Copyright © 2008 by "Ian McKeever & Co" · All Rights reserved · E-Mail: ianmckeever@actuaries.eu.com
Valuing Your Future
Ian McKeever & Co Consulting Actuaries
Market Views
Markets
Markets
Why should the government have to rescue banks?
The banking Crisis
The banking Crisis
Economic Views
The Economic Outlook
The Economic Outlook
Professional
Services
Services
Issued by Ian McKeever & Co. Authorised and regulated by the Financial Services Authority in the conduct of investment business
What Government Borrowing means for you
What it means
What it means
Retirement And Immediately Pre Retirement 2
How Annuities Work
As a young man with a small family and a mortgage to support you probably took out life assurance to make sure that your family were provided for if you met with a fatal accident. Term Life assurance works quite simply. Premiums are collected, most of the money goes to pay claims, some of it goes to pay expenses and hopefully a small amount goes to provide the insurance company with a profit. Light mortality over the portfolio of term insurance business increases the insurer's profit and heavy mortality reduces it. Virtually all the benefits and profits come from those policy holders who take out insurance and survive to the end of their policy having effectively lost their premiums but grateful to have survived.
In retirement the risk is not of dying early but of living too long, so that your money runs out before you die. Annuities are essentially are a form of longevity insurance. Annuities work in the opposite way to life assurance. The insurer takes in a pot of money and from that pot annuities are paid. Each year some of the insurer's annuitants die and the money in the pot is used to continue paying annuities to the survivors. In effect the annuitants who die early subsidise the benefits of those who survive. It is the opposite of life assurance where the survivors subsidise those who die early. When annuity rates are calculated, it is assumed that annuitants will die and therefore that subsidy is allowed for in annuity rates.
Most of the money goes to pay annuities, some goes to pay expenses and a small part of the pot provides the insurer with a profit. This is like life assurance really except that lighter mortality reduces that profit and heavier mortality increases it.
The model insurers use is fairly complicated and the mortality assumptions are to an extent a commercial secret. It would however be reasonable to assume that an insurer will be working on the assumption that a pot that is today shared by 1000 65 year old males will be shared by say 995 66 year old males in a years time. The cross subsidy from mortality will be just over half of one percent. However they might expect a pot shared by 1000 75-year-old males to be shared among 982 76-year-old males in a year’s time. The subsidy to the survivors from deaths has therefore risen to about one and three-quarter percent. Where there are widow's pensions as well, the effect of the subsidy is reduced but the general point is that at age 65 the subsidy survivors get from early deaths is quite small but at age 75 it is significant. In either case the pot after one year is; the pot now plus a year's interest less annuities paid out.
Annuities and Interest Rates.
Allowing for expected mortality the actuaries at the insurance company can predict how much the company will be paying out each year for the next 40 years or so and the insurers investment managers can then buy a portfolio of Gilts which can provide an income stream almost exactly matching the outflow of annuity payments. That way whatever happens on investment markets the insurer is protected.
That may all seem esoteric but it does mean that when you do retire the cost of annuities will be closely linked to gilt yields.
The cost of paying the annuities will not match the projections exactly because of random fluctuations but this effect averages out over time. However, mortality has been steadily improving for years and if mortality improves faster than expected the insurer loses money. That increasing life expectancy also means that annuities tend to get more expensive as time goes on but it is worth remembering that it is interest rates that are the key factor in determining the level of annuity rates at any particular time.
Index Linked Annuities
Index linked annuities work in much the same way except that the insurer's liabilities are matched with a portfolio of Index-Linked Gilts.
If you take out an Index-Linked annuity the pension paid out is smaller than it would be for a level pension, at least in the early years. The subsidy from early deaths for index linked pensioners is therefore greater than for pensioners with level annuities because at the end of the year their pot is larger. Clearly if you are in good health you expect to be receiving the subsidy and if you are in poor health the risk is that you will be providing the subsidy.The index linked versus level annuity question is therefore also a health question.
How it affects you
Most of the younger generation is healthy with a few exceptions but for the older generation’s health is much more variable. There are old and sickly people of 70 and there young healthy people of 85.
The thrust of the pensions legislation is still to make people take out longevity insurance in the form of an annuity but if your are in poor health you will have little desire to be one of those annuitants who subsidises the long lived. On the other hand if you are very healthy you might as well take advantage of that subsidy.
Your general state of health is of crucial importance in your financial planning. It is a matter of playing the odds. Either way you are making some kind of bet on how long you are going to live. In practice people only die once, unhealthy people can live until they are a hundred and apparently healthy people can have a heart attack tomorrow.
Depending on your health the options are as follows:-
Terminally Ill
Someone who is expected to live less than 12 months as certified by a doctor can under Inland Revenue Rules commute their whole pension for a lump sum or take the fund from a pension policy. The payment should be tax-free but detailed medical evidence is likely to be required. It should also be noted that the money is likely to increase the size of your estate for Inheritance Tax purposes. On the other hand deferring your retirement may also incur an Inheritance Tax charge.
As a young man with a small family and a mortgage to support you probably took out life assurance to make sure that your family were provided for if you met with a fatal accident. Term Life assurance works quite simply. Premiums are collected, most of the money goes to pay claims, some of it goes to pay expenses and hopefully a small amount goes to provide the insurance company with a profit. Light mortality over the portfolio of term insurance business increases the insurer's profit and heavy mortality reduces it. Virtually all the benefits and profits come from those policy holders who take out insurance and survive to the end of their policy having effectively lost their premiums but grateful to have survived.
In retirement the risk is not of dying early but of living too long, so that your money runs out before you die. Annuities are essentially are a form of longevity insurance. Annuities work in the opposite way to life assurance. The insurer takes in a pot of money and from that pot annuities are paid. Each year some of the insurer's annuitants die and the money in the pot is used to continue paying annuities to the survivors. In effect the annuitants who die early subsidise the benefits of those who survive. It is the opposite of life assurance where the survivors subsidise those who die early. When annuity rates are calculated, it is assumed that annuitants will die and therefore that subsidy is allowed for in annuity rates.
Most of the money goes to pay annuities, some goes to pay expenses and a small part of the pot provides the insurer with a profit. This is like life assurance really except that lighter mortality reduces that profit and heavier mortality increases it.
The model insurers use is fairly complicated and the mortality assumptions are to an extent a commercial secret. It would however be reasonable to assume that an insurer will be working on the assumption that a pot that is today shared by 1000 65 year old males will be shared by say 995 66 year old males in a years time. The cross subsidy from mortality will be just over half of one percent. However they might expect a pot shared by 1000 75-year-old males to be shared among 982 76-year-old males in a year’s time. The subsidy to the survivors from deaths has therefore risen to about one and three-quarter percent. Where there are widow's pensions as well, the effect of the subsidy is reduced but the general point is that at age 65 the subsidy survivors get from early deaths is quite small but at age 75 it is significant. In either case the pot after one year is; the pot now plus a year's interest less annuities paid out.
Annuities and Interest Rates.
Allowing for expected mortality the actuaries at the insurance company can predict how much the company will be paying out each year for the next 40 years or so and the insurers investment managers can then buy a portfolio of Gilts which can provide an income stream almost exactly matching the outflow of annuity payments. That way whatever happens on investment markets the insurer is protected.
That may all seem esoteric but it does mean that when you do retire the cost of annuities will be closely linked to gilt yields.
The cost of paying the annuities will not match the projections exactly because of random fluctuations but this effect averages out over time. However, mortality has been steadily improving for years and if mortality improves faster than expected the insurer loses money. That increasing life expectancy also means that annuities tend to get more expensive as time goes on but it is worth remembering that it is interest rates that are the key factor in determining the level of annuity rates at any particular time.
Index Linked Annuities
Index linked annuities work in much the same way except that the insurer's liabilities are matched with a portfolio of Index-Linked Gilts.
If you take out an Index-Linked annuity the pension paid out is smaller than it would be for a level pension, at least in the early years. The subsidy from early deaths for index linked pensioners is therefore greater than for pensioners with level annuities because at the end of the year their pot is larger. Clearly if you are in good health you expect to be receiving the subsidy and if you are in poor health the risk is that you will be providing the subsidy.The index linked versus level annuity question is therefore also a health question.
How it affects you
Most of the younger generation is healthy with a few exceptions but for the older generation’s health is much more variable. There are old and sickly people of 70 and there young healthy people of 85.
The thrust of the pensions legislation is still to make people take out longevity insurance in the form of an annuity but if your are in poor health you will have little desire to be one of those annuitants who subsidises the long lived. On the other hand if you are very healthy you might as well take advantage of that subsidy.
Your general state of health is of crucial importance in your financial planning. It is a matter of playing the odds. Either way you are making some kind of bet on how long you are going to live. In practice people only die once, unhealthy people can live until they are a hundred and apparently healthy people can have a heart attack tomorrow.
Depending on your health the options are as follows:-
Terminally Ill
Someone who is expected to live less than 12 months as certified by a doctor can under Inland Revenue Rules commute their whole pension for a lump sum or take the fund from a pension policy. The payment should be tax-free but detailed medical evidence is likely to be required. It should also be noted that the money is likely to increase the size of your estate for Inheritance Tax purposes. On the other hand deferring your retirement may also incur an Inheritance Tax charge.
 |
 |
 |
 |