An annuity is an insurance product that converts a pension pot into a guaranteed income, usually paid for life. The pension saver hands a lump sum to an insurer, which in return pays a fixed or escalating amount at set intervals.
In one line: An annuity swaps a pension pot for a guaranteed income that an insurer pays out, typically for the rest of the holder's life.
How an annuity works
Annuities are regulated by the Financial Conduct Authority. The income offered depends on the annuity rate, the saver's age, health and whether features such as inflation-linking or a spouse's pension are added. Rates move with long-term gilt yields, so timing affects the quote.
For a worked example, a 65-year-old with a 100,000 GBP pot buying a single-life level annuity at a 7% rate receives 7,000 GBP a year for life. Adding inflation protection or a 50% spouse's pension lowers that starting figure.
Once bought, a standard annuity cannot usually be reversed, so the rate is locked in. Shopping the open market rather than accepting the existing provider's offer can raise the income materially.
Annuity vs pension drawdown
An annuity gives certainty: a known income that cannot fall, with the longevity risk carried by the insurer. The trade-off is loss of access to the capital and limited flexibility once the contract starts.
Drawdown keeps the pot invested and lets the holder vary withdrawals, but the income can run out and is exposed to market falls. Many savers blend both across retirement.
Primary source: FCA: Annuities