How annuity rates are calculated

An annuity is a payment of income for life in return for a lump sum investment, which usually comes from a pension fund but may also come from money saved elsewhere (purchased life annuity).

In the simplest of terms we could say that if you were to invest £100,000 and live for 20 years then you would receive an income of £5,000 per annum. Obviously, it's a little more complicated than that... the annuity provider has operating costs, the pool is invested and the annuity provider has to estimate how long a person will live in order to determine how much they will pay out. 

The components of an annuity calculation are;

• Annuity Term (estimated life expectancy, determined by current age,  gender and health)
• Rate of Return (the annuity provider invests your money but they take very little risk, so the rate of return is quite low - in the region of 3%-4%pa after charges to operate the fund)
• Payment frequency and timing of payment; at the start of a period (advance) or at the end of a period (arrears)
• Amount Invested
• Escalation: Whether payments remain level or increase by a certain amount

Payment frequency, amount invested and escalation are known facts from the outset - these make up a very simple part of the calculation.

Rate of return comes from investing in Government securities called Gilts which can provide known returns over periods of 15 years or more. Such rates of return can be relied upon because they are provided by the Government - a problem might arise if the Government failed to pay its debts.

The remaining component is the annuity term - this is life expectancy. It is very difficult to work out how long an individual person will live but the average life expectancy from thousands of people is much easier to determine. If that group is very large (millions of people) it is surprisingly accurate to work out how long the average person will live. Income is then diverted from those that do not live as long as expected to those that live longer than expected.

Annuity Rate Formula

The formula using an excel spreadsheet would be pmt(rate,nper,pv,fv,type); e.g. rate=2%, nper=19, pv =10000, fv=0, type=0 - the annuity is calculated at £637.82 pa. This would be the annual annuity payable to a person investing £10,000 (pv) who has reached age 65 and is expected to live 19 years (nper).

The annuity would be payable in arrears (type) and the underlying rate of return is 2% (rate) after charges. FV or future value is zero since no money is expected to remain after the death of the last person in the pool.

To calculate a monthly payment we would divide 'rate' by 12 and multiply 'nper' by 12. The annuity rate will differ between annuity providers as they will use their own variables based on their own charges and expectation of life expectancy and investment return.

What is likely to happen to annuity rates going forward?

Historically, annuity rates have fallen significantly. This is because people are living longer and investment returns have fallen as a result of low interest rates and inflation. Interest rates are at an all time low and this has affected annuity rates in the last few years. Eventually interest rates will increase and this should provide a boost to annuity rates. Unfortunately, interest rates are not the only factor to consider. Life expectancy continues to increase and this has a huge impact on annuity rates.

Furthermore the make-up of the typical annuity pool is changing. People with lower life expectancy are being placed in one pool - their rates will increase. People with higher life expectancy will form another pool and their annuity rates will decrease. Annuity pools are commonly segmented according to health, postcode and smoking status - the pool in which you are placed will have an affect on your individual annuity rate. The outlook for annuity rates is probably a continued decline.

How long can we expect to live?

In the UK, a newborn boy could expect to live to age 77.4 and a newborn girl to age 81.6. If age 65 is reached then a male could expect to live to age 82.4 and a female to age 85. Annuity funds are therefore expected to last a little under 20 years if the average age at retirement is 65.

Life expectancy varies by country in the UK, as shown in the table below. This has led to some annuity providers including postcodes to determine their annuity rate. Higher annuity rates may be offered to people with certain illnesses that are known to reduce life expectancy - this leads to worsening annuity rates for healthy people.

Advances in medical science and improved living standards mean we are living longer than our grandparents and parents before them. This will further erode annuity rates. It has been said that people born today could live on average to age 100 - that remains to be seen but would depress annuity rates further.