How annuity rates are calculated

The components of an annuity calculation are;

• Annuity Term (estimated life expectancy, influenced 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 2%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

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 your life expectancy. It is very difficult to work out how long an individual person will live but do to averages it is much easier to determine how long a group of people will live. If that group is very large (millions of people) it is surprisingly accurate to work out how long the average person will live. This information is very important to an annuity provider in determining how much an annuity should pay since their annuity pool will be made up of lots of people whose life expectancy overall will develop an average.

Annuity Rate Formula

We now have the basic components to calculate an annuity rate, The formula using an excel spreadsheet is pmt(rate,nper,pv,fv,type). For variables: 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 male investing £10,000 (pv) who has reached age 65 and is expected to live 19 years (nper).

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 experience and expectations of charges, 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 been diminishing 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 rates will increase, so this should provide a boost to annuity rates. Unfortunately, interest rates are not the only factor to consider. Life expectancy is increasing and this has a huge impact on annuity rates.

Furthermore, on an individual basis, 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.

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. Annuities 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.