You can buy an annuity with some or all of your pension pot. It pays income either for life or for an agreed number of years. When you use money from your pension fund to buy an annuity, you can take up to a quarter (25%) of the amount as tax-free cash and the income you get is taxed as earnings.

What types of annuities are there?

The different types of annuities that are available include:

  • Lifetime annuity
  • Fixed-term annuity
  • Enhanced annuity
  • Investment-linked annuity
  • Purchased life annuity

The type of annuity that is most suitable for your individual circumstances will depend on a range of considerations, including what other retirement income you have, whether you have a health problem, and what your appetite for risk is.

Lifetime annuity

This will pay you a guaranteed income for the rest of your life. It might be suitable if you’re generally risk adverse and don’t want your pension pot to be subject to any investment risk.

It’s a good option if you want peace of mind or are worried about your money running out. You don’t have to use all your pension pot to buy an annuity. So you could buy an annuity to cover some, rather than all, of your income needs – for example, your essential spending like food and household bills.

You could buy an annuity that increases each year to protect you from inflation but the decision is irreversible if you subsequently change your mind. You could also  choose to provide an income or lump sum for a dependant when you die. The amount of income you get will depend on the provider you choose, so it’s important to shop around to make sure you’re getting the best deal. 

Depending on how long you live, you might get back less than you paid for your annuity. 

Fixed-term annuity

This will pay you a guaranteed income for a set period of time. You can choose a term from between one and 40 years – although five to ten years is typical. The annuity provider invests the money you pay for the annuity and at the end of the term, you’ll usually get a ‘maturity amount’. This lump sum is the money you paid, plus the investment growth – but minus the income you’ve received so far. The amount will depend on how much income you needed over the term, and how much you paid for the annuity at the start.

You can use your maturity amount in the way that is most suitable for you. For example, you could use it to provide a flexible retirement income (pension drawdown) or buy another annuity. If annuity rates have improved by the end of the term, you could take out a new annuity potentially with a better rate based on you being older, or if your health has deteriorated.

The maturity amount is agreed when you take out the product. So, if you choose to have a lower annuity income, you’ll get a higher maturity sum at the end.
If you die before your fixed term annuity ends, the maturity amount can usually be paid to a beneficiary you’ve nominated. Some providers also offer an option to end your fixed term annuity earlier than your original fixed term. At this point, they’ll recalculate the maturity amount payable at that time.

When considering a fixed-term annuity, it’s important to shop around to make sure you’re getting the best deal. You can also add a range of other features that suit your circumstances. 

Enhanced annuity

Have you been diagnosed with an illness, or have other health problems that could reduce your life expectancy? Then you might be able to get a higher retirement income from an ‘impaired life’ annuity.

Health problems that mean you could get a higher retirement income include:

  • Stroke
  • Cancer
  • Diabetes
  • Heart attack
  • Kidney failure
  • Chronic asthma
  • Multiple sclerosis
  • High blood pressure
  • High cholesterol. 

There are some other health conditions that could also mean you get a higher income. For example, if you’re overweight or if you smoke regularly. Some companies also offer higher annuity rates to people who have worked in certain jobs. For example, those involving a lot of manual labour, or who live in certain areas of the country that have, for example, lower life expectancies.

You’ll be asked medical questions before you’re offered an enhanced annuity rate. The annuity provider might ask your doctor for more information or ask you to attend a medical examination. The annuity rate you’re offered is based on an estimate of your personal life expectancy. This is calculated using the medical information supplied.

Investment-linked annuity

This is a type of lifetime annuity where part of your income is guaranteed, and part is linked to investment performance. You choose the guaranteed level of income you want, and part of your pension fund is used to provide this.

The balance of the fund is invested, and pays extra income based on the investment returns. You would get higher levels of income if investment markets are performing well but you might only get the minimum guaranteed amount if markets are falling.

Purchased life annuity

You can buy this type of annuity with money that’s not in your pension pot. You could also buy it with the tax-free lump sum you can take when you begin taking money from your pension.

This annuity has the same options as pension annuities, although it is treated slightly differently for tax purposes. Each annuity payment includes a return of part of the sum invested (the capital) plus the part that is interest. You won’t pay income tax on the capital; you‘ll only pay tax on the interest part of your annuity income.

They can be written on a capital protected basis. This means they’ll always pay out at least as much income before tax as the amount used to buy the annuity.

If you opt for ‘no form of protection’ when you buy it, then no capital will be returned when you die.