloma Kubiak
Written By:
Paloma Kubiak

Annuities are ‘back in fashion’ as rates have soared, but what are they and should you consider one for your retirement and income plan? We go back to basics to explain more.

Annuities provide private pension holders with a guaranteed income for life, and that income is now at its highest level in two decades. Since the start of 2022 alone, lifetime incomes are up nearly 50%.

Based on current rates (average 7.11%) for a 65-year-old opting for an annuity on a £100,000 pension pot in recent weeks, Standard Life calculations reveal the average annual income stands at £7,115. This is an increase of £1,277 on the £5,888 annual income they would have received in June 2022.

As income rates have risen, so have annuity sales. According to data from the Association of British Insurers (ABI) – the voice of the long-term savings industry – annuity sales surged 22% during the first three months of 2023. Between January and March, 16,256 annuities were bought which is one of the largest numbers recorded. Annuity premiums for the quarter totalled £1.2bn, the highest figure since pension freedoms were introduced in 2015. In the second quarter of 2023, individual annuity premiums totalled £1.1bn.

So, while the increases to pension annuity income sound good, you may be unfamiliar with what they are, the rules and important details about the schemes.

Indeed, recent research by Standard Life revealed that half of over 50s who were aware of annuities didn’t know how they work or what they do.

With this in mind, our Q&A with Standard Life reveals the answers to some of the burning questions you may have on annuities:

What are pension annuities?

An annuity is a guaranteed income for life – with payment beginning from the day you take out the annuity for as long as you live.

They’re available to workplace pension schemes and those with a Defined Contribution pension, and are provided by a life assurance company or other provider. Typically, this is something you consider buying at retirement with an accumulated pension fund.

There are also other types of annuities available outside of a pension wrapper, such as Purchased Life Annuities and Lifetime Care Plans.

If you have a Defined Benefit pension, you receive a regular retirement income, with the level outlined in your pension scheme.

Do you need to buy an annuity at retirement?

Until 2015 and the dawn of pension freedoms, everybody was legally obliged to use their pension fund to buy an annuity by age 75, though you could take 25% of your fund as tax-free cash before doing this.

Today, people are free to flexibly draw on their pension funds as they see fit, with unspent funds passed to the next generation if so wished. Annuities can also be bought at any point during retirement, and it can pay to wait as annuity rates improve with age. But it’s best to check individual policies. Standard Life’s maximum annuity age is 86, for example.

When approaching retirement, it’s likely you’ll receive information from your pension provider about income options, including an annuity.

However, individuals can normally buy an annuity if they are at least 55 (rising to 57 on 6 April 2028), but there are some circumstances such as special occupations and ill health where a pension annuity can be bought before the age 55.

How do I buy an annuity?

You can buy an annuity directly from your pension provider or through a financial adviser, so both advised and non-advised routes. But it’s important to know that you don’t have to buy an annuity from your pension provider, so you should shop around to make sure you get the best rate. In fact, experts suggest you should never accept the offer made to you by your existing pension provider without considering rates available elsewhere.

This is because each company will have its own view on the economic outlook, potential investment returns, and how they view people’s health and lifestyle information which affect how much they can afford to give to each customer.

A good starting point may be a financial adviser or you can get free impartial guidance from Pension Wise, a service from MoneyHelper. There are no requirements to seek advice before taking an annuity, but if in doubt, seek professional help to understand all your options.

What do I need to consider when opting for an annuity?

You can start thinking about an annuity when you start to plan for retirement. Think about how much income you’ll need each month for the rest of your life, and how you want or can meet this.

Factor in any regular payments or expenses and try to look at your approximate life expectancy.

Also think about if you need to pass on any income or wealth to relatives or dependants.

There are no explicit fees when taking an annuity without advice. The annuity income incorporates all expenses associated with the set-up of the annuity, including any commission paid to brokers.

But if you are buying an annuity through an adviser, you will be charged for their service so bear this in mind. Fees will be agreed upfront.

I have lots of pension pots, do I need to consolidate to get an annuity?

These days people move from job to job, picking up several pension pots from different workplace providers over their careers.

According to Standard Life research, one in 10 incorrectly believe they have to use their whole pension pot when buying an annuity.

But you can use all or part of your pension/pension pots to purchase an annuity at any point during retirement. You can also annuitise portions of your pension savings in stages and keep some money invested to help mitigate the impact of inflation.

And as above, it could mean improved annuity rates as you age. The one caveat here is that money left invested can go up as well as down.

Once I buy an annuity, can I change my mind or renew it later?

An annuity can’t be changed once it’s set up which is why it’s so important to shop around to make sure you’re getting the best deal.

It’s also important to remember there are various options available when it comes to your retirement income, so you can use a combination of drawdown and an annuity – the annuity covering essential costs and the remainder accessible in drawdown.

Annuitising in stages may also be beneficial for you, as above.

What income can I receive from an annuity?

Rates have soared in recent times meaning you’ll likely get a better income now compared to six or 12 months ago.

The successive Bank of England base rate hikes since December 2021 are one factor that have helped improve annuity rates.

Standard Life explained that insurance companies back annuities with long-term assets including corporate bonds. The price of these assets falls when long-term interest rates rise. These rising interest rates have caused annuity rates to improve by 20% since June 2022, with a total increase of 48% since the start of 2022.

As well as the economic outlook, the sum of money in your pension pot is important, as are other factors such as age, health, lifestyle and postcode. Fully disclosing your medical history and any medication you are receiving, plus personal information such as height, weight and alcohol consumption can also make a big difference in the annuity offered.

Further, any benefit options chosen will also impact the income level, how often income is paid, eg monthly, quarterly, bi-annually or yearly, as well as any adviser charges.

Payments are made either in advance or in arrears, directly into people’s bank or building society account.

Below Standard Life’s annuity rate tracker reveals the current rates and incomes which could be achieved on a £100,000 pension pot:

Current Rates and Total Expected Income (2023)
Age Average Annuity Rate Annual Income Total Expected Income – Female Total Expected Income – Male
60 6.39% £6,387 £172,455 £155,849
65 7.11% £7,115 £158,660 £142,296
70 7.93% £7,935 £141,234 £125,365
*Total expected income figure based on life expectancy statistics from the Office for National Statistics, and are based on age annuity is first purchased. Total expected income includes annuity income only. 

This looks like I’ll get back more income than I pay in, is that right?

Annuities provide a guaranteed income for life, no matter how long you live. The ‘break even’ point is the point at which savers receive their original investment back through income. And given the improvements in annuity rates, the payback period on a benchmark £100,000 annuity is 14 years for a 65-year-old – down by five years.

Calculations from Standard Life suggest the total expected lifetime income for a woman with a £100,000 pension who bought an annuity at 65 has increased from £130,000 in June of last year to £158,000 as of June 2023 – a difference of over £28,000. The equivalent figure for a male was £117,000 to £142,000 – a difference of £25,000.

What are enhanced annuities?

An enhanced annuity typically provides a more generous income based on a broad range of lifestyle and health factors. This is why it helps to share your medical history and lifestyle information to maximise your retirement income.

People with a broad range of medical conditions and lifestyle factors can qualify for an enhanced annuity, including smokers, those with high cholesterol or being overweight, all the way to more serious or life-threatening conditions, such as cancer or heart disease.

Is there any inflation protection with annuities?

Inflation reached an eye-watering 11.1% in October last year but it has come down in recent months. However, inflation erodes the spending power of your money meaning an annuity secured earlier may not go as far as expected when prices rise steeply.

If inflation is a concern, you can choose an annuity that increases by a fixed rate each year, or you can choose to link the increase to inflation. An inflation-linked annuity, also known as an index-linked annuity, is a type of annuity that gives the option for retirement income to increase in line with an inflation index, or to increase at an agreed fixed rate each year. Choosing an inflation-linked annuity will result in a lower starting income but will provide protection against the impact of inflation in future.

Alternatively, you may want to consider buying an annuity with a portion of your pension pot at different times as you get older so you benefit from potentially improved income rates over time.

What happens with an annuity at death?

Annuities can be set up to cover the life of a surviving partner, and as they come with various benefit features, you can opt for ‘value protection’. This provides a death benefit to a customer, ensuring their investment is returned to their beneficiary (less any income taken), while purchasing a guaranteed period for up to 30 years secures a regular income for a customer’s beneficiaries or dependants if anything should happen.

If you choose a dependant’s income, payments will be made to your spouse or civil partner and/or dependants if you die before them.

There is no Inheritance Tax (IHT) payable on death but the income or lump sum payable may be subject to income tax.