Pension Annuity overview

What is an annuity?

An annuity is an income for life which can be bought with a lump sum of capital. An annuity is a guaranteed stream of income provided by an authorised insurance company or Friendly Society in exchange for a lump sum investment. The annuitised income is payable throughout the life of the policyholder. The annuity industry is about the pooling and transferring of risk from the annuitant to the provider. If you die early, the Life Office receives a windfall, since the annuity is extinguished- unless you have included spouse's benefits. When you buy an annuity, you purchase an income which is predictable, but for an unpredictable period of time.

The most common way to draw benefits from a pension fund is to take the maximum tax-free lump sum and use the balance of the fund to buy an annuity. Where the fund used to purchase an annuity originates from a pension scheme, a compulsory purchase annuity (CPA) must be bought. Compulsory Purchase Annuities can be paid at any age from 50 onwards regardless of whether the individual has physically retired from work.

If an annuity is bought with a lump sum from other sources (including the tax-free cash element of the pension fund) the annuity is known as a Purchased Life Annuity (PLA).

With the dramatic changes to life expectancy, and the consequent reductions to mortality tables, combined with the prognosis that long term gilt yields, upon which annuity rates depend, will remain low has meant an on-going and significant reduction in annuity rates. In 1901, males had an average life expectancy of 45 and females could expect to live to age 49, on average. In 2006, the life expectancy at birth for females was 81 years and 77 for males.

Open Market Annuity Option

If, after making yourself aware of the other options concerning generating an income in retirement, you decide that an annuity is the right choice, it is essential that you exercise an "open market option". This is your right to chose whichever annuity provider is paying the best rates. You do not have to purchase your annuity from the same company who provided your pension.

Annuity rates vary considerably from one provider to another - as the following table, taken from the Financial Services Authority web site shows.

How are Annuity Rates Calculated?

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In broad terms the price of an annuity is based on the life expectancy of the client when the annuity commences. Some people will live longer than others and receive more in payments than they have put into the fund, plus interest. Others will not even get their money back if they die earlier than expected. That part of the original purchase price which they do not receive back is then available to meet the annuity payments that are due to those who survived. This cross subsidy can mean that a longer survivor receives a comparatively high return from the original lump sum investment.

Each installment of an annuity can therefore be considered to be made up of three parts: a share of the original purchase price, an element of investment return, based on the gilt (or other investment) yield underlining the annuity rate and a share of the assumed mortality profit released by earlier deaths of other policyholders

Annuity rates do not depend solely on gilt yields- the life office will also take into account how long an annuitant is expected to survive based on an assumption as to the future mortality experience of annuitants. This assumption will not only recognise how long on average an annuitant is expected to survive, but also the fact that some annuitants will die earlier than this, and some later.

Based on this mortality assumption, the office can calculate how many individuals, out of a pool or group of similar annuitants, e.g. 60 year old males, are expected to survive for one year, how many for two years, how many for three years, and so on. A hypothetical total annuity purchase price can then be spread over this assumed pattern of life expectancies, allowing for investment return, expenses and any annuity escalation, to derive an annuity rate. This spreading must also allow for the cost of providing any benefits that are payable on the death of each annuitant.

The shorter the pattern of life expectancies, or the lower the value of the benefits that are payable on death, the higher the annuity that can be provided as the given purchase price is spread over a shorter overall period. This calculation must be repeated for all other similar groups, e.g. 61 year old males, 60 year old females, etc.

If the office then sold annuities to such a group of individuals, and all the assumptions were borne out, it would have exactly sufficient money to meet each annuity installment. On the death of an annuitant, any part of that annuitant's original purchase price (plus investment return) that had not been used to provide benefits for that individual, would be used to help meet the cost of the annuity installments due to the remaining survivors. This is known as a mortality cross subsidy: any money released on death - a mortality profit - is used to subsidise the benefits of those annuitants who survive.

Annuity Taxation

All Compulsory Purchased Annuities are taxed as earned income. Purchase Life Annuities are split into two elements. One part is tax-free and is known as the capital content. The remainder of each payment is known as the interest element and is taxable as unearned income. Neither category is subject to National Insurance contributions.

Financial Strength of Annuity Providers

Whilst it is important to be able to secure the best annuity rate and most appropriate type of annuity, it is vital that the financial standing of the life office is considered. Financial strength i.e. the ability of the life office to be able to meet its commitment to pay an annuity in the future is therefore a key consideration, not just which company offers the highest annuity rate.