An annuity converts a lump sum into an income for life. It has a poor reputation, partly deserved and partly a result of the environment in which most people encountered it.
What is actually being bought
The purchase transfers longevity risk to an insurer.
Which means the buyer no longer faces the possibility of outliving their money, and the insurer takes that risk across a large pool where it is predictable in aggregate.
That is a genuine service and it is the only instrument that provides it.
Nothing else — no investment strategy, no withdrawal rule — removes the risk of living longer than planned. They can only reduce the probability of running out.
How the price is set
Two inputs dominate.
The yield the insurer can earn on the assets backing the promise, which tracks long-term bond yields.
And expected mortality for someone of that age and profile.
Which means annuity rates move with bond yields, and the extended low-rate period made them look terrible.
Rates improved substantially when yields rose, and the reputation formed during the low-rate era persisted well beyond it.
The mortality cross-subsidy
The feature that makes an annuity mathematically attractive and emotionally difficult.
Because the pool includes people who will die early and people who will live long, and payments cease at death, those who die early subsidise those who live.
This is called the mortality credit, and it is genuine additional return unavailable from any investment.
It is also why the arrangement feels like a bet, and framing it as a bet is what stops people using it.
The more accurate framing is insurance — the same logic as any insurance, where those who do not claim fund those who do.
The variants
A level annuity pays a fixed amount, which erodes in real terms.
An escalating annuity increases annually, either at a fixed rate or with inflation, and starts substantially lower.
A joint annuity continues to a surviving spouse at some proportion, and costs more.
A guarantee period pays for a minimum term regardless of death, which reduces the mortality credit and provides some estate protection.
Each feature has a price and the pricing is generally fair, which means the choice is about preferences rather than about finding a bargain.
Enhanced rates
The most commonly missed opportunity.
Health conditions and lifestyle factors that reduce life expectancy increase the annuity rate offered, sometimes substantially.
Which means smoking, high blood pressure, diabetes and a range of other conditions are worth disclosing.
Many people accept a default rate from their existing provider without exploring this, and the difference can be considerable.
The open market option — shopping around rather than accepting the incumbent's offer — is the single most valuable action available at this point.
The alternative
Drawdown keeps the money invested and withdraws from it.
Which retains flexibility, retains the possibility of leaving something behind, and retains the risk of exhaustion.
Sequence of returns risk is the specific danger — poor early returns combined with withdrawals do disproportionate damage, because the withdrawals crystallise losses that cannot then recover.
Which is why withdrawal rate research is more complicated than a simple percentage suggests, and why the widely quoted safe withdrawal figures come with substantial caveats about the periods and markets they were derived from.
The hybrid
Increasingly common and reasonably sensible.
Annuitising enough to cover essential expenditure, and keeping the remainder in drawdown for flexibility.
Which secures the floor while retaining upside, and it addresses the actual concern most people have, which is not maximising expected value but avoiding a bad outcome.
The proportions depend on what essential expenditure actually is and what other guaranteed income exists, which is a personal calculation.
The necessary caveat
This is a description of how these products work. It is not advice and cannot be, because the right answer depends on health, other income, dependants, tax position and preferences that no article can know.
Retirement income decisions are largely irreversible, which is exactly the situation where paying for regulated advice is most obviously worthwhile.
Deferred annuities
A variant that addresses the problem more efficiently and is underused.
Purchasing at retirement an income that begins many years later — at eighty or eighty-five — costs far less than an immediate annuity, because payments start late and some purchasers will not reach the start date.
Which secures the tail risk of extreme longevity cheaply, leaving the earlier years to be funded from drawdown with a known end point.
Knowing that income arrives at a fixed future date makes the drawdown problem finite rather than open-ended, which is a substantially easier calculation.
Availability varies by market and tax treatment differs, which is why this remains a minority approach despite the arithmetic favouring it.
Provider security
Since the promise extends decades, the insurer's ability to honour it matters.
Insurers are subject to solvency regimes requiring capital against their liabilities, and compensation schemes cover policyholders if an insurer fails, with coverage terms varying by jurisdiction.
Checking what protection applies before committing a large sum is worth the few minutes it takes.