What is an annuity?

An annuity is a type of retirement product you can purchase using a portion of the pension pot you’ve saved for retirement. It usually pays a regular fixed income that you can choose to last for your lifetime, or for a set period.

On this page, you’ll learn what an annuity is, how annuities work and the different types available. We also consider the alternatives to a pension annuity and explain how cash savings accounts can form part of a retirement strategy. 

An annuity is a financial retirement product that allows you to convert your pension pot into a regular, fixed payment. Purchasing an annuity provides you with a set income for the rest of your life, or for a set period of time.

There are different types of annuities available to purchase. For instance, you could choose a single life annuity that pays an income just to you, or a joint life annuity that continues to pay your partner after you pass away. Each option will have its own advantages and disadvantages.

The amount you’ll receive from an annuity will depend on your life expectancy, health, and the amount you pay into it, among other factors. Depending on the type of annuity you choose, the provider may also offer other features such as principal protection, long-term care cover, and legacy planning.

Once you retire, you can use your pension pot to purchase an annuity that will give you a set income.

Example 

Person A has a total pension pot of £145,000 when they decide to retire, which is close to the UK median for someone aged 65 to 74. Under current UK rules, they might choose to take 25% of this total, which equals £36,250, as a tax-free lump sum. They could use this money for immediate plans, such as home improvements or funding a separate savings account, or earn interest on it with an account such as a fixed rate bond. 

They could then use the remaining 75%, which is £108,750, to buy an annuity from an insurance provider. An illustrative rate of 6% would provide £6,525 a year. A 7% rate would provide £7,612.50 annually, while an 8% rate, their income would offer £8,700 each year. These examples are for illustration only and actual rates vary based on market conditions and individual circumstances.  

Insurance companies typically sell annuities, and you’ll pay income tax on your annuity income. The amount you pay will depend on your income tax band.

Annuities and pension annuities are terms that refer to the same product. The most common way to purchase an annuity is by using your pension pot, which is why you’ll often hear the two terms used interchangeably.

There are many different types of pension annuities, so it’s important to shop around and choose one that suits your needs. The different types of annuities include:

• Single life: This type of annuity makes payments solely to you for life or a fixed number of years.
• Joint life: With a joint-life annuity, your spouse or partner can receive payments after you pass away.
• Fixed-term annuity: This product pays an income for a set number of years. It also typically provides a pre-agreed maturity sum that you can use to purchase another retirement product later.
• Short-term annuity: This pays out for a set number of years, often less than five. Payments from this type of annuity will also stop if you pass away during the term.
• Enhanced or impaired annuity: This type of annuity may pay more than others if you smoke or have certain medical conditions.
• Escalating: Escalating annuities increase the amount you receive each year to help reduce the effects of inflation.
• Level annuities: A level annuity pays a flat amount of income every year, which means its real purchasing power may decrease over time due to inflation.
• Investment-linked: This is linked to the stock market, and the amount you’ll receive will depend on the performance of the annuity’s investments. This means your income may fluctuate over time. 
• Value protected annuities: With this type of annuity, a nominated person will receive a lump sum if you die before earning back the value of your original pension pot.

Some annuities feature a guarantee period. This feature ensures that your pension pays out for a minimum set term. For example, if you have a 10-year guarantee period but pass away after six years, your beneficiary will receive the income for the remaining four years.

When you buy an annuity, the provider calculates the rate they can offer based on several personal factors. The main elements that influence your rate include:

• Age: Your age plays a significant role. Generally, if you purchase an annuity when you are younger, you will receive a lower annual income, as the provider expects to pay out for a longer period.
• Health and lifestyle: Your medical history is a key factor. If you have certain health conditions or smoke, you might be eligible for an enhanced annuity. This type of product often offers higher payments to account for a potentially shorter life expectancy.
• Pot size and product features: The total size of your pension pot and the specific features you choose, such as adding a joint life policy or inflation protection, will directly impact the final calculation.

Annuity rates also fluctuate based on broader economic conditions, and they can vary significantly between different companies, so it’s highly recommended to compare options. Which? looked into the impact this could have over the course of a retirement period. Using a figure of £162,729 (the average amount used to purchase an annuity in 2025), annual payouts for a healthy 65-year-old purchasing a single life annuity ranged from £11,601 to £12,815. The difference over a 20-year retirement would add up to £24,280.*

*Source: https://www.which.co.uk/news/article/retirees-are-using-more-of-their-savings-to-buy-an-annuity-should-you-aAclV7E5QAUB?

The regular income you receive from an annuity is subject to income tax. It’s taxed in the same way as a regular salary. This is because you received tax relief from the government on your contributions while you were saving into your pension pot. The exact amount of tax you pay will depend on your total income and your personal tax band. Before purchasing your annuity, you can usually take up to 25% of your pension pot as a tax-free lump sum, capped at £268,275.

Here are some common considerations when buying an annuity: 

• You don’t have to purchase your annuity from your current pension provider. You have the right to shop around on the open market. Comparing rates from different insurance companies can often help you secure a higher regular income.
• You must be fully transparent about your medical history and lifestyle. Full disclosure ensures your income calculation is fair and protects the validity of your contract.
• Take inflation into account and think about how it might affect your purchasing power over the years. While a level annuity pays a higher starting income, an escalating annuity increases each year to potentially help protect your money against the rising cost of living.

A standard single life annuity usually stops paying out when you pass away. However, you can select options specifically designed to benefit your heirs as well. For example, a joint life annuity will continue to pay a regular income to your spouse or partner. Alternatively, an annuity with a guaranteed period ensures  your nominated beneficiary will receive the remaining payments if you pass away within a set timeframe. You can also look into capital protected annuities, which return a lump sum to your estate if you die early in your retirement.

If you are able to pass on your annuity, the tax your beneficiaries pay depends on your age when you pass away.

Under current UK rules, if you die before the age of 75, your beneficiaries will typically receive the annuity payments tax-free. However, under the Finance Act 2026, most unused pension funds and death benefits will be included in the deceased person's estate for Inheritance Tax (IHT) purposes for deaths occurring on or after 6 April 2027. If you pass away at age 75 or older, the income your beneficiaries receive will be subject to standard income tax. This means the payments will be taxed at their own personal income tax rate.

Buying a pension annuity is just one option. There are various ways you can fund your retirement, such as income drawdown or taking a lump sum from your pension. Each one has its own rules and tax implications, so you’ll need to think carefully before making a decision. The best option will depend on your individual circumstances, so speak to an independent financial advisor if you’re unsure about anything.

Your pension pot might be your main source of income in retirement, but it’s possible to generate income from other sources too. One strategy is to put some of your money into a savings account, such as a fixed rate bond. These accounts provide a fixed interest rate, meaning your returns are certain and, unlike investing, capital is not exposed to market volatility. Provided you’re happy to lock away your money for a fixed period, you can use the interest earned to supplement your pension (though inflation risks must also be considered). 

To view competitive savings accounts from a range of partner banks, simply register for a Raisin UK Account and apply for free online today.