How Annuities Work

Annuities are offered by insurance companies, and since Roman times they have been a simple way of buying a future series of (annual) payments.

Favorable tax treatment has triggered extended uses of annuities to serve more general saving and investment purposes, and for this reason we have a wide range of annuities available making it necessary to understand what the key differences between them are.

Fixed or variable

Fixed annuities give you a series of fixed future payments in exchange for one or more earlier payments:

Variable annuities on the other hand give a series of payments that depend on the performance of an investment portfolio:

When you purchase a variable annuity you will typically be given some choice over which types of investments your payments will be used to make. Hence a wide range of portfolio choices become available that can determine risk, liquidity and other characteristics.

Accumulation and payout periods

Both fixed and variable annuities are divided into two periods:

  1. Deferral: when you are making payments
  2. Payout: when you are receiving payments

A special case is an immediate-payment annuity which has no deferral period, but exchanges a fixed up-front lump sum for a stream of income which starts almost immediately.

Life and term-certain

The duration of the payout period can be a fixed amount of time – a term certain annuity. More often the payout period is linked to the lifespan of one or more individuals, that is the payments of income continue for as long as the individual(s) are still alive.

Such life annuities are popular because they guarantee an income stream that lasts for as long as an individual is alive and can therefore be very useful for retirement planning. They remove the risk associated with term-certain annuities that the beneficiary outlives the term of the annuity and is left with a reduced income.

In many cases the life annuity will also provide a death benefit, which is a lump sum payment to the estate of the deceased made if they die before significantly enjoying the payout period of their life annuity.

Motivations

The motivations for investing in a fixed or a variable annuity will tend to be quite different:

  • a fixed annuity can provide certainty of future cash flow to meet expected need like for retirement
  • a variable annuity can provide a way to invest in a tax efficient way into bonds, stocks, mutual funds and exchange-traded-funds where the benefits from the investing are enjoyed in the future

Pricing

The price of an annuity will tend to be higher the:

  • longer the life expectancy of the policy holder of a life annuity
  • longer the payout period of a term-certain policy
  • higher the income stream during the payout period of a fixed annuity
  • shorter the deferral period
  • lower market interest rates are
  • lower inflation expectations are

Annuities are written by insurance companies and sold either directly or through intermediaries, and through this typically competitive market the price for each individual policy is established.

Tax

Annuities receive favorable tax treatment in many countries mainly due to their categorization as an insurance product. This is the main reason for the existence of variable annuities, since if it were not for tax reasons, savers and investors could achieve the same investment profile through a fund or a private portfolio.

Payments into a variable annuity may benefit from a deferred tax treatment. This means that taxes do not become due on earnings and gains on the portfolio which payments into the annuity are used to buy  until the payout period.

There may be other ways of deferring tax available, but for investors who have ‘maxed out’ on these options variable annuities may present an interesting tax planning choice.

Risks

Annuities share many risk categories with more general investment options but also present some unique concerns:

Inflation: if an annuity is bought to provide for a future income such as for retirement, then even a fixed payout series does not guarantee a certain real income because inflation may erode the purchasing power of money in the meantime. This is a particular concern if you are considering a fixed annuity or if the payout period is expected to start far into the future.

Transferability: unlike investments in marketable instruments such as stocks, exchange traded funds or bonds, it will typically not be possible to transfer an annuity to someone else. This may limit your.

Longevity: if you buy a term-certain annuity then there is the risk that you will live longer than the term of the payout period and hence will be left with a reduced income. If you buy a life annuity then you may face the risk that if you die before the payout period begins then the value of the payouts received under the policy fall short of the amount invested in it and hence reduces the net value of the estate.

Issuer: the payments due to you under an annuity will be paid by the insurance company writing the policy, and hence you are relying on their ability to do so. This may depend on: a) what they have invested your premiums in, b) the overall credit quality of the insurer, and c) any credit support or guarantee schemes from the insurance industry as a whole or government.

Strategies

Annuities may form part of a tax planning strategy at any stage in your life by taking advantage of tax deferrals.

As you get nearer to retirement age annuities can progressively be used to remove market risk from your portfolio and to increase certainty around what your monthly income will be.

Annuities can be used to ensure a steady income stream for other people you care for, and in particular it may be possible to invest in life annuities linked to the lifespan of more than one person.

If you are buying variable annuities then you may be able to fine tune the portfolio profile of your investment and to change that over time to reflect your outlook and preferences.

Johannes Tynes, CFA, has more than a dozen years of investment experience from leading, global financial institutions dealing in both public and private markets. He is a Senior Advisor at Inpirical - an investment research and development company, and was educated at the London School of Economics and the Chicago Booth School of Business. Johannes believes that a solid grasp of financial concepts and data-driven analysis are the cornerstones of investment decision-making.

2 Responses to “How Annuities Work”

  1. Emma says:

    Excellent article about annuities, one subject that is very important but noone knows anything about. Thanks for posting this Johannes Tynes.

  2. efpierce says:

    Are annuities mainly a retirement thing or could they be used as an investment based savings account? I am not sure I completely understand even though you have explained it so well to me. :)

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