Basics of Purchasing an Annuity

For many people approaching retirement their retirement funding will require the purchase of an annuity. An annuity is an agreement by an insurance company, or finance house to provide regular monthly payments for a term, which usually extends to death in exchange for a lump sum investment. This purchase is important. A crash course in annuities is justified so that an informed decision can be made.

For a novice it is helpful to look at an annuity is the opposite of an investment product. A regular saving investment scheme requires regular savings to build up a lump sum. An annuity starts with a lump sum and arranges for regular sums to be paid out until a future date

Many life insurance and pension products are sold with a stipulation that they convert into an annuity at a specified date. Typically, a life insurance policy is designed to pay the life benefit at the soonest occurrence of the policyholder death or 60th birthday. On the 60th birthday, provided the policyholder is still alive, the life benefit transfers into an annuity. Many but not a1l schemes now give subscribers the opportunity to select the annuity provider. This is a good thing. Circumstances can change a great deal over the 25 year duration of life policy and it can pay to shop around for the annuity.

When purchasing an annuity it is useful to glance over the performance 1eague tables that can be found in leading money magazines. These tables list how much the annuity providers are prepared to pay back to the purchaser each month in return for a £100,000, or $100,000 lump sum. The figures vary depending upon the assumptions made by the actuaries within the annuity providing firms and the type of annuity that is purchased.

The actuary makes two major assumptions. The first concerns the interest rate.  The second concerns the life expectancy. These are the major determinants in the price of the annuity.

First consider the interest rate. The providing company will usually fund the annuity through an investment in Government bonds. This is prudent because Government bonds (the current crisis in Greece aside) are traditionally seen as having little likelihood of default. The yield on Government bonds is of crucial importance when pricing an annuity.

When the actuary anticipates a high yield high interest rate regime in the future the professional will factor in a higher monthly annuity payment. When the actuary anticipates lower future yields the planned monthly payments are reduced.

Actuaries currently predict that bond yields will fall. This means that annuities are becoming more expensive. On the surface this implies that it is best to purchase an annuity as soon as possible. In practice the decision is complicated because, depending on stock market conditions, an investment can in sometimes increase in value to more than compensate for the more expensive annuity taken up at a later date

During 2009 there was a surge in annuity purchases. Many people decided to lock into an annuity rather than risk a fall in share prices and a decline in annuity rates.

Next consider life expectancy. Although most annuities are arranged to pay regular payments until death the actuary calculates the annuity on the assumption that the annuitant will complete his life expectancy and no more. Statistically this means that over the whole portfolio the annuities are priced in a way that the company can afford. If the annuitant lives longer than his expected life expectancy the annuity provider is out of pocket. If the annuitant dies prematurely the company is in profit.

Pricing basis upon average life expectancy has several implications. Life expectancies are rising faster than revisions to actuarial tables. This alone means that annuities will  become more expensive. Under this pricing those that die early subsidise the elderly. Rather than accept this discrimination a person with a medical history which routinely offer better rates for smokers.

Once committed, the annuity provider is contractually obliged to continue the payments for the duration, which in the context of this article means the death of the annuitant.

To counter the very slight possibility that the income stream could dry up in the event of the insolvency of the annuity provider a prudent purchaser should make some enquiries regarding the financial strength of the provider. Although the confirmation of financial strength by a reputable ratings agency such as Standard and Poor’s should suffice it is worth remembering that the best annuity offers may carry more risk, because actuaries are being less prudent in their assumptions compared to their peers.

The annuitant should also note that a standard annuity provides a level payment until death. It does not protect against inflation. Index linked annuities are available from the market.

Although the standard annuity refers to payment in respect to a single life much more complex products are available. For example, a couple can arrange for an annuity to continue until the second of two deaths.

Currently there is no market in second hand annuities.

Having illustrated some of the issues involved in purchasing an annuity the reader should turn to an annuity broker or financial adviser to discuss specific advice, tax implications and individual quotes. This article is intended to be illustrative and not constitute investment advice. As with all financial advice, establish whether the adviser is paid a commission for sale of a particular product because this will highlight possible bias in the professional advice.