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In the rush to take advantage of the new pension freedoms it is easy to forget what a pension actually is. A pension is an income paid each month after a person has retired from work. This income continues for the rest of their (and their partner’s) life.

An annuity is the only policy that can pay an income for life because it converts a pension pot into a stream of future income.

What is an annuity

An Annuity is a financial policy that guarantees to pay a secure income for the rest of your life, no matter how long that is.

A conventional annuity pays a guaranteed income for life and it is possible to get a higher income if you smoke or have a medical condition.

Annuities = income for life


How do they work

The capital from a pension pot (annuities can also be purchased with personal money and these are called purchased life annuities) is used to purchase an annuity from an insurance company who convert the capital into a series of lifetime income payments.

The amount of income payable depends on a number of factors:

  • Age and health – the older the annuitant the higher the income payments. Those who have certain health conditions may qualify for an enhanced annuity
  • Interest rates – annuities are priced in relation to the yields on long-term fixed interest investments so when yields are low annuity rates are low and vice versa
  • The options selected – e.g. single or joint life, level or escalating, guarantee period or value protection and choice of payment frequencies.

Mortality cross subsidy

The income for life guarantee is provided by the concept of ‘mortality cross subsidy’

Actuaries calculate annuity rates assuming people will live until their normal life expectancy.

However, some policyholders will die before they are expected to and some will live longer than expected.

Insurance companies make a profit from those dying early and a loss from those living longer, but they use savings from the early deaths to subsidise the income paid to those who live longer than expected.

This is mortality cross subsidy.

Higher income for those with poor health

Standard annuity rates are calculated with reference to the average life expectancy for people living in the UK. This is fine for those in good health, but not so good for those who have below average life expectancy.

An enhanced or impaired life annuity pays a higher income because an allowance is made for any medical conditions which might reduce life expectancy

You will probably qualify for an enhanced annuity if you can answer yes to one of the following questions:

  • Do you smoke?
  • Are you taking prescription medication?
  • Have you been to hospital recently for a medical condition?

Sample enhancements

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If you want to make the most of pension freedoms you should start planning ahead and make sure your financial affairs are in good shape in the years running up to retirement.

William Burrows

William Burrows

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