It's a minefield trying to understand an Annuity and whether it's right for you, so I will keep it as simple as possible, if that's possible.  Let's focus on a simple view: someone planning for retirement and looking for an income for the rest of their life.

What is an annuity in retirement terms?

An annuity is something you buy.  You have worked for a company for the last 20 years, paying into a pension each month, your employer contributes, you contribute, and at the end of it, you have a pot of cash with £300,000 in it.  You are now ready to retire, and that pot of cash needs to fund your retirement.

If you want certainty in retirement, of having an income for the rest of your life, then you likely want to buy a lifetime annuity.

That being the case, you hand over your £300,000 pot of cash to an annuity provider and in return buy an annuity which will do exactly that, provide an income for life.  No matter how long you survive, an income will come in every single month.

How safe is an annuity?

An important question: if you buy an annuity when you're 65 and live to 100, how safe is an annuity?  You want to be sure that for those 35 years, there is no risk that the annuity provider fails and your income stops.

The good news in the UK is that annuity is fully covered by the Financial Services Compensation Scheme (FSCS).  If the annuity provider goes out of business, the income you receive will continue via the FSCS.

Whilst there are different types, a lifetime annuity cannot go down.

It's very important to decide carefully, though.  Once a lifetime annuity is purchased, it cannot be cancelled, it's locked in, so you need to be sure it's the right thing for you.

An example of a lifetime annuity

As noted above, there are different types of annuities. Here we are looking at a lifetime annuity that also provides inflation protection.  Whilst it's good to have the certainty of an income, it would be nice to also know that each year it will increase in line with inflation.

Let's lock in some assumptions.

1. Your age is 65
2. You're in good health
3. Your pot of available cash is £300,000
4. Want a lifetime annuity with inflation protection

Please remember, a bloke with a blog is not the right place for advice or accurate figures, treat this as an example, not reality

At current rates that I have seen recently, a lifetime, inflation-protected annuity based on the 4 items above is returning on average around 3.8%.

Based on 3.8% and your £300,000 cash pot, the annuity will start at £11,400 for the 1st year or £950 per month.  But you have inflation-protection, so that will increase year after year.  For example (assuming 3% inflation):

Now, you may be thinking, crikey, is that all?  Yes, but remember, this is for life.  The annuity provider may have to pay out until you're 100, maybe more, however unlikely that may seem.  

Or to look at it another way.  After 20 years, the annuity company will have paid out £330,000, £30,000 more than you gave them.  Of course, they invested that money, but it all assumes they made money.  You would hope they will in that business, but they still need to make money too.  After 25 years, they will have paid out £460,000, and if you survive 30 years, the total paid out will be £615,000.

However, there is a risk here.  If you only survive for 10 years, all they will have paid out is £132,000.  You don't get anything back of your £300,000, not that you will need it, but nothing is left to a partner or as a potential inheritance for your kids. 

If you're close to state pension age, though, the £11,400 and the state pension of £11,973 give you £23,373 each year, maybe combined, they would be enough?

This is why you need to be careful with an annuity, but there are different options, which I will come to next.

The Annuity company is betting on your life

Sounds dramatic, but it's true.  A life insurer is betting on the chances of you dying, an annuity company is betting on how long you will live.  The issue with an Annuity is that the healthier you have lived your life, the less you will get.

Annuity companies look at many factors when determining how much they will pay out.  If you're 65, smoked all your days and had a heart bypass, they will likely give you more than the £11,400 I mentioned above simply because they will be betting you won't reach too far into old age.

The rate they offer is very much based on how long they think they will need to pay you.  You're entering a lifespan gamble!

Other options

The example I provided is a fairly standard one, a lifetime annuity with inflation-protection.  But you can get other options built in.

1. You could get a lifetime annuity without inflation protection
2. You can opt for a spouse/partner to receive a % of the income after death
3. If you have poor health, there is an enhanced annuity option
4. You could get an annuity for a fixed period
5. You could get an annuity that pays for a guaranteed minimum period, even if you die earlier

All of these options can come with a cost, though.  If you don't take inflation protection, you will start with more income, but inflation will erode its value over time, and the amount you receive will be worth less after each year.  

If you want a spouse/partner to continue receiving a % of the annuity income after your death, then it means the amount you get while alive will be less.

An enhanced annuity, sometimes known as an impaired life annuity, takes your health into account.  If you have certain health conditions or risks that may shorten your life expectancy, then you will get a higher starting income.  People with Diabetes, a history of cancer, smokers, and so on would qualify.  Again, betting on your life expectancy, but in this case, not being too long.

Summary

It's a minefield, like I said earlier.  This is why you need the right advice to understand whether it's the right option for you when the time comes.  But hopefully, that gives you a starting point to at least understand the annuity.  And honestly, what I have covered are not the only options, but due to the array of options, you need proper advice to ensure you know what is best for you.