What is an annuity pension?

Pension jargon can make it tricky to work out exactly what you should do with your retirement savings when you stop work

A jar full of saved one pound coins.

Here, we explain what annuities are, how they can be used to provide you with a regular guaranteed income, and some of their advantages and drawbacks.

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How do annuities work?

 When you buy an annuity, you hand over some or all of your defined contribution pension savings to an insurance company, and in return they provide you with a regular income for life.

There are several different types of annuity, including level annuities, which pay the same amount of income every year for the rest of your life, and escalating annuities, which pay a rising level of income, often linked to inflation. This type of annuity is more expensive than a level annuity and your income is likely to be much lower initially.

There are also enhanced annuities for those with a health condition or who are considered to have a lower life expectancy, perhaps because they smoke. These will pay out a higher level of income than standard annuities, so make sure you declare any medical problems.

How much income will an annuity provide?

The amount you’ll receive from an annuity depends on lots of different factors, such as your age, health, life expectancy, and current annuity rates. These are currently very low, so even a significant pension pot may not provide you with a comfortable income in retirement.

According to research by financial website Moneyfacts.co.uk, someone age 65 with a £100,000 pension who used it to purchase an annuity on January 1 this year, would have bought an average annual income of £4,680. The same pension pot used to buy an annuity on September 10 would have got an average annual income of £4,100.

Steven Cameron, pensions director at Aegon said: “For those approaching retirement, news that annuity rates have hit a 25-year low mean the cost of securing a guaranteed income for life are at an all-time high. Annuity rates have fallen in recent years because of gilt yields also being at an all-time low, coupled with life expectancy continuing to rise.”

Is there any alternative to an annuity?

Yes, pension freedoms introduced in 2015 gave people a much wider choice of options when accessing their pension funds. One of these is drawdown, which means your pension savings stay invested, and you draw an income as and when you need it. This can provide more flexibility than an annuity, but you need to be careful not to withdraw too much too soon, or you could run out of money. There’s also the risk that your investments don’t perform as well as you expect, leaving you with less to live on.

If you’re not sure which route to take, make sure you seek professional financial advice.

You can also find free and impartial government guidance on your pension options at www.pensionwise.gov.uk.

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Richard Eagling, head of pensions at Moneyfacts.co.uk, said: “In the last few years, there has also been an increasing awareness of using annuities as part of a wider range of retirement solutions, typically to provide a baseline income from which to cover monthly living costs. As such, the security that annuities offer makes them an integral part of the retirement income landscape.