The annuity principle

The annuity principle

Life insurance and annuities are built on the same mortality tables, but they protect against opposite risks. Life insurance protects against dying too soon: it creates an estate for the people left behind. An annuity protects against living too long: it turns a sum of money into income that cannot be outlived. That reversal is the core of the annuity principle, and it is why an annuity is often described as the mirror image of life insurance.

What an annuity is

An annuity is a contract between a purchaser and an insurance company. The purchaser pays a lump sum or a series of payments, and in return the insurer makes regular disbursements, starting either immediately (within 12 months) or at some future date. The goal of most annuities is a steady stream of income for a specified period or for the rest of one or more lives.

Three roles appear in every annuity:

• Owner (contract holder): buys the contract, pays the premium and controls it.
• Annuitant: the person whose life the income payments depend on. The owner and annuitant are often the same person.
• Beneficiary: receives any amount still payable if the annuitant dies, under a death benefit, period certain or refund feature.

How pooling makes lifetime income possible

No individual knows how long they will live, so an individual saving alone must either spend cautiously and die with money left over, or spend freely and risk running out. An insurer solves this by pooling many annuitants of similar age. Using a mortality table, it can predict how many of the group will be alive each year, even though it cannot predict which ones.

The money of annuitants who die early stays in the pool and helps fund payments to those who live longer than average. These are called survivorship benefits (or mortality credits). So each lifetime payment is made up of three parts:

1. a return of the annuitant's own principal,
2. interest earned on the unpaid balance, and
3. survivorship benefits from members of the pool who have died.

That third part is something no savings account or bond can supply, and it is why a straight life annuity can pay more each month than the owner could safely withdraw on their own.

Scientific liquidation of an estate

Life insurance creates an estate. An annuity liquidates one systematically: it spends down principal and interest on a schedule calculated so that the money lasts exactly as long as the annuitant does. Most annuities run in two phases:

• Accumulation phase: premiums are paid in and earn interest or investment returns, tax-deferred.
• Annuity (payout or liquidation) phase: the owner annuitizes, converting the accumulated value into a stream of income payments.

An immediate annuity skips the accumulation phase and begins paying within 12 months. A deferred annuity postpones payments for at least 12 months.

The trade-off in a straight life annuity

Because payments under a straight life annuity stop at the annuitant's death, it pays the highest income for a given premium. The price is risk: if the annuitant dies soon after buying, only a small part of the premium may ever come back. Adding a period certain or refund feature guarantees a minimum return to a beneficiary, but lowers each payment.

How the insurer prices it

Lifetime income is driven by the annuitant's age, gender, the insurer's mortality table and the premium paid, and sometimes health and marital status. Underwriting runs in the opposite direction from life insurance: an annuitant with a shorter life expectancy may qualify for higher payments, because the insurer expects to pay for fewer years. Women, who live longer on average, generally receive lower lifetime payments than men of the same age for the same premium where sex-distinct rates are used.

Remember: life insurance guards against the financial risk of premature death; an annuity guards against the financial risk of longevity, outliving your money.