For many investors - in particular those with smaller pension funds - purchasing an annuity is often the most suitable option for securing an income in retirement. An annuity guarantees an income payout for the life of the annuity holder, which means there is no danger of your pension pot running out of money - one of the risks of a drawdown arrangement.
Annuities are the best known and most widely used vehicle for unlocking an income from a pension fund. The concept is simple: you accumulate a pension pot over the course of your working life then at retirement you use this money to purchase an annuity from a life insurance company. Rather than being a direct investment, you are handing over your pension capital to the life insurance company, which will invest your money in low-risk investments such as government bonds.
In return for handing over your pension capital, the insurance company pays you regular income payments which can be monthly, quarterly, semi-annual or annual. The income can be paid in advance or in arrears depending on the arrangement with your annuity provider.
An annuity is therefore essentially an insurance policy which guarantees you an income for life. The biggest drawback of an annuity is that when you pass away, the life insurance company gets to keep all the money you used to fund your annuity purchase.
How annuity income is calculated:
The two main factors that will impact an annuity income are:
1. The size of your pension fund (at the time of purchasing the annuity).
2. The annuity rate offered by the insurance company.
The annuity rate is the factor used to convert a pension pot into a pension income. Hence, if you want to determine the income you will receive from an annuity, the calculation is relatively simple: annuity income = pension fund x annuity rate
The size of the pension fund will logically depend on how much money you have contributed over the lifetime of the pension while the annuity rate is calculated by actuaries using factors such as:
■ mortality (how long you are likely to live in retirement)
If you are older, or if your health is impaired, your annual annuity payments are likely to be higher as these factors are believed to reduce your longevity and hence the insurance company expects to not have to pay out for as long. If you live in areas such as Glasgow and Manchester, you have a lower life expectancy rates than, for example, Kensington and Chelsea, which means you’re likely to receive a higher annuity payout per year than if you live in Kensington.
The annuity provider, who is investing your pension capital, will primarily invest in low-risk gilts, which means that medium-term interest rate movements and inflation expectations will also have an impact on the annuity rates. In recent years insurers have been investing in a higher proportion of lower risk gilts. With these at all time lows, annuity rates have fallen significantly. See Annuity Rates plummet in May.