PSI20.3.4 - Funding and Surpluses: Insured Schemes - General - Calculation of Fund Requirement

(This archived guidance relates to HMRC discretionary practice before the 6th April 2006. For current guidance on Registered Pension Schemes see the Registered Pension Schemes Manual)

A life office uses annuity rates to estimate the capital required to provide a pension. The annuity rate determines the amount of annuity a life office is prepared to pay in return for a cash sum. It takes account of mortality expectations (see PSI20.1.20-23) and the interest (see PSI20.1.33-35) which will be earned on the balance of the cash sum remaining after payment of each annuity instalment. You will normally find annuity rates expressed as a percentage. For example, an annuity rate of £100:11 or 11% means that a capital sum of £100 will buy £11 of annuity or, in other words, that each £1 of annuity purchased will cost £9. It follows that where the commutation factor and annuity rate coincide, the commutation factor is 9:1. Because annuity rates are subject to market forces, they fluctuate over short periods, reflecting the prevailing interest rate at any given time. Commutation factors on the other hand are based on longer term interest rates over a period indicated by the appropriate mortality assumptions. It cannot therefore be assumed that the commutation factor and the annuity rate will correspond.

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