Calculating Your Annuity

When you come to buy an annuity, the amount you receive will depend on the value of your pension fund, the number of years you are expected to live and the economic conditions of the time. An insurance company will consider the potential financial repercussions to their business of paying you the agreed annuity for the duration of your retirement. For example, if you have a pension fund of fifty thousand pounds, you will not be offered an annuity of ten thousand pounds; if you live longer than five years after retirement, the insurance company will be making a loss. You may be offered a high annuity if you are in very poor health, and are expected to live for a short period of time. If you have a life expectancy of two years and a pension fund of fifty thousand pounds, you may well be offered an annuity of ten or even fifteen thousand pounds a year; the insurance company considers the likelihood of you living more than three years an improbable one, and thus offers you a high annuity, confident that you will not live long enough to cause them a loss in profits.

In general however, someone retiring at sixty-five in good health can be expected to live twenty years or longer; the insurance company must bear in mind the likelihood of having to pay the agreed annuity for an extended period of time. Calculating the expected length of your retirement in relation to the size of your pension fund will give you some idea of what to anticipate when you come to purchase an annuity. For example, a sixty year old woman in good health, retiring with a pension fund of sixty thousand pounds would be expected to live at least twenty years, barring accident or illness. An insurer would be unlikely to offer this woman a high annuity, for example eight thousand pounds a year, knowing that in all likelihood they may be required to pay this annuity for at least twenty years: 20 x £8,000 = £160,000. For a pension fund worth sixty thousand pounds, they face payments worth one hundred and sixty thousand pounds. They are much more likely to offer an annuity of three thousand pounds and risk payments of sixty thousand if the woman lives twenty years. If the woman dies at seventy, they have made annuity payments worth only thirty thousand pounds.

However, annuities are calculated according to the size of your pension fund, your life expectancy and the economic conditions at the time you purchase your annual pension. If you have a pension fund of sixty thousand pounds, inflation is low and investment returns are high, your insurance company may well offer you a reasonably valuable annuity. Essentially, if the insurance company is confident that your pension fund will not devalue rapidly, such as in times of high inflation, your money will be worth more to the company for longer. Similarly, if investment returns are high and the economic market is healthy, the insurance company may be confident that they can invest your pension fund and earn significant investment returns which would offset the cost of paying you a better annuity rate. Your annuity rate will also be affected by your health; if you have poor health, for example, you are unfit and have previously suffered a heart attack, you may be offered a higher annuity than a healthy person because you are expected to die sooner than they are. Similarly, smokers have a shorter life expectancy and may be offered a higher annuity.

When you come to purchase an annuity, you may be quoted an 'annuity rate'; this takes the different factors affecting the cost of annuities into consideration and informs you how much income you can expect from your investment. For example, you may be quoted a rate of seven hundred pounds income for every ten thousand pounds invested. This means that your pension fund of five thousand pounds would entitle you to an annual pension of three hundred and fifty pounds, whilst a pension fund of sixty thousand pounds would entitle you to an annuity worth four thousand two hundred pounds. It is important to do your research and request annuity quotations from a range of insurance companies. If one insurance company offers an annuity rate of five hundred pounds for each ten thousand pound investment, and another company offers eight hundred pounds for the same invested amount, you might be able to increase your annual retirement income by three hundred pounds without having investing any more money.

For more details see Deferring your annuity purchase and Types of annuity.