Life annuity
Encyclopedia
A life annuity is a financial contract in the form of an insurance product according to which a seller (issuer) — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer (annuitant) in exchange for the immediate payment of a lump sum (single-payment annuity) or a series of regular payments (regular-payment annuity), prior to the onset of the annuity.
The payment stream from the issuer to the annuitant has an unknown duration based principally upon the date of death of the annuitant. At this point the contract will terminate and the remainder of the fund accumulated is forfeited unless there are other annuitants or beneficiaries in the contract. Thus a life annuity is a form of longevity insurance
, where the uncertainty of an individual's lifespan is transferred from the individual to the insurer, which reduces its own uncertainty by pooling many clients. Annuities can be purchased to provide an income during retirement, or originate from a structured settlement of a personal injury lawsuit
.
. Medieval German and Dutch cities and monasteries raised money by the sale of life annuities, and it was recognized that pricing them was difficult. The early practice for selling this instrument did not consider the age of the nominee, thereby raising interesting concerns. These concerns got the attention of several prominent mathematicians over the years, such as Huygens, Bernoulli
, de Moivre and others: even Gauss and Laplace had an interest in matters pertaining to this instrument. It seems that Johan de Witt
was the first writer to compute the value of a life annuity as the sum of expected discounted future payments, while Halley
used the first mortality table drawn from experience for that calculation. Meanwhile, the Paris Hôtel-Dieu
offered some fairly priced annuities that roughly fits the Deparcieux table discounted at 5 %. Here is a quick comparison table of early life annuity prices:
Continuing practice is an everyday occurrence with well-known theory founded on robust mathematics, as witnessed by the hundreds of millions worldwide who receive regular remuneration via pension
or the like. The modern approach to resolving the difficult problems related to a larger scope for this instrument applies many advanced mathematical approaches, such as stochastic
methods, game theory, and other tools of financial mathematics.
It is possible to structure an annuity contract so that it has only the distribution phase; such a contract is called an immediate annuity.
Annuity contracts with a deferral phase—deferred annuities—are essentially two phase annuities, but only having growth of capital by investment in the accumulation phase (now the deferral phase), with no customer deposits.
The phases of an annuity can be combined in the fusion of a retirement savings and retirement payment plan: the annuitant makes regular contributions to the annuity until a certain date and then receives regular payments from it until death. Sometimes there is a life insurance component added so that if the annuitant dies before annuity payments begin, a beneficiary gets either a lump sum or annuity payments.
). Interest rates and inflation can affect the decision to purchase, as they are reflected in the annuity rates, and also affect secure investment potential by varying bond yields. Inflation
deteriorates the buying power of an annuity and can therefore be a concern.
Variable annuities are used for many different objectives. One common objective is deferral of the recognition of tax
able gains. Money deposited in a variable annuity grows on a tax-deferred basis, so that taxes on investment gains are not due until a withdrawal is made. Variable annuities offer a variety of funds ("subaccounts") from various money managers
. This gives investors the ability to move between subaccounts without incurring additional fees or sales charges.
(tax-advantaged) savings vehicle, and uses the money to buy an annuity whose payments will replace the retiree's wage payments for the rest of his/her life. The advantage of such an annuity is that the annuitant has a guaranteed income for life, whereas if the retiree were instead to withdraw money regularly from the retirement account (income drawdown), he/she might run out of money before death, or alternatively not have as much to spend while alive as could have been possible with an annuity purchase.
The disadvantage of such an annuity is that the election is irrevocable and, because of inflation, a guaranteed income for life is not the same thing as guaranteeing a comfortable income for life.
In the UK it has become common for life companies to base their annuity rates on an individual's location. Legal & General may have been the first company to do this.
are poorly managed "practically everywhere". Longevity insurance
is now becoming more common in the UK
and the U.S. (see Futures) while Chile
, in comparison to the U.S., has had a very large life annuity market for 20 years.
generation in the US will increase the demand for this type of instrument and how it might be optimized for the annuitant; this growing market will drive improvements necessitating more research and development of instruments plus increase insight into the mechanics (including dynamics in more than the sense of the dynamical system
) involved on the part of the buying public. An example of increased scrutiny and discussion is that related to privatization
of part of the U.S. Social Security Trust Fund
.
In late 2010, discussions, related to cutting Federal taxes, raised anew the following concern: how much would an annuity cost a retiree if he or she had to replace their Social Security income? Assuming that the average benefit from Social Security is $14,000 per year, the replacement cost would be about $250,000 for the individual. The figures are based upon the individual receiving an inflation-adjusted stream that would pay for life and be insured.
In the UK any annuities that are taken out after 21st December 2012 will have to comply with the ruling.
The payment stream from the issuer to the annuitant has an unknown duration based principally upon the date of death of the annuitant. At this point the contract will terminate and the remainder of the fund accumulated is forfeited unless there are other annuitants or beneficiaries in the contract. Thus a life annuity is a form of longevity insurance
Longevity insurance
Longevity insurance, insuring longevity, is an annuity contract designed to pay to the policyholder a benefit if he or she survives to a pre-established future age....
, where the uncertainty of an individual's lifespan is transferred from the individual to the insurer, which reduces its own uncertainty by pooling many clients. Annuities can be purchased to provide an income during retirement, or originate from a structured settlement of a personal injury lawsuit
Lawsuit
A lawsuit or "suit in law" is a civil action brought in a court of law in which a plaintiff, a party who claims to have incurred loss as a result of a defendant's actions, demands a legal or equitable remedy. The defendant is required to respond to the plaintiff's complaint...
.
History
The instrument's evolution has been long and continues as part of actuarial scienceActuarial science
Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in the insurance and finance industries. Actuaries are professionals who are qualified in this field through education and experience...
. Medieval German and Dutch cities and monasteries raised money by the sale of life annuities, and it was recognized that pricing them was difficult. The early practice for selling this instrument did not consider the age of the nominee, thereby raising interesting concerns. These concerns got the attention of several prominent mathematicians over the years, such as Huygens, Bernoulli
Nicolaus I Bernoulli
Nicolaus Bernoulli , was a Swiss mathematician and was one of the many prominent mathematicians in the Bernoulli family....
, de Moivre and others: even Gauss and Laplace had an interest in matters pertaining to this instrument. It seems that Johan de Witt
Johan de Witt
Johan de Witt, heer van Zuid- en Noord-Linschoten, Snelrewaard, Hekendorp and IJsselveere was a key figure in Dutch politics in the mid 17th century, when its flourishing sea trade in a period of globalization made the United Provinces a leading European power during the Dutch Golden Age...
was the first writer to compute the value of a life annuity as the sum of expected discounted future payments, while Halley
Edmond Halley
Edmond Halley FRS was an English astronomer, geophysicist, mathematician, meteorologist, and physicist who is best known for computing the orbit of the eponymous Halley's Comet. He was the second Astronomer Royal in Britain, following in the footsteps of John Flamsteed.-Biography and career:Halley...
used the first mortality table drawn from experience for that calculation. Meanwhile, the Paris Hôtel-Dieu
Hôtel-Dieu de Paris
The Hôtel-Dieu de Paris is regarded as the oldest hospital in the city of Paris, France, and is the most central of the Assistance publique - hôpitaux de Paris hospitals. The hospital is linked to the Faculté de Médecine Paris-Descartes...
offered some fairly priced annuities that roughly fits the Deparcieux table discounted at 5 %. Here is a quick comparison table of early life annuity prices:
| Head age (x) | Value of a unit annuity | |||||
| Ulpian Ulpian Gnaeus Domitius Annius Ulpianus , anglicized as Ulpian, was a Roman jurist of Tyrian ancestry.-Biography:The exact time and place of his birth are unknown, but the period of his literary activity was between AD 211 and 222... ca. 200 AD |
de Witt 1671 |
Hôtel Dieu ca. 1680 |
Halley 1693 |
Deparcieux 1746 |
||
| 1 | 30 | 16 | n/a | 10,28 | n/a | |
| 10 | 30 | 15,19 | n/a | 13,44 | 16,25 | |
| 20 | 28 | 13,83 | 20 | 12,78 | 15,58 | |
| 30 | 22 | 12,22 | 20 | 11,72 | 14,84 | |
| 40 | 19 | 10,39 | 15 | 10,57 | 13,62 | |
| 50 | 9 | 8,68 | 12 | 9,21 | 11,58 | |
| 60 | 5 | 6,70 | 10 | 7,60 | 9,24 | |
| 70 | 5 | 3,77 | 8 | 5,32 | 6,36 | |
| 80 | 5 | 0 | 8 | 3,05 | 3,86 | |
| 90 | 5 | 0 | 6 | 1,74 | 1,58 | |
| 95 | 5 | 0 | n/a | 1,02 | 0 | |
| Values are approximated | ||||||
Continuing practice is an everyday occurrence with well-known theory founded on robust mathematics, as witnessed by the hundreds of millions worldwide who receive regular remuneration via pension
Pension
In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
or the like. The modern approach to resolving the difficult problems related to a larger scope for this instrument applies many advanced mathematical approaches, such as stochastic
Stochastic process
In probability theory, a stochastic process , or sometimes random process, is the counterpart to a deterministic process...
methods, game theory, and other tools of financial mathematics.
Phases of an annuity
There are two possible phases for an annuity:- The accumulation phase in which the customer deposits and accumulates money into an account, and ;
- The distribution phase in which the insurance company makes income payments until the death of the annuitants named in the contract.
It is possible to structure an annuity contract so that it has only the distribution phase; such a contract is called an immediate annuity.
Annuity contracts with a deferral phase—deferred annuities—are essentially two phase annuities, but only having growth of capital by investment in the accumulation phase (now the deferral phase), with no customer deposits.
The phases of an annuity can be combined in the fusion of a retirement savings and retirement payment plan: the annuitant makes regular contributions to the annuity until a certain date and then receives regular payments from it until death. Sometimes there is a life insurance component added so that if the annuitant dies before annuity payments begin, a beneficiary gets either a lump sum or annuity payments.
Decision to defer or not
The option to defer purchase of an annuity (income drawdown) has the benefit of investment flexibility, offset by the risk of falling annuity rates as the life expectancy of the surviving individual rises (mortality dragMortality drag
Mortality drag is a term used, in reference to lifetime annuities, to describe a negative impact that is experienced when an annuity purchase is delayed on a fund from which regular withdrawals are being taken by an individual. It is the increasing risk of falling annuity rates, and grows...
). Interest rates and inflation can affect the decision to purchase, as they are reflected in the annuity rates, and also affect secure investment potential by varying bond yields. Inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
deteriorates the buying power of an annuity and can therefore be a concern.
Types of life annuity
With the complex selection of options available, consumers can find it difficult to decide rationally on the right type of annuity product for their circumstances.Fixed and variable annuities
Annuities that make payments in fixed amounts or in amounts that increase by a fixed percentage are called fixed annuities. Variable annuities, by contrast, pay amounts that vary according to the investment performance of a specified set of investments, typically bond and equity mutual funds.Variable annuities are used for many different objectives. One common objective is deferral of the recognition of tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
able gains. Money deposited in a variable annuity grows on a tax-deferred basis, so that taxes on investment gains are not due until a withdrawal is made. Variable annuities offer a variety of funds ("subaccounts") from various money managers
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
. This gives investors the ability to move between subaccounts without incurring additional fees or sales charges.
Guaranteed annuities
With a "pure" life annuity, annuitants may die before recovering the value of their original investment in it. If the possibility of this situation, called a "forfeiture," is not desired, it can be ameliorated by the addition of an added clause, forming a type of guaranteed annuity, under which the annuity issuer is required to make annuity payments for at least a certain number of years (the "period certain"); if the annuitant outlives the specified period certain, annuity payments then continue until the annuitant's death, and if the annuitant dies before the expiration of the period certain, the annuitant's estate or beneficiary is entitled to collect the remaining payments certain. The tradeoff between the pure life annuity and the life-with-period-certain annuity is that in exchange for the reduced risk of loss, the annuity payments for the latter will be smaller.Joint annuities
Multiple annuitant products include joint-life and joint-survivor annuities, where payments stop upon the death of one or both of the annuitants respectively. For example, an annuity may be structured to make payments to a married couple, such payments ceasing on the death of the second spouse. In joint-survivor annuities, sometimes the instrument reduces the payments to the second annuitant after death of the first.Impaired life annuities
There has also been a significant growth in the development of Impaired Life annuities. These involve improving the terms offered due to a medical diagnosis which is severe enough to reduce life expectancy. A process of medical underwriting is involved and the range of qualifying conditions has increased substantially in recent years. Both conventional annuities and Purchase Life Annuities can qualify for impaired terms.United States
With a "single premium" or "immediate" annuity, the "annuitant" pays for the annuity with a single lump sum. The annuity starts making regular payments to the annuitant within a year. A common use of a single premium annuity is as a destination for roll-over retirement savings upon retirement. In such a case, a retiree withdraws all of the money he/she has saved during working life in, for example, a 401(k)401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
(tax-advantaged) savings vehicle, and uses the money to buy an annuity whose payments will replace the retiree's wage payments for the rest of his/her life. The advantage of such an annuity is that the annuitant has a guaranteed income for life, whereas if the retiree were instead to withdraw money regularly from the retirement account (income drawdown), he/she might run out of money before death, or alternatively not have as much to spend while alive as could have been possible with an annuity purchase.
The disadvantage of such an annuity is that the election is irrevocable and, because of inflation, a guaranteed income for life is not the same thing as guaranteeing a comfortable income for life.
United Kingdom
In the conversion of pension income into an annuity is compulsory by the age of 75 and has led to a large market for annuities of various types. The most common are those where the source of the funds required to buy the annuity is from a pension scheme. Examples of these types of annuity, often referred to as a Compulsory Purchase Annuity, are conventional annuities, with profit annuities and unit linked, or "third way" annuities. Annuities purchased from savings (i.e. not from a pension scheme) are referred to as Purchase Life Annuities and Immediate Vesting Annuities. In October 2009, the International Longevity Centre-UK published a report on Purchased Life Annuities (Time to AnnuitiseIn the UK it has become common for life companies to base their annuity rates on an individual's location. Legal & General may have been the first company to do this.
Internationally
Some countries developed more options of value for this type of instrument than others. However, a recent study reported that some of the risks related to longevityLongevity
The word "longevity" is sometimes used as a synonym for "life expectancy" in demography or known as "long life", especially when it concerns someone or something lasting longer than expected ....
are poorly managed "practically everywhere". Longevity insurance
Longevity insurance
Longevity insurance, insuring longevity, is an annuity contract designed to pay to the policyholder a benefit if he or she survives to a pre-established future age....
is now becoming more common in the UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
and the U.S. (see Futures) while Chile
Chile
Chile ,officially the Republic of Chile , is a country in South America occupying a long, narrow coastal strip between the Andes mountains to the east and the Pacific Ocean to the west. It borders Peru to the north, Bolivia to the northeast, Argentina to the east, and the Drake Passage in the far...
, in comparison to the U.S., has had a very large life annuity market for 20 years.
Future of annuities
It is expected that the aging of the Baby boomerBaby boomer
A baby boomer is a person who was born during the demographic Post-World War II baby boom and who grew up during the period between 1946 and 1964. The term "baby boomer" is sometimes used in a cultural context. Therefore, it is impossible to achieve broad consensus of a precise definition, even...
generation in the US will increase the demand for this type of instrument and how it might be optimized for the annuitant; this growing market will drive improvements necessitating more research and development of instruments plus increase insight into the mechanics (including dynamics in more than the sense of the dynamical system
Dynamical system
A dynamical system is a concept in mathematics where a fixed rule describes the time dependence of a point in a geometrical space. Examples include the mathematical models that describe the swinging of a clock pendulum, the flow of water in a pipe, and the number of fish each springtime in a...
) involved on the part of the buying public. An example of increased scrutiny and discussion is that related to privatization
Privatization
Privatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...
of part of the U.S. Social Security Trust Fund
Social Security Trust Fund
In the United States, the Social Security Trust Fund is a fund operated by the Social Security Administration into which are paid contributions from workers and employers under the Social Security system and out of which benefit payments to retirees, survivors, and the disabled, and general...
.
In late 2010, discussions, related to cutting Federal taxes, raised anew the following concern: how much would an annuity cost a retiree if he or she had to replace their Social Security income? Assuming that the average benefit from Social Security is $14,000 per year, the replacement cost would be about $250,000 for the individual. The figures are based upon the individual receiving an inflation-adjusted stream that would pay for life and be insured.
European Court of Justice ruling
In March 2011 a European Court of Justice ruling was made that prevents annuity providers from using gender to set different premiums for men and women. Annuity rates for men are generally higher than those for women because they have shorter life expectancies. The change means that either annuity rates for men will fall or annuity rates for women will rise.In the UK any annuities that are taken out after 21st December 2012 will have to comply with the ruling.
See also
- Actuarial present valueActuarial present valueIn actuarial science, the actuarial present value of a payment or series of payments which are random variables is the expected value of the present value of the payments, or equivalently, the present value of their expected values....
- Annuity (European financial arrangements)#Life annuity
- Certificate of lifeCertificate of lifeA Certificate of Life is a certificate produced by an embassy or other government body to confirm that an individual is still alive....
- PensionPensionIn general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...