How Do Annuities Work and What Income Could You Receive?

An annuity is one way to turn pension savings into a regular retirement income. For people who want certainty in later life, it can provide reassurance that a set level of income will be paid either for life or for a fixed period.

This guide answers the question, “How do annuities work?”, explains what affects the income you could receive, and outlines what to consider before using some or all your pension savings to buy one.

How Do Annuities Work and What Does the Contract Include?

A pension annuity is a financial product that converts pension savings into retirement income. You normally buy one using money from a defined contribution pension, and in return, an insurance provider agrees to pay you an income under the terms of the annuity.

The contract sets out the key details, including how much income you will receive, how often payments will be made, whether the income will increase over time, and what happens when you die. Once the annuity is set up, the main terms usually cannot be changed, so it is important to choose carefully.

The process usually works as follows:

• You decide how much of your pension pot to use
• You choose the type of annuity and any extra features
• The provider calculates the income available
• You receive regular payments under the contract

When people ask how annuities work, the key point is that an annuity usually exchanges access to a pension pot for a more predictable income. More specifically, how do pension annuities work depends on the type of annuity selected and the options included.

Once set up, most annuities cannot be changed or cancelled, so the decision is usually permanent

Factors That Determine How Much Income You Get

The income from an annuity can vary significantly. Two people with the same pension pot may receive different quotes depending on their age, health, lifestyle and the options they choose. The main factors are outlined in the table below.

Provider pricing can also vary. One provider may offer a stronger quote for a standard annuity, while another may be more competitive if health or lifestyle factors apply. This is one reason why shopping around is important.

Your annuity income could be higher or lower depending on your age, health, provider, annuity rates, selected features and market conditions at the time. A £100,000 pension pot, for example, will not produce the same result for everyone. A level single-life annuity may provide a higher starting income than an annuity that increases with inflation or continues paying income to a partner after death.

Choices that can reduce or increase your starting income

The income you receive is not based on pension pot size alone; your choices can make a meaningful difference to the starting income available.

Choices that may reduce starting income:

• Income that increases over time
• Joint-life cover for a spouse or partner
• Guarantee periods
• Value protection
• Payments made more frequently or in advance

Choices that may increase starting income:

• Choosing a level income (an income that won’t increase over time)
• Buying at an older age
• Choosing single-life cover
• Qualifying for an enhanced annuity
• Using a larger pension pot

These choices show that the highest starting income is not always the best option. A lower starting income may provide better long-term value if it includes features that matter to you, such as inflation protection or income for a surviving partner.

How to buy an annuity and why shopping around matters

You do not have to buy an annuity from your existing pension provider. You can usually compare quotes from different providers before deciding. This is often known as using the open market option.

Shopping around can be important because annuity rates and underwriting approaches vary. If you accept the first quote you receive, you may miss out on a higher income or more suitable features elsewhere.

Before buying an annuity, it can help to think about:

• How much income you need
• Whether you want income for life or a fixed term
• Whether someone else relies on your pension income
• Whether income should increase over time
• Whether health details could improve your quote
• Whether you want to take tax-free cash first

A personalised quote is important because general examples cannot reflect your exact circumstances. Even small differences in options can affect the income available.

When an annuity may suit and when another option may be better

An annuity may suit people who want a secure income and do not want to manage investments throughout retirement. It can be useful for covering essential spending, such as household bills, food and regular commitments.

However, an annuity may be less suitable if you want flexible access to your pension, want to keep your money invested, or expect your income needs to change significantly over time.

Some people use an annuity for part of their pension and keep the rest in drawdown or cash. This can help balance a secure income with flexibility.

Level, escalating and inflation-linked annuities explained

A level annuity pays the same income each year. It usually provides a higher income at the start, which may appeal if you want more income immediately.

An escalating annuity increases each year, either by a fixed percentage or in line with inflation. This can help protect spending power over time, but the starting income is usually lower.

The right choice depends on whether you prioritise income now or protection later.

Single life, joint life and guarantee period options

A single-life annuity pays income for your lifetime only. It usually offers a higher starting income because payments normally stop when you die.

A joint-life annuity continues paying some income to a spouse, partner or dependant after your death. This can provide reassurance if someone else depends on your income, although it usually reduces the starting amount.

A guarantee period means payments continue for a set number of years, even if you die during that period. This can help ensure some value is passed on.

Enhanced annuities for health or lifestyle factors

An enhanced annuity may offer a higher income if your health or lifestyle suggests a shorter life expectancy. Providers may ask about medical conditions, medication, smoking, height, weight and other details.

It is important to answer these questions accurately. Even details that seem minor could affect the income offered. If you are eligible for an enhanced annuity, failing to disclose relevant health or lifestyle information could mean receiving less income than you might otherwise qualify for.

Tax-free cash and how annuity income is taxed

Before buying an annuity, you may be able to take up to 25% of your pension as tax-free cash, depending on your circumstances. Taking this money reduces the amount left to buy an annuity, so it may lower your regular income.

Annuity income is usually taxable. It is normally added to your other income for the tax year, such as State Pension, earnings or other pension income. This means the tax you pay will depend on your overall income and tax position.

How do fixed-term annuities work?

A fixed-term annuity pays income for a set period rather than for the rest of your life. For example, it may pay income for five or ten years. At the end of the term, there may be a maturity value available for further retirement planning. This could be used to buy another annuity, move into drawdown or take another pension option.

Fixed-term annuities can offer more flexibility than lifetime annuities, but they do not provide income for life unless further arrangements are made.

Open Market Option and getting a better quote

The open market option means you can compare annuity quotes across providers rather than automatically accepting the offer from your existing pension company.

This matters because the difference between quotes can affect your income for many years. It is also important to compare like with like. A level single-life annuity will not produce the same income as an inflation-linked joint-life annuity because the features are different.

When To Seek Advice

Buying an annuity is usually a long-term decision, and once it is set up, it can be difficult or impossible to change. Advice can help you understand the options and avoid choosing based only on the highest starting income.

You may want to seek advice if:

• You are unsure how much income you need
• You are comparing annuity and drawdown
• You want income to continue to a partner
• You have health conditions that could affect your quote
• You want to understand tax-free cash choices
• You are considering a fixed-term annuity
• You have several pension pots or income sources

Professional advice can help you compare quotes, understand trade-offs and decide whether an annuity fits your wider retirement plan.

Frequently Asked Questions

This information is for guidance only and does not constitute financial advice. Pension rules, tax treatment and benefits depend on individual circumstances and may change in the future.