Jargon Buster: What on earth is an annuity?

If you’re not sure what the Queen Mother has to do with annuities, then please read on. It will all become crystal clear!

An annuity is a means whereby a capital sum is turned into income for your lifetime. You will often have heard the term in relation to pensions.

What happens is that the capital sum in your pension pot is handed over to an insurance company and in return they guarantee to pay you an income for life.

The insurance company will estimate your life expectancy and use this to determine what level of income to pay you. In an ideal world at the date you die your capital sum will have been depleted exactly to nil.

However, since we don’t live in an ideal world the 2 options that are likely to happen:

• You die earlier than expected and therefore there is still some money left in your pot
• or
• You die later than expected and your pot has been used up before you die.

So what happens in these 2 scenarios?

If you die earlier than expected, you haven’t had your money’s worth from your annuity, since the insurance company had expected to pay it over a longer period.

If it had been known in advance you would die earlier than anticipated the provider would infact have paid you a higher sum each month, to take this into account.

However, although you didn’t get your money’s worth there is no refund of the balance of funds into your estate.

This is because this surplus is used to fund those who live longer than anticipated.

If you live longer than expected your pot of money will run out before you do! However, an annuity is a promise to pay you an income for life. Therefore the insurance company continues to pay. This shortfall is financed by those who die earlier than anticipated.

If the insurance company estimates that you will live to 86 but infact you live for another 10 years the insurance company will continue to pay you the promised level of income for the next 10 years.  They don’t stop paying just because you’ve passed the age they had expecting to keep paying you for.

With an annuity those who die earlier than anticipated fund the shortfall on those who manage to cling on for longer than anticipated.

If you can, cling on for as long as possible. It’s always nice to get a bargain!

Be like the Queen Mother. She lived to age 101. I’ve no idea if she had an annuity, but if she did she certainly got her money’s worth. Imagine she’d chuckle about that!

If you need any advbice on your annuity please do email me at Mary@mary-waring.co.uk. I’d be delighted to help.

Photo credit: Flickr/rivieragalleryartist