What is an annuity and how do annuities work?
Many people are looking for reliable ways of funding their retirement. Perhaps you’re planning trips you put off because life kept getting in the way or have a hobby you’d like to devote more time to. Or maybe you just want to make sure the bills are covered for the rest of your life.
An annuity is a way of turning your pension savings into a guaranteed income that usually lasts for the rest of your life. It can be a very reliable way of funding some or all of your retirement. That’s why you could say that the real meaning of an annuity is security.
What’s the actual definition of an annuity?
An annuity is a financial product that gives you a regular, guaranteed income when you retire. You’ll get monthly, quarterly or annual payments. They can last for the rest of your life or for a fixed period.
That makes annuities a very low risk way of funding your retirement and help you with your planning and budgeting. That’s why we often talk about annuities really meaning security.
- People usually buy annuities with money from their pension pot.
- You can only buy one when you’re 55 or older, or 57+ from 6 April 2028.
- Once you’ve set one up you can’t make any changes to it.
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Barry: Hi, I'm Barry, and I'm coming up to that real pivotal age in life where I'm thinking about retirement and I've been doing a bit of research, but I really don't know quite the best way to go. So, I'm really fortunate to be joined by John, Legal & General's annuity expert, who's going to help me out a bit today. So, John, like I say, I'm approaching retirement
Barry: I want to look at the best options available for me. I looked at the annuity calculator and an annuity income looked good. But what is an annuity and how does it work?
John: Well first of all, Barry, well done for using the annuity calculator. That's a great start to looking at your options and deciding how to best approach retirement. An annuity, it's a product that will give you a guaranteed income. And the way you purchase it is with your pension savings. You give us a lump sum of your pension savings and then we will guarantee the income over a period of time, now that period of time can be for your lifetime, or it can be for a set period of time.
Barry: Okay, that sounds good, but is there more than one type of annuity?
John: There's actually a number of annuities and options you can look at, Barry. Probably the most common one is the lifetime annuity and as it says in its name, you take this out for the whole of your life, and we guarantee that we will pay your income for the whole of your life, regardless of how long you live for.
John: So if you live to 120, we'll still be paying out your income at that time. Conversely to that, there's what's called a fixed term annuity and that's where we pay it for a set amount of time that you choose. And this can sort of be used for what's called a bridging income. So, a typical example of that is if you were to maybe reduce your hours at work, but you want to maintain a similar amount of income, you don't want your income to reduce, then you can take the fixed term annuity out for the period before you maybe hit full retirement, and then you fully stop working. Alongside those you can have options to take the annuity out with a loved one. Okay. And when you do that, it means that we guarantee that when you die that the income will continue to be paid to your loved one after that.
John: So that can give peace of mind for you and for your loved one in your family as well. And finally, there's the enhanced annuity. Now, if you have certain medical conditions or lifestyle factors. So, for example, you smoke or you drink heavily, then we could offer you a higher amount of income, as a result so it would enhance the annuity.
Barry: I certainly hope to live to 120 years. That'd be nice, wouldn't it. Yeah, yeah. So, for someone like me what are the key benefits?
John: To reiterate it's the guaranteed payments is the main benefits, Barry. You will have peace of mind through the whole of your retirement, you will continue to receive income. But that's the massive benefit, they're well-established products in the marketplace. They've been around for a while and it's something that's going to continue to be around for a while.
Barry: I certainly like that they're established. But what are the other key things I need to be aware of?
John: When you take out annuity, Barry, there will be a number of options you can have to, what we call shape the annuity and make it personal to you. So you need to be aware of your personal goals, your personal circumstances, and make sure the annuity is going to be fit for purpose for you, which you will be able to do.
John: But you just need to be aware of that fact. Also, if you were to die soon after taking the annuity out, then there's chance you will get back less than you invested. And also, once you've set up your annuity, Barry, you won't be able to make any changes to it. Okay. So, that's why you need to be sure that it's right for you.
Barry: So when can I take this out and because it sounds like there's lots of options, would I need to speak to a financial advisor?
John: So you can take out an annuity from age 55, although in 2028, April 2028, that is going to rise to 57 as the minimum age you can take one out. As for a financial advisor, you don't have to use a financial advisor, Barry. But we would recommend you use one if you are unsure of what to do and if the options are proving too confusing for you, then that could be a route to go down.
John: But there's also the government's Pension Wise service that you can use. And they will give you unbiased guidance and help you see your options as well. And that's a free service that the government provide. But you can apply for annuity directly with us. You can do that online through our website. And as part of that quote journey we will tell you if you can get better income elsewhere.
John: Okay. So different providers provide different levels of income. We don't all provide the same amount. And we also have the annuity ready service, which will allow you to find out who is providing the best income. And they will actually help you apply for that as well. So you can achieve the best income, even where that income isn't provided by Legal & General.
Barry: It's brilliant that you tell me if there's a different rate elsewhere, do I have to pay for that?
John: No, we won't charge you anything extra for that service. So we will just let you know where the best rate can be found and help you apply for that.
Barry: Crikey, right, that's amazing. Thank you for all your time today, John. It's been really helpful.
John: Oh, you're very welcome, Barry. Thank you. Visit legal&general.com/annuities for information and helpful guides. And also if you liked the video, remember to like, share and subscribe.
What sort of annuities can I choose from?
The most common type of annuity is a lifetime annuity. It regularly pays out a guaranteed sum of money for the rest of your life. If that doesn’t meet your needs, other types of annuity include:
- Joint lifetime annuities, which regularly pay out a guaranteed sum of money for the rest of your life, then keep paying it to a loved one after you die.
- Fixed term annuities, which pay out a guaranteed sum of money for a fixed period of time, stopping when that time ends. You can also choose a lump sum payment at the end of it.
- Enhanced annuities, which give you a better annuity rate if you have certain health or lifestyle issues.
How do annuities work?
An annuity usually pays you a regular monthly, quarterly or annual income for the rest of your life, no matter how long you live. You can also choose a temporary annuity (or fixed-term annuity) which only pays out for a set period. Both types can keep paying out to a loved one if you die before them.
The amount of income you can get will depend on:
- how much you choose to spend when you set it up
- what choices you make when you set it up
- the annuity rate your provider offers you
- health and lifestyle factors
You set the income amount when you buy your annuity.
Calculating your annuity
- You can use our Annuity Calculator to find out what your potential income could be based on the amount you have to spend.
- We can create a personalised annuity quote for you, which will also tell you if you could get a better rate elsewhere. We want you to find the right annuity for you.
What are your annuity options?
When you’re choosing and setting up your annuity, you’ll probably have different options to choose from. In particular, you’ll have to decide whether you want your annuity payments to:
- Last for the rest of your life or for a fixed period only
- Fixed term products usually last for between three and 25 years
- Some fixed term products also pay out a lump sum when they end
- Rise over the life of your annuity
- This will help your income keep up with inflation
- Bear in mind that your starting rate will be lower
- Look after a loved one after you die
- Keep paying them for a fixed period or the rest of their life
- Pay them a one-off lump sum
Is an annuity income taxable?
Yes – your annuity income is treated like any other taxable income, including your State Pension. If your total income, including the money you receive from your annuity, goes above your personal allowance, it’s taxable.
The exact amount of tax you pay will depend on your personal circumstances – it may change if your income tax rate changes. Whether or not you’re working will also make a difference. Once you stop receiving a salary and begin relying on your retirement income, you could find that you’re in a lower tax bracket. Your annuity income can still affect any means-tested benefits you might receive.
If you die and your annuity income starts going to a loved one, they’ll have to pay income tax on it and it could affect their benefits too. But the annuity income won’t incur any inheritance tax.
What happens to an annuity when you die?
Usually, when you die your payments will end. But you’ll probably have other options if you want to make sure a loved one is taken care of. These can include:
- Having some or all of your income paid to a loved one. That can continue either for a set period of time or until they reach the end of their own life.
- Protecting a percentage of the money you use to buy your annuity – for example, 25%, 50% or 100% of it. Your provider will pay out a lump sum based on that amount.
Their exact details will depend on the provider you choose. They’ll probably cover the costs of any after-death benefits by offering you a lower annuity rate. But remember that if you live longer than average, the payments you receive are likely to add up to more than you paid to buy the annuity. But if you die earlier than expected, you might get back less than you spent on it.
FAQs
HMRC treats any annuity income you receive as part of your taxable income, which also includes your State Pension. Any money you get above your personal allowance is taxable. The amount of tax you pay will depend on your personal circumstances and may change in the future.
People often talk about annuities meaning just a lifetime annuity. In fact, you can choose between many different types of annuity. Each has its own specific benefits – the full list is:
- Lifetime annuities
- Fixed term annuities
- Joint lifetime annuities
- Enhanced annuities
- Deferred annuities
- Variable annuities
- Immediate needs annuities
- Purchased life annuities
We talk through them all in detail in our Types of annuity article.
A pension is a tax-efficient way of investing for your retirement, often with the help of your employer or the government. As you invest in your pension you build up your pension pot.
When the time comes to retire, you can spend some or all of your pension pot on an annuity. An annuity gives you a guaranteed income for the rest of your life or for a fixed period.
To find out more about annuities, take a look at our How annuities work article.
As with any financial decision, it depends on your goals and circumstances. For an in-depth comparison of the two types of product, check out our Annuity vs drawdown article.
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