Let’s start by addressing a common misunderstanding about annuities. The debate about whether or not they make sense in a low-interest rate environment has nothing to do with short-term interest rates (like the overnight rate, for example). Short-term rates don’t drive annuity prices, long-term rates do. This is because it is long-term rates that determine the return on investment annuities providers — like my employer — can earn to pay the holders of their annuities.
Even when rates are low, annuities are attractive to a lot of investors because they offer a commitment on the part of the financial institution to make regular income payments to the annuitant.
How does an annuity work?
It’s useful to think of annuities as a bet on the part of the financial institution. The bet is that among all of the consumers who buy annuities from them, the premiums the company receives plus the interest it can earn investing those funds will more than make up for the cost of providing each of their customers the promised income payments.
This is one of the things actuaries do. Annuity prices are based on life expectancy rates (i.e., how long the clients will require payment) and long-term interest rates (i.e., how much the financial institution can earn investing those funds). By selling annuities to a large population, the financial institution pools its risk, and a business is created.
That business offers consumers more than a few options.
There are term certain annuities, which pay the annuitant a regular income for a period of time. That period can stretch 10 or 20 years, or it can run until the client reaches a certain age. If the annuitant dies before this term ends, the leftover income payments are made to his or her beneficiary.
There are also life annuities, which provide income that is guaranteed to continue for the annuitant’s lifetime. Here are 4 common types:
- Life annuity without a guaranteed period. The financial institution commits to regular payments to the client until he or she dies. Payments stop at that time, regardless of when that happens. This annuity calculator will give you an estimate of your guaranteed retirement income with an annuity.
- Life annuity with a guaranteed period. In addition to regular payments during the client’s life, the institution commits to a guaranteed period. If the client dies before that period is over, the remaining income payments are made to the client’s beneficiary or the beneficiary could choose a lump sum (commuted value of the remaining income payments) instead.
- Life annuity with indexing. Income payments rise over time at a fixed rate, compounded each year. These increases are calculated for as long as the annuitant lives. Guaranteed periods are available for these annuities, too.
- Joint life annuity. This covers the income needs of 2 annuitants. After 1 annuitant dies, payments continue to the remaining annuitant until he or she dies. There are various options: 1) with no guaranteed period; 2) with a guaranteed period; 3) with income reducing (which reduces the income payments after 1 annuitant dies); and 4) with indexing (which increases income payments each year as long as 1 annuitant is alive).
There are other types. Ask your advisor about impaired, integrated, temporary life and variable annuities (also known as segregated funds or guaranteed investment funds). It’s also worth asking about a deferred annuity, which allows you to purchase the annuity in advance of your retirement date. During deferral, your funds could earn interest, thus increasing your future income payments.
One last note: While annuities can play an important part in a retirement plan, clients are rarely advised to annuitize 100% of their retirement savings. Typically, it’s only consumers with modest retirement savings and few resources at their disposal who should consider annuitizing all or a large portion of their savings.
- Find out how guaranteed investment funds and payout annuities can help take the uncertainty out of your retirement finances: Welcome to the no-surprise party.