Annuity can be defined as a fixed sum of money that is paid out periodically by a financial institution. An individual funds the financial instrument for a pre-determined period called the accumulation phase and later starts to receive a steady annual stream of income. This period is called the annuitization phase.
A Little More on What is an Annuity
Annuities are created by financial institutions to provide for a steady stream of guaranteed income for the rest of the annuitant’s life no matter how long one lives.
Annuity premium payment can be in a series of payments, for example, in the case of pensions and social security, or single lump sum payment in the case of individuals awarded large sums of money, for instance, lottery winners or cash from a lawsuit settlement.
Annuities can be classified and be structured differently depending on annuitant’s choice. For instance, according to how the annuity generates returns, alternatively, they can be categorized according to the payment period guaranteed by the annuity.
Immediate and Deferred annuities
An immediate annuity involves the annuitant making a lump-sum payment to a financial institution upfront, in exchange for the right to receive a fixed stream of income from the institution regularly beginning immediately.
In contrast to an immediate annuity, deferred annuity involves the annuitant making a series of payment to a financial institution upfront over a long period, in exchange for the right to receive a fixed stream of income from the institution regularly beginning at the age specified in the annuity contract(Sunset years).
Both immediate and deferred can be structured to pay out funds upon annuitization for the rest of the annuitant and chosen beneficiary life or just a fixed period like 10 to 20 years from maturity date. With a deferred annuity, payments can be much higher compared to immediate annuity due to the long accumulation phase.
Fixed vs. Variable
Fixed annuities are structured to provide regular periodic payments to the annuitant and value increases based on stated returns within the annuity contract.
In contrast, variable annuities periodical payments are tied to the performance of the overall market or group of investments, or a combination of the two. Although a variable allows the annuitant to reap greater future returns if annuity fund investments do well, also there is the risk of smaller payments if investment performs poorly.
Fixed annuities provide a stable periodical payment as the financial institution bears all risks compared to variable annuities which are tied to investment performance; therefore, provides for less steady cash flow. Both types of annuities are tax-deferred.
Whereas variables annuities carry great investment risk, annuitants can buy riders and other features which allow them to function as hybrid fixed-variable annuities. With riders added to the annuity contract, annuitants are guaranteed of minimum amounts of withdrawal income, or death benefits or accelerated payouts; in case of a terminal illness.
One notable criticism with annuities is that annuitants have limited access to their cash when in need. Funds are usually locked up during the formative period known as the surrender period; an attempt to withdraw comes with surrender charges, penalties, and tax consequences.
Financial Institutions Selling Annuities
Investment and insurance companies, through their appointed agents and brokers, are typically the ones that sell annuity products. It is a mandatory requirement that an agent or broker selling annuity should hold a life insurance license and a security license as well if selling a variable annuity.
In comparison, a life insurance policy is sold to a policyholder to assure against mortality risk, whereas an annuity, on the other hand, is sold to an annuitant to secure and alleviate fears of longevity risk, or outliving one’s assets.
Annuities are an essential contract for insurance companies as they act as an alternative to reduce the risk for their insurance products.
The risk of life insurance to a financial institution is that the policyholder may die prematurely and death benefit paid at a net loss to the insurer without making any profit. The risk of an annuity, on the other hand, is that annuity holders will outlive their initial investment with the financial institution.
Actuarial science and claims experience enables insurance companies to price policy premium so that on an average policyholder will live long enough for the insurer to earn a profit. Annuity issuers, on the other hand, may reduce longevity risk by selling annuities to annuitants with a higher risk of premature death.
Annuity products from all financial institutions are regulated by the Financial Industry Regulatory Authority (FINRA) as well as the Securities and Exchange Commission (SEC).
Purchasers of Annuities
Annuity contracts are a preferred financial solution for individuals seeking a stable and fixed periodical stream of income, for instance during retirement or for a stipulated period.
Annuities work by annuitants trading a liquid lump sum or a series of payment to a financial institution which becomes illiquid due to penalties involved, and in exchange, the financial institution provides a stable cash flow in the future.
References for Annuities
Academic Research on Group Annuities
- Allocation of solvency cost in group annuities: Actuarial principles and cooperative game theory, Alegre, A., & Claramunt, M. M. (1995). Insurance: Mathematics and Economics, 17(1), 19-34. The paper examines the consistency of the two conventional methods used in the allocation of solvency cost; actuarial principle and co-operate game theory.
- Group annuities supplementing retirement benefits under old-age and survivors insurance, Van Eenam, W. (1948). Soc. Sec. Bull., 11, 29. The paper looks at how group annuities are the best investment vehicles for supplementing retirement benefits under old-age as well as a survivorship insurance benefit.
- An Analysis of Group Annuities, Black Jr, K. (1954). The Journal of Finance, 9(1), 51-52. The paper gives an analysis of the effectiveness of group annuities and the risk mitigation involved with such annuities.
- Securitization of mortality risks in life annuities, Lin, Y., & Cox, S. H. (2005). Journal of risk and Insurance, 72(2), 227-252.The article evaluates the security of mortality bonds and swaps based on individual annuity data.
- Comparison of frontier efficiency methods: An application to the US life insurance industry, Cummins, J. D., & Zi, H. (1998). Journal of Productivity Analysis, 10(2), 131-152. The paper looks at how econometric and mathematical programming methods influence the efficiency of returns to an insurance investment with a focus on US life insurance.
- The relations among organizational and distribution forms and capital and asset risk structures in the life insurance industry, Baranoff, E., & Sager, T. (2003). Journal of Risk and Insurance, 70(3), 375-400. The literature attempts to integrate studies the relation between capital structure and asset risk on the one hand, and between organizational form and distribution system on the other hand, into a single structural framework for decision making by life insurers.
- Entry, size distribution, scale, and scope economies in the life insurance industry, Kellner, S., & Mathewson, G. F. (1983). Journal of Business, 25-44. The paper looks at the various factors that influence the life insurance industry such as entry, distribution size and scope economies and their impact.
- Capital accumulation and annuities in an adverse selection economy, Eichenbaum, M. S., & Peled, D. (1987). Journal of Political Economy, 95(2), 334-354. The paper asserts that there is a significant advantage that is not being fully exploited in capital accumulation for higher rates of return on annuities by investing in the adverse selection economy and discusses policies in the selection.
- Agency theory and life insurer ownership structure, Pottier, S. W., & Sommer, D. W. (1997). Journal of Risk and Insurance, 529-543. The paper examines operational, financial, and institutional determinants of ownership structure using insight from agency theory in the US life-health insurance industry, and attempt to bring out the systemic differences.
- Mortality risk, inflation risk, and annuity products, Brown, J. R., Mitchell, O. S., & Poterba, J. M. (2000). (No. w7812). National Bureau of Economic Research.The paper examines the Mortality risk and inflation risk concerning annuity products and tries to make a comparison with similar research on trends in the United Kingdom and several other nations.
- A new mortality basis for annuities, Jenkins, W. A., & Lew, E. A. (1999). The paper tries to suggest new ways to look at how annuities can be structured to cater to life expectancy and the risk of longevity adequately.