What is an annuity and should you be using them for your retirement income?

When planning for retirement, one of the most important decisions you'll face is how to turn your pension savings into a reliable income. Among the options available, annuities are making a notable comeback. But what is an annuity, and are annuities worth it for those looking to begin to take their retirement income? 

An annuity is a financial product that converts a lump sum into a guaranteed income for life or for a fixed period. The most common forms of annuity are pension annuities, with a lump sum from your pension scheme used to purchase one.

In essence, you hand over a lump sum to an insurance provider, and in return, they pay you a regular income. This can offer peace of mind, especially for those who value certainty and stability in retirement.

Prior to 2015, retirees had to convert a portion of their pension savings to an annuity, but since then it has become optional.

For years after the pension freedoms of 2015 made them optional, annuities fell out of favour. Low interest rates meant poor returns, and the relative inflexibility of annuities once purchased meant that the guaranteed income didn’t offer enough of an incentive for many investors to consider them.

With interest rates in recent years finally rising from their historic lows, the value proposition has become more attractive, but the real catalyst for annuities coming back to the fore has been the proposed changes to pension IHT legislation.

Should the proposed new IHT rules come in to force as announced, retirees will face the prospect of having their remaining pension assets subject to IHT, and then their beneficiaries potentially also being levied income tax on any withdrawals. It’s no surprise that many are now considering other forms of retirement income, such as annuities.

The rise in annuity rates has also come at a time when investors have gone through a period of increased market volatility. The main alternative to pension annuity income, flexi-access drawdown, gives investors more control over their year-to-year income from their pot, but also exposes it to investment risk.

With annuities potentially becoming a better financial option, many investors are reconsidering a guaranteed income stream which isn’t affected by market movements.

The answer depends on your personal circumstances. There are some significant benefits to taking out an annuity, including:

Guaranteed income: Ideal for those who want certainty and don’t want to worry about market fluctuations, such as that cause by President Trump’s ‘Liberation Day’ tariffs.

Simplicity: Once set up, there’s no need to manage investments or worry about running out of money.

Attractive rates: With current rates, annuities can rival or even exceed the income from rental properties or drawdown strategies.

Full FSCS protection: Annuities purchased from UK-regulated insurers are fully protected by the Financial Services Compensation Scheme¹, with no upper limit on the amount you will be re-imbursed if the insurer collapses.

However, there are still trade-offs:

Inflexibility: Once you buy an annuity, you can’t change your mind. You’re locked into the terms.

Limited death benefits: Traditionally, annuities didn’t allow for much to be passed on to beneficiaries. While you can opt for various types of guarantees or death benefits, these all impact the rates you are offered.

Payments subject to tax: The payments received from an annuity are subject to income tax and might also affect any means-tested benefits you receive. The amount of tax you pay on income from an annuity will depend on your circumstances and may change in the future.

One of the biggest historical drawbacks of annuities was their poor treatment for inheritance tax (IHT).

Previously, children couldn’t inherit annuity income, and spousal benefits came at a cost. Comparing this to pension pots and flex-access drawdown accounts, which could be passed on free of IHT, made annuities even less attractive.

But with expected changes in pension tax rules from April 2027, this is becoming less of a concern. With pensions no longer offering the same inheritance tax advantages, using your pension to buy an annuity may not create any drawbacks from an IHT standpoint.

You may have a perception of annuities as rigid and inflexible. And while there is truth to this once the annuity has been purchased, there are many different ways to structure an annuity to match your own unique needs.

For example, to address concerns about dying early in retirement and losing out, many annuities now offer value protection. This feature ensures that if you pass away before receiving the full value of your annuity, your estate can receive a lump sum of the remaining amount.

There are also options to continue making income payments to your husband, wife or civil partner when you die and you can index your payment amount to inflation.

While annuities are becoming more attractive, they’re not a one-size-fits-all solution. The good news is that it doesn’t have to be all or nothing. Annuities can form a large part of your retirement income plans, or a relatively small one.

You probably wouldn’t want to commit your entire retirement pot to an annuity, but for those with a large enough investment portfolio, using part of it to secure a guaranteed income can provide peace of mind while keeping flexibility elsewhere.

Annuities are no longer just for the ultra-cautious. With higher rates, improved tax treatment, and added flexibility through features like value protection, they deserve a place in the retirement planning conversation.

If you're wondering whether an annuity is right for you, speak to a financial planner at Evelyn Partners about your retirement income strategy.

¹ FSCS, Pension protection