How to Secure a ‘Guaranteed’ Retirement Income
For many retirees, ensuring a reliable income throughout retirement is a key priority. One option to consider is purchasing an annuity, which provides a guaranteed income for life or for a fixed term. But is an annuity the right choice for you? This article explores how annuities work, the different types available, and the key factors to consider.
What is an Annuity?
An annuity is a financial product that converts your pension savings into a regular income. You essentially “buy” an annuity from an insurance company using your pension pot, and in return, they guarantee to pay you an income for a set period or for life. Unlike pension drawdown, where funds remain invested and withdrawals are flexible, an annuity provides certainty by guaranteeing payments for a set period or for life.
Types of Annuities
Lifetime Annuities
A lifetime annuity guarantees an income for the rest of your life, regardless of how long you live. Options include:
- Level annuity – Pays a fixed income, but inflation may erode its purchasing power over time.
- Escalating annuity – Increases over time (e.g., by a fixed percentage or in line with inflation) to help maintain your standard of living.
- Enhanced annuity – Provides a higher income if you have health conditions or lifestyle factors that may reduce life expectancy.
- Joint-life annuity – Continues paying an income to a surviving spouse, partner or other dependent after your death.
Fixed-Term Annuities
Unlike a lifetime annuity, a fixed-term annuity provides an income for a set period (e.g., 5 or 10 years), after which a lump sum is returned to you. This can offer flexibility for those who may want to reassess their retirement income options later.
For example, consider a 62-year-old retiree who needs income for 5 years until their state pension starts at 67. By purchasing a fixed-term annuity, they can secure a guaranteed income for this period, bridging the gap between early retirement and state pension eligibility. This approach provides financial stability and peace of mind during the transition, ensuring a steady income without committing to a lifetime annuity. Once the state pension kicks in, the retiree can reassess their financial situation and explore other long-term income options if needed.
Key Considerations When Purchasing an Annuity
- Flexibility vs. Security – Annuities offer certainty, but once purchased, they cannot usually be altered.
- Inflation Protection – A ‘level’ annuity may lose value in real terms, while an ‘escalating’ annuity provides long-term security but starts at a lower rate. Including an escalation feature in a lifetime annuity reduces the starting income because the provider must account for future payment increases, which increases their long-term financial obligations.
- Health and Lifestyle – If you qualify for an enhanced annuity, you could receive a significantly higher income.
- Spouse’s Benefits – If providing for a partner is important, consider a joint-life annuity.
Shopping Around for the Best Annuity Rate
When purchasing an annuity, it’s crucial to shop around to secure the best rate. Different providers offer varying annuity rates based on their calculations, and choosing the right one can significantly impact your retirement income. You are not obligated to purchase an annuity from your existing pension provider, so comparing options can lead to a better deal. Websites like MoneyHelper offer tools to help you compare annuity rates and find the most suitable option for your needs.
Why Have Annuity Purchases Increased?
Historically, annuity sales declined following pension freedoms introduced in 2015, as more retirees chose drawdown for its flexibility and because annuity rates were low (lower rates mean it’s more expensive to buy a set amount income compared to when rates are higher). However, in the past couple of years, annuity purchases have risen significantly due to increasing annuity rates.
Annuity rates are closely tied to interest rates and gilt yields. Higher interest rates and rising UK government bond (gilt) yields lead to better annuity rates, making them more attractive compared to previous years.
Current Annuity Rates
Annuity rates fluctuate based on interest rates, gilt yields, and life expectancy assumptions. As of March 2025, a healthy 65-year-old purchasing a ‘level’ annuity with a 10-year guarantee period could expect a rate of 7.4% which equates to an income of £925 per month (before tax), based on an annuity purchase price of £150,000.
If the same 65-year-old instead purchased an ‘escalating’ annuity at 3% (i.e. the annuity income increases by 3% each year) the starting annuity income would fall to £676 per month (before tax).
What about tax?
Annuity income in the UK is subject to income tax at the annuitant’s marginal rate. This means that the payments you receive from your annuity are added to your other sources of income and taxed according to your overall tax bracket. For most retirees, this will be at the basic rate of 20%, but those with higher total incomes may pay 40% or even 45% on a portion of their annuity income.
It’s important to note that typically, 25% of your pension pot can be taken as a tax-free lump sum before purchasing an annuity, potentially reducing the taxable portion of your retirement income. As with all pension income, annuity payments are usually paid with tax already deducted under the PAYE (Pay As You Earn) system.
Is an Annuity Right for You?
Annuities suit those who prioritise guaranteed income and do not want to manage investments in retirement. However, they may not be suitable for everyone, particularly those who prefer flexibility or have other income sources. For retirees seeking a more flexible retirement income ‘drawdown’ may be more appropriate. More on drawdown in our next blog article!
Need Help Choosing the Right Option?
Deciding on an annuity is a significant financial decision. If you need personalised advice on whether an annuity is right for you and which options best suit your needs, contact us today for expert advice.