Individuals have a finite but unknown lifespan. The efficient allocation of financial resources across an unknown lifespan is a planning challenge because consumption smoothing requires the allocation of available financial resources across an expected time frame. One efficient strategy is to pool the risk of an unknown lifespan across individuals through the use of an annuity.

A basic annuity is a one-time premium payout in exchange for fixed payouts received for the life of the annuitant. The initial premium is the investment. When the annuity ends, the payouts cease.

Annuity terminology includes:

  • The insurer collects the premium and makes the future payouts. (The insurer is often an insurance company, the company.)
  • The annuitant receives the annuity payouts in the future.
  • The contract owner pays the premium to purchase the annuity and is usually the annuitant.
  • The beneficiary receives any remaining value of the contract at death of the annuitant. In many cases, there is no beneficiary as payouts cease at death of the annuitant.
  • The premium, which is normally paid once at purchase, could also be referred to as the value of the contract. The premium paid to the company is the price of the annuity. However, the convention is to keep the premium constant and adjust the stated annual payout. This means that a lower/higher quoted payout to the annuitant is equivalent to a higher/lower price for the annuity.

Annuities take many forms. A DB pension plan from a private company or government that pays for the life of the retiree is a form of annuity. Annuities can also be purchased and used to supplement or replace DB plan payouts.

In a deferred annuity, the annual receipts start at a deferred future date. Deferred variable annuities are common and allow the owner to select from a list of investment options. Higher/lower investment returns will increase/decrease the future payouts to be received. While often compared to mutual funds, the investment choices are more limited and expenses are high. The annuity can also include an insurance feature with a guarantee of some minimum payouts received back. Otherwise, the payouts would just cease at death of the recipient. The investor may also be able to cash out the value and terminate the annuity at a future date . Unless the individual pays for additional features, the variable annuity does not guarantee any minimum future payouts.

Deferred fixed annuities pay a fixed benefit for life that starts at a defined future date. The longer the delay between initial premium paid and start of payouts received, all else the same, the lower the cost of the annuity, as the company can invest and increase the funds available before making payouts on the annuity.

An advanced life deferred annuity is a relatively lower cost way to hedge the longevity risk of the annuitants outliving their other assets. Like most fixed and variable annuities, they require an immediate premium payout at purchase. Like deferred fixed annuities, the payouts are fixed, but the delay period before they start is long, often age 80 or 85 for the annuitant. The low premium reflects three factors. First, the long delay before payouts begin allows the company a longer period to invest and grow the premium’s value. Second, the period of payouts will be shorter as the life expectancy of the older annuitant will be shorter when payouts do begin. Third, a greater proportion of the annuitants will die before they receive any payouts.

Immediate variable annuities start payouts immediately, but the amount of the future payouts is indexed to the performance of some reference asset, such as a stock index. As the reference asset increases/decreases, the payouts increase/decrease. Immediate fixed annuities begin payout immediately and the payout amount does not change.

The features of the annuity and the annuitant’s status will affect the payout. Typical features include:

  • Life annuity with payouts for the life of the annuitant.
  • Period certain annuity with payouts for a specified time period.
  • Life annuity and period certain with payouts for the longer of the two periods.
    • Life annuity with refund is similar in concept but specifies a refund amount if a specified minimum payout amount has not been received before death of the annuitant.
  • Joint life annuity specifies payout continues as long as at least one of the annuitants is alive.

The volatility of future benefits is obviously different. Lower risk investors may prefer the certainty of fixed payouts, and higher risk investors may prefer the potential for increasing variable payouts.

Flexibility often differs. Fixed annuities are generally irrevocable and payouts cannot be changed. In variable annuities the future value of the annuity and payouts are linked to the performance of a reference asset. Variable annuities are more likely to allow withdrawal of the funds at subsequent market value (after surrender fees for withdrawal).

Future market expectations will affect the choice. Payouts on a fixed annuity are largely determined by initial bond market interest rates. If rates are expected to increase, delay in purchase can lead to higher payouts on annuities purchased later.

The choice is not so simple and requires a consideration of mortality credits. Some individuals will die before, and some after, their expected lifespan. Annuitants who die earlier collect fewer payouts, effectively subsidizing those who die later. That is why insurance is called risk sharing or transfer. This concept is called mortality credits. All other factors the same, mortality credits make annuities less costly to purchase at a younger age.

Mortality Credits

Market expectations also affect variable annuity versus fixed annuity payouts because variable annuities shift risk to the annuitant from the company. The payout is based on the future performance of the risky reference asset. The annuitant earns both a mortality credit and a risk premium. The net effect is the total expected value of the payouts is higher, reflecting the higher expected return on the reference asset . The variable annuity is also more likely to allow cashing out, but at a value linked to the reference asset. Fees for variable annuities tend to be higher. Variable annuities are also more complex and difficult to analyze. This difficulty tends to reduce price competition and further increase the price of variable annuities.

Inflation is also a factor. Variable annuities that link payout to an appreciating asset like the stock market are more likely to provide long-term inflation protection. Conventional fixed annuities that pay a constant nominal amount offer no inflation protection.

Taxes are a factor, but they are complex and vary by jurisdiction. Typically, increases in value of an insurance product are not taxed before payouts. At payout, tax may or may not be due on the increase in value.

The alternative to purchase of an annuity is to self-insure longevity risk. In other words, invest in financial assets and set a withdrawal amount that lasts to an assumed life expectancy. The life expectancy should be high because the alternative is running out of money. The decision is complex because the annuity payment reflects three components:

  • Return of the principal (premium).
  • Interest on the principal.
  • Mortality credits as annuitants who die sooner are subsidizing (receiving fewer payouts) the annuitants who live longer (receive more payouts).

Self-insurance can earn the first two, but not the third. This favors use of the annuity. However, use of annuities reduces aggregate wealth of the users as the insurance companies invest rather conservatively and must cover costs plus profit. The decision becomes how much risk for the retiree to take versus cost. Factors that favor use of annuities rather than self-insurance include:

  • A longer than average life expectancy.
  • A desire for lifetime income.
  • Less desire to leave an estate for the benefit of others.
  • Conservative investors (high risk aversion).
  • An absence of other guaranteed income sources such as pensions.

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