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Guaranteed retirement income (annuities) explained

Are you planning your retirement and thinking to use some or all of your pension to secure a guaranteed income by buying an annuity? Find out the types of annuity available, the pros and cons of each, and how to choose one that’s right for you. 

What is an annuity?

An annuity provides you with a regular guaranteed income in retirement.

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 pot to buy an annuity, you can take up to a quarter (25%) of the amount as tax-free cash.

You can then use the rest to buy the annuity – and the income you get is taxed as earnings.

Annuities are sold by insurance companies.

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Types of annuity

The different types of annuity that are available include:

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

Which type is best for you depends on lots of things, such as what other retirement income you have, whether you have a health problem, and what your appetite for risk is.

Lifetime annuity

  • It 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 can buy an annuity that increases each year, to protect you from inflation.
  • When you buy one, the decision is irreversible, you can’t change your mind later.
  • Depending on how long you live, you might get less than you paid for your annuity. Although you could 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.

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Make sure you explain any medical conditions you or your partner have – as it might mean you get a higher annuity income.

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Fixed-term annuity

  • It 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. 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 best suits. 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 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 convert and exit 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. 

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Enhanced annuities

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. This is also known as 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, got 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 annuities

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 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 amounted 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. 

How much retirement income will I get from an annuity?

Your retirement income and whether or not you should buy an annuity will depend on:

  • the size of your pension pot
  • how old you are when you buy your annuity
  • how long you want the annuity to last – for a fixed term or for your lifetime
  • annuity rates at the time you buy
  • where you expect to live when you retire
  • your health and lifestyle
  • which annuity type, income options and features you choose.

Means-tested benefits and debts

Taking money from your pension may affect your eligibility for means-tested state benefits. 

A company or person that you owe money to cannot normally make a claim against your pensions if you've not started taking money from them yet. This also applies to County Court Judgements and Individual Voluntary Arrangements. Once you have withdrawn money from your pension, however, you may be expected to pay.

If you need to clear debts, it’s important to get specialist help before accessing your pension.

How to choose the best type of annuity

What is the best type of annuity? That depends a lot on your situation.

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There are lots of different features you can choose when buying at annuity. So it’s important to shop around to find one that best fits your needs.

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What are the alternatives to buying an annuity?

There are four other options for using your pension pot other than an annuity:

  • keep your pension pot where it is and delay taking money from it 
  • using your pot to provide a flexible retirement income – pension drawdown
  • taking a number of lump sums from your pot
  • taking your whole pot as a lump sum.

You can also mix your options to give you more flexibility.

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Can you continue contributing to a pension if you purchase an annuity?

If you’re planning to take your tax-free lump sum, set up a guaranteed income from an annuity and make further contributions into the same pension or another one, you need to be aware of the ‘pension recycling’ rules.

These are designed to prevent people from getting further tax relief on contributions where they have already benefited from tax relief.

You could be affected by the pension recycling rules if you plan to use some or all of your tax-free lump sum to significantly increase contributions to a pension.

If you’re considering reinvesting your tax-free lump sum into a pension, consider speaking to a financial adviser. They can help you look at whether putting the money back into a pension is the best option for you and help you avoid any pitfalls.

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MoneyHelper is the new, easy way to get clear, free,
impartial help for all your money and pension choices.
Whatever your circumstances or plans, move forward with MoneyHelper.

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Looking for us? Now, we’re MoneyHelper

MoneyHelper is the new, easy way to get clear, free,
impartial help for all your money and pension choices.
Whatever your circumstances or plans, move forward with MoneyHelper.

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