A Rare Financial Guarantee – The Annuity Explained

Certainty can be elusive. Especially these days. And especially when it comes to your money. 

Investments can rise and fall. Interest rates change. Inflation can affect what your income is worth. And when you reach retirement, one of the biggest questions is how to turn your pension savings into an income that can last for the rest of your life. 

There is one financial product that can provide a particularly high degree of certainty: the annuity. 

A lifetime annuity can provide a guaranteed income for life, according to the terms of the contract, regardless of how long you live or what happens to investment markets. 

But that certainty comes with a trade-off. Once you have purchased an annuity, the terms are generally fixed. You are exchanging some of the flexibility of your pension pot for the security of a guaranteed income. 

That makes an annuity neither inherently good nor bad. It is simply one of the options available when deciding how to fund retirement, and whether it is appropriate depends on your circumstances, objectives and wider financial position. 

Annuities have also become more relevant in recent years. The ABI reported that 87,600 individual pension annuities were sold in 2025, with total premiums of £7.4 billion. 

What is a pension annuity?

So, what is a pension annuity? Put simply, it is a financial product that allows you to exchange some or all of your pension savings for a regular income from an insurance company.

A pension annuity can provide an income for the rest of your life, according to the terms of the contract. This means the insurer takes on the risk of you living longer than expected and continuing to receive payments.

That can provide valuable certainty in retirement, but the decision to purchase an annuity is generally irreversible. Once you have exchanged your pension pot for an annuity, you cannot normally change your mind and recover the capital.

How does a pension annuity work?

A pension annuity allows you to exchange some or all of your pension savings for a regular income from an insurance company. 

Typically, you can take up to 25% of your pension as tax-free cash, subject to the standard lump sum allowance of £268,275 for most people. The remaining pension can then be used to purchase an annuity. 

So, how does an annuity work in practice? 

You use the pension money you have accumulated to purchase an annuity from an insurance company. In return, the insurer provides a regular income, usually for the rest of your life. 

The amount of income you receive will depend on a number of factors, including: 

• the size of your pension pot 
• your age when you purchase the annuity 
• your health and lifestyle 
• whether you want the income to continue to a spouse or partner after your death 
• whether you want the income to increase over time 
• the type of annuity you choose 
• the rate offered by the provider. 

Annuity rates are influenced by a number of factors, including gilt yields. Broadly speaking, higher gilt yields can support higher annuity rates, although the relationship is not quite as simple as a direct link. 

Rates have increased significantly from the exceptionally low levels seen in 2020 and 2021.

What are annuity rates in the UK?

If you are researching annuity rates in the UK, it is important to understand that there is no single rate available to everyone. 

The rate you are offered will depend on your individual circumstances and the type of annuity you choose. Age, health, lifestyle, the size of your pension pot, whether the income is for one or two people, whether it increases over time and whether you include any protection can all affect the quotation. 

For example, published market rates in 2026 show that a healthy 65-year-old with a £100,000 pension could potentially obtain an annual income of around £7,900 from a competitive single-life, level annuity with no guarantee. 

However, this is an illustration rather than a quotation. The income available to an individual can vary significantly depending on their circumstances, the options selected, and the rates offered by different providers at the time of purchase. 

Someone purchasing an annuity at a later age will generally receive a higher income from the same pension pot, because the insurer expects to pay the income for fewer years. Someone who qualifies for an enhanced annuity may also receive a higher income.

The types of annuity: what the options mean

There are several different types of annuity, and the choices you make will affect both the starting income and how that income changes over time. 

Level annuity 

A level annuity pays the same amount throughout your lifetime. 

The main attraction is that it provides a known income from the outset and will generally offer a higher starting income than an annuity designed to increase over time. 

The downside is inflation. 

If your income remains fixed while the cost of living rises, the real value of that income will gradually fall. An income that is sufficient today may therefore provide less purchasing power in the future. 

Escalating annuity 

An escalating annuity starts at a lower level but increases by a fixed percentage each year. 

For example, an annuity could increase by 3% annually, depending on the terms of the product. 

This can provide some protection against the effects of inflation, although the increase is fixed rather than necessarily matching the actual rate of inflation. 

The trade-off is a lower starting income in exchange for the prospect of higher payments in future years. 

Index-linked annuity 

An index-linked annuity increases in line with an inflation measure specified by the policy, such as RPI or CPI. 

This can provide greater protection against inflation than a level annuity. However, the starting income will generally be lower than that available from a level annuity. 

Whether that trade-off is worthwhile will depend on your circumstances and how important it is to protect the future purchasing power of your retirement income. 

Enhanced or impaired life annuity 

An enhanced annuity may be available to people whose health or lifestyle means that an insurer expects them to have a shorter life expectancy than the standard assumptions used for an ordinary annuity. 

Factors that may be taken into account can include certain medical conditions and lifestyle factors. The criteria vary between providers. 

If you are considering an annuity, it is therefore important to provide accurate information about your health and lifestyle when obtaining quotations. You may qualify for an enhanced rate without realising it. 

The increase in income can sometimes be significant, although there is no standard uplift and eligibility will depend on the provider and your individual circumstances. 

Joint life annuity 

A joint life annuity can continue paying an income to a spouse or civil partner after the original annuity holder dies. 

You can generally choose the proportion of your original income that will continue, subject to the product’s terms. 

Because the insurer may need to make payments for longer, the starting income from a joint life annuity will generally be lower than that from a comparable single-life annuity. 

This can nevertheless be an important consideration where both partners depend on pension income. 

Fixed-term annuity 

A fixed-term annuity provides a guaranteed income for a specified period rather than for the rest of your life. 

At the end of the term, there may be a maturity value, depending on the terms of the product. 

A fixed-term annuity can therefore provide some certainty over a particular period while leaving decisions about the remainder of your retirement income to a later date. 

What happens to your annuity when you die? 

This is one of the most common concerns people have about annuities. 

If you buy a straightforward single-life annuity without any protection, the income will normally stop when you die. 

However, there are options that can provide benefits to a spouse, partner or other beneficiary. 

Guaranteed Payment Period 

A Guaranteed Payment Period means that the annuity will continue to make payments for a specified period even if you die during that period. 

For example, if an annuity has a ten-year guarantee and you die after three years, payments may continue to your nominated beneficiary for the remaining seven years, subject to the terms of the contract. 

Value protection 

Value protection can provide a payment to a nominated beneficiary when you die. 

Depending on the policy, this can be based on a proportion of the original amount used to purchase the annuity, less the income already paid. 

The precise calculation and available options vary between providers. 

Joint life 

As described above, a joint life annuity can continue to provide an income to a surviving spouse or civil partner. 

All of these options affect the income available when the annuity is first purchased. Adding protection will generally reduce the starting income compared with an otherwise equivalent annuity without that protection. 

It is therefore important to consider the balance between the income you want during your lifetime and the benefits you may want to provide to someone else after your death. 

There are also tax considerations where an annuity continues to a beneficiary. The treatment depends on the circumstances, including the age of the original annuity holder at death, so this should be considered as part of the wider retirement-planning decision. 

Do you pay tax on annuity income? 

Annuity income from a pension is normally taxable as pension income. 

The tax-free cash available from your pension is separate. For most people, up to 25% of their pension can be taken tax-free, subject to the £268,275 lump sum allowance. The income subsequently paid by the annuity is generally taxable. 

Your personal allowance and other income will affect how much tax you actually pay. 

For example, if your total taxable income is within your available personal allowance, you may have no Income Tax to pay. If your income exceeds the allowance, tax will normally be due at the applicable rate. 

The annuity provider will generally deduct tax through PAYE using the tax code supplied to them. 

It is therefore important to consider an annuity alongside your other sources of retirement income, rather than looking at the quoted annuity income in isolation. 

The open market option: why shopping around matters 

You do not have to buy your annuity from the company that currently holds your pension. 

Annuity rates vary between providers, and the difference can have a significant effect on the income you receive over the course of retirement. 

This is known as the open market option. 

It is particularly important to compare providers if you may qualify for an enhanced annuity. A provider that specialises in enhanced annuities may offer a different rate from your existing pension provider. 

Once an annuity has been purchased, however, it is generally not possible simply to change the terms because a more attractive rate becomes available elsewhere. 

For that reason, comparing the available options before making a decision is important. 

Annuity vs drawdown

An annuity is not the only way of taking an income from a pension. 

Flexi-access drawdown allows you to keep your pension invested while taking withdrawals from it as required. 

The two approaches have very different characteristics: 

Neither option is automatically better. 

An annuity provides certainty but less flexibility. Drawdown provides flexibility but leaves you exposed to investment and longevity risk. 

For some people, a combination of the two may be appropriate. 

For example, part of a pension could be used to secure an income to cover essential expenditure, while the remainder stays invested in drawdown. This can provide a degree of certainty while retaining some flexibility and exposure to potential investment growth. 

The appropriate balance will depend on your circumstances, objectives, attitude to investment risk and wider sources of income and capital. 

Who might consider a pension annuity? 

An annuity may be worth considering if you: 

• want greater certainty over your retirement income 
• would prefer not to rely entirely on investment returns to meet essential expenditure 
• are concerned about the possibility of outliving your pension 
• may qualify for an enhanced annuity because of your health or lifestyle 
• have other assets or sources of income and want to use part of your pension to provide a guaranteed income 
• are prepared to accept less flexibility in exchange for greater certainty. 

An annuity may be less suitable if you: 

• need significant flexibility over how much income you take 
• want to retain control over your pension investments 
• are comfortable accepting investment risk in pursuit of potential growth 
• want to retain a pension pot that can potentially be passed to beneficiaries
• have other circumstances that make flexibility particularly important. 

These are general considerations rather than recommendations. Whether an annuity is appropriate depends on your individual circumstances and objectives. 

How are annuity rates set? 

Annuity rates are influenced by a range of factors, including gilt yields, interest rates, the insurer’s pricing assumptions and the characteristics of the person buying the annuity. 

Generally, higher gilt yields can support higher annuity rates, while lower yields can put downward pressure on rates. 

This is one reason rates have changed considerably over recent years. 

Rates also vary according to: 

• age 
• health 
• lifestyle 
• the type of annuity 
• whether it is single or joint life 
• whether income increases over time 
• whether protection is included 
• the provider. 

There is therefore no single annuity rate that applies to everyone. 

And while a rate can be fixed once an annuity is purchased, you cannot lock in today’s rate for a purchase you may make in several years’ time. 

Are annuities an option worth considering? 

Annuities have had a chequered reputation. 

Some of that is understandable. They were once effectively the default way of converting a pension into an income and people had limited flexibility over their retirement choices. 

The introduction of pension freedoms changed that. 

Today, an annuity is one option among several. 

That makes the question less about whether annuities are “good” or “bad” and more about whether the characteristics of an annuity fit your particular circumstances. 

The attraction is clear: a lifetime annuity can provide a guaranteed income for life, removing the investment and longevity risks associated with generating that particular income from an invested pension pot. 

The trade-off is equally important: once purchased, the annuity is generally inflexible, and the capital used to purchase it is no longer available for investment or other uses. 

For some people, that trade-off may be appropriate. For others, drawdown or a combination of approaches may be more suitable. 

With annuity rates in the UK having recovered from the lows of 2020 and 2021, and with thousands of people continuing to use annuities to secure retirement income, they deserve to be considered alongside the alternatives. 

The right question is not whether an annuity is right for everyone. 

It is whether it is right for you. 

If you are approaching retirement and want to understand how different income options could work alongside your wider financial plan, First Wealth can help you assess the choices available to you. Get in touch. 

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.