Immediate vs. Deferred Annuities
The first basic distinction among annuities contracts is between immediate vs. deferred.
As we have seen in the preceding blog posts, all annuities are designed to be irrevocably converted into income at some point, by definition. We might even say that deferred annuities—those that appear designed to grow like bank or investment accounts and offer some access to our principal—are simply waiting to grow up into immediate annuities, at which point our claim on principal goes poof, and we have only a stream of periodic checks where once was a mighty pool of liquidity.
Once again, by contract and by design, a deferred annuity is an immediate annuity waiting to happen.
In a moment, we are going to pretend that there really is a distinction, but you MUST forever bear in mind that annuities are designed to ultimately convert liquid principal into income according to some contractual scheme. This is a fundamental characteristic of what annuities are. We’ll get into a bit more detail later, and for now will focus on the very basics. Ok, here we go.
Immediate Annuities
Immediate annuities are annuities in their purest form. With them, the buyer irrevocably, which means you can never change your mind and undo the contract, converts principal into income paid monthly, quarterly, or annually (which are the most common intervals) or every blue moon, for a specified term.
Payout periods
The term can be for a period of years, and a good way to think of these annuities is like mortgages in reverse: instead of borrowing a sum and paying it back, with interest, over so much time, you give (actually lend) a sum of money in exchange for payments with interest until the contract has been repaid. The payback term can be very straightforward, like for twenty years, and at the end the entire sum has been returned at the contracted rate of interest.
This simple type of annuity is called for a period certain, and the insurance company makes money by paying you a rate of interest lower than it expects to be able to earn on the money it invests. This is very similar to how a bank makes its money, on the spread between what it earns, and the lower amount it pays depositors.
Beware annuitization with interest rates at historically low levels
Buyers, take note: in the ultra-low interest rate environment of the early 21st Century world, in many cases, annuity payments may be calculated such that you barely get principal back with little or no interest, and it is possible that you get back less than you put in. There are many, many moving parts, and this is an oversimplification, but it is entirely possible to contract to receive lifetime payments that add up to less than you put in (sort of a negative interest effect).
But annuities, being life insurance contracts, are subject to the dark art of actuarial science, the cold equations of money and death, and most annuities are based on payouts figured on the life expectancy of the annuitant.
With enough lives in the pot, an actuary can pretty precisely calculate the average payout period—based on the average life expectancy of annuitants—and price annuity interest payout rates such that the insurance company is very likely to make money.
Pure life annuities
A pure life annuity pays for only so long as the annuitant shall live. Annuity payments continue only so long as the annuitant is alive. If we assume an average life expectancy of twenty years for a given age class, the insurance company really makes out on those that die sooner, and gets hurt on those that outlive the life expectancy.
This latter point—the ability to contract for income lasting longer than life expectancy if you live a long time—is a key benefit of annuities that nothing else (except a pension, which is really an annuity) will do. There will be more on these so-called longevity credits later.
Of course, as in Vegas, the insurance companies don’t ever expect to actually get hurt. So long as they have enough players, the laws of averages come into play, and the house will always win, since it is the one who gets to set the odds, provided it is smart enough to set them right.
Running the numbers on annuity payments
Let’s look at an example from the good old days when the word “interest” actually meant something. Say we assume an average life expectancy of 20 years, and a $100,000 annuity premium to be annuitized into income. Also say that prevailing investable interest rates—like on high-grade corporate bonds, mortgages, and long-term government bonds—average 8%, and the insurance company can invest annuity premiums at that rate.
Investing $100K at 8% for twenty years will pay $836/month for twenty years, after which (just like a mortgage in reverse) the principal will have been repaid with interest, and the payments will cease. If the insurance company sets its annuity payout rate at 5%, the annuity will actually pay $660 a month, leaving a spread profit for the insurance company of something like $176/mo. This will translate into a profit of $104,000 for the insurance company at the end of the 20 years, before expenses. This is the same thing as saying that $176 invested each month—the “extra” earnings on the annuity premium that the insurance company keeps—will grow to be about $104K after 20 years at 8%.
The blissfully ignorant annuity payout recipient will get $660 a month. If he (men have shorter life expectancies) dies sooner than 20 years, the insurance company pockets the unpaid balance. If she outlives the 20 years, the company will have to keep paying out of its profits until she dies.
To put things in modern context, the payment would be $417 a month over 20 years with a zero interest rate.
Will you live long enough to get your money back?
But those that say, “The annuity owner bets they will outlive their life expectancy, and the insurance company bets they will die sooner,” really miss the point. Insurance companies endeavor to predict with cold accuracy how long the average annuitant will live and build in a healthy margin to make sure they make money. And the trick is really in the interest rate used to figure the annuity payments: the lower it is, the lower the payment, and the more profitable the product for the company. Back in the 1990s as a life agent selling these kinds of products, I was constantly amazed at the difference in offered payouts for the same person for the same premium. Given (we presume) the same assumed life expectancy, and the same premium dollars offered, the monthly payout quotes varied widely. The only difference was in the interest rate used to figure the payout . . . and the profit for the insurance company.
Joint and survivor annuities
Once you get a feel for this sort of black art, all kinds of payout periods come to mind. Joint and survivor means we will pay until the last of two people die, and, of course, given their sexes and ages, we can figure a joint life expectancy on which to base the payout period. Joint and one-half survivor? No problem! We’ll figure out a full payout for his life expectancy, then mix in a payment cut in half for the balance of her life expectancy after he dies.
Refund annuities
Refund annuity—where they’ll pay out the “unpaid” balance of the unpaid initial premium in case he dies before getting all of his initial outlay back at his death)? Piece of cake. Since the insurance company can easily compute the average payout term in any such scenario, making money is easy, since it can always figure a payout level less than what it will make on the money paid in via immediate annuity premium, provided it gets average life expectancy right.
Annuity payout math gets complicated
Of course, it goes without saying that the layperson is helpless at trying to duplicate the math and evaluating just what a “fair” payout level might be. Too many folks think that “getting the money back”—breaking even—after so many years is a fair proposition. Remember that getting $5K a year for 20 years is breaking even, but that at even 6% the really fair annual payment is over $8,700, a 74% difference.
And that most of us can (and should) shoot for far more than 6% over a 20-year income period (even with the low interest rates of the early 21st century). 8% bumps the annual payment to $10,200, more than twice break even. 10% brings it to almost $12K annually.
But for those with the right training and the right computers, making money by pricing annuities for insurance companies is as easy as setting up the slot machines in a casino.
This payment amount, by the way, can be based on the interest rate prevailing at the time of annuitization (best to shop, these rates vary from company to company even on the same day), in which case we have a fixed immediate annuity whose regular payment amount does not change from the initial schedule.
While the schedule can incorporate future changes triggered by events like inflation or the death of an annuitant, the payment itself is determined by the interest rate at annuitization. Variable immediate annuities, on the other hand, have payments whose amounts vary based on the performance of securities markets, like stock indices. These can be complicated beyond the belief of the layperson, and turn out to be real shockers for those on fixed incomes when the markets drop.