How Annuities Work

An annuity answers one of retirement’s hardest questions: how do you turn a finite pot of savings into an income that lasts as long as you do? In exchange for some or all of your pension, an insurer promises to pay you a set income, for the rest of your life, however long that turns out to be. It is the closest thing the private market offers to the security of the State Pension.

For years, low interest rates made annuities unfashionable. Higher gilt yields have since revived them, and a guaranteed income is once again worth serious consideration. This guide explains the main types, what drives the rate you are offered, and how annuities stack up against keeping your money invested in drawdown.

What an annuity is

A lifetime annuity is an insurance contract. You hand over a lump sum, usually from your defined contribution pension, and in return the provider pays you a guaranteed income until you die. The insurer takes on the “longevity risk”: the danger of living longer than your money would otherwise last. That transfer of risk is the whole point.

Before buying, you can normally take up to 25% of your pension as tax-free cash, then use the remaining 75% to purchase the annuity. The income you receive is then taxable as ordinary income. Once bought, a standard annuity generally cannot be reversed, so the decisions you make at outset, the type, the features, the provider, lock in for life.

It helps to separate the two kinds of annuity you may come across. A lifetime annuity, the focus of this guide, pays you until you die. A fixed-term annuity, by contrast, pays a guaranteed income for a set number of years and then hands back a maturity value you can use however you like, a halfway house for people who want certainty for a while without committing forever. There are also investment-linked annuities, where the income can rise or fall with an underlying fund; they offer growth potential but reintroduce the very uncertainty most annuity buyers are trying to escape. For the majority of retirees, the conventional lifetime annuity remains the reference point.

The main types of annuity

Annuities are not one product but a family of them, and the choices you make shape both your income and your family’s protection. The big decisions are whether the income stays flat or rises, whether it continues to a partner, and whether any money is protected if you die early.

A level annuity looks generous on day one, but decades of inflation can quietly halve its buying power. An escalating annuity starts lower and climbs, protection that matters most for those retiring young or in good health. Joint-life and guarantee features cost income now in return for security later. There is no single right answer; it depends on your health, your partner, and how much certainty you want.

The inflation question deserves particular thought. At 3% inflation, the buying power of a level income roughly halves over 24 years, well within a typical retirement. An index-linked annuity protects against that erosion, but the lower starting figure can be a hard trade to accept, and it may take a decade or more before the rising income overtakes the level alternative in cash terms. Retirees in good health at 60 or 65 have the most to gain from inflation protection; someone buying later, or with a shorter expected retirement, may reasonably prefer the higher flat income. It is a genuine judgement call rather than a right-or-wrong choice.

The joint-life decision is just as consequential, because it is really about the person you leave behind. A single-life annuity stops the day you die, which can leave a surviving spouse suddenly poorer. A joint-life basis, typically continuing at 50% or two-thirds to your partner, costs income now but protects the household later. For couples, this is rarely a decision to make in isolation; it interacts with your partner’s own pensions and your combined retirement income needs.

How much income you get

As a rough 2026 benchmark, a healthy 65-year-old using £100,000 to buy a single-life, level annuity might secure in the region of £7,000 a year for life. Add inflation-linking or a spouse’s pension and the starting figure falls; buy at an older age or with health conditions and it rises. Rates change daily with gilt yields, and can differ meaningfully between providers.

What drives your rate

The income an insurer offers reflects how long it expects to pay you and what return it can earn on your money in the meantime. Several factors feed into the quote:

• Your age, older buyers get higher rates because the expected payment period is shorter.
• Gilt yields and interest rates, the backdrop against which insurers price guarantees.
• Your health and lifestyle, conditions, smoking or a high BMI can increase your income.
• The features you choose, inflation-linking, joint life, guarantees and value protection all lower the starting figure.
• The size of your pot, larger amounts sometimes attract slightly better terms.

Enhanced and impaired-life annuities

One of the most overlooked opportunities is the enhanced (or impaired-life) annuity. If you have a medical condition, take regular medication, smoke, or are overweight, an insurer may expect to pay you for fewer years and therefore offer a higher income, sometimes 20% to 40% more than a standard rate. Even conditions such as high blood pressure or diabetes can count.

Because these enhancements are never applied automatically, disclosing your full health and lifestyle when you shop around is essential. It is one of the few situations in finance where being candid about your health can leave you better off for the rest of your life.

Shopping around

The single biggest mistake at retirement is accepting the first annuity quote your pension provider sends. The “open market option” lets you buy from any provider, and differences between the best and worst quotes can be substantial and permanent. Because the decision is irreversible, it is worth the effort of comparing, or asking a regulated adviser to do it for you.

• 1

  Take your tax-free cash decision first

  Decide how much of your 25% tax-free entitlement to take before buying, as it reduces the amount annuitised.

• 2

  Disclose your health fully

  Complete a health and lifestyle questionnaire to unlock any enhanced rates.

• 3

  Compare the whole market

  Get quotes from several insurers, not just your current provider.

• 4

  Choose your features deliberately

  Weigh single vs joint life, level vs escalating, and any guarantee period.

• 5

  Check for guaranteed annuity rates

  Some older pensions include valuable guaranteed rates worth far more than the open market, never give these up without advice.

Annuity vs drawdown

The great retirement debate is annuity versus drawdown. They answer different needs: an annuity buys certainty, drawdown buys flexibility. Understanding the trade-off is the key to choosing, or to blending both.

Many retirees do not choose one or the other. A popular approach is to annuitise enough to cover essential bills, guaranteeing the floor, and keep the rest invested in drawdown for flexibility and growth. Our guide to drawdown versus annuity explores that blend in more depth, and how much you need to retire helps you size the “floor” of essential spending.

Timing is another lever. You do not have to annuitise everything on the day you retire. Some people stay in drawdown through their early retirement, then buy an annuity in their seventies, by which point rates are higher (because the expected payment period is shorter) and any decline in health may unlock an enhanced rate. This “drawdown first, annuity later” path lets you keep flexibility while you are active and lock in security when certainty matters more. The trade-off is that you carry investment risk in the meantime, and rates could move against you.

Whichever route you take, do not overlook any guaranteed annuity rate attached to an older pension. Some policies sold decades ago promise conversion terms far more generous than anything available today, and cashing them in or transferring away can quietly destroy thousands of pounds of lifetime income. These guarantees are easy to miss in the small print, so it is worth checking every old plan before you make any move.

Is an annuity right for you?

An annuity tends to suit people who value certainty above all, who worry about outliving their savings, or who do not want to manage investments in later life. It is less appealing if you want to leave a large legacy, expect a shorter retirement, or place a high value on flexibility. Rising rates have made the decision finely balanced again, which is why timing and personalised modelling matter.

This is information, not personal advice, and annuity choices are largely permanent. If you would like an expert to compare the market, factor in your health, and weigh an annuity against the alternatives, Vetted Wealth can match you, free, with an independently vetted, FCA-regulated retirement planning specialist.

Common questions on retirement