How annuities work

An annuity is an exchange. You hand an insurer a sum of money and the insurer promises you an income: for a fixed number of years under a term annuity, or for the rest of your life under a life annuity. The second kind is the one worth understanding properly, because it is not an investment product with an unusual name. It is insurance, and what it insures is the risk of living a long time.

That risk cannot be spread inside one household. You can hold thirty companies in a portfolio, but you only get one lifespan. An insurer solves it the way risk pooling solves everything else, by writing the same contract for many people at once. One lifespan is unpredictable. The average lifespan of ten thousand people aged 65 is far more predictable, but not perfectly so, and the difference matters. Pooling cancels the variation between individuals. It does nothing about a general improvement in longevity that lengthens every life in the pool at once, because that is one risk rather than ten thousand independent ones. That part stays with the insurer, and it is priced.

Compare the two ways of turning a pot into an income. Suppose you hold $100,000 and want $525 a month, which is a 6.3 percent payout rate. Treat that rate as illustrative rather than as a quote: what an insurer will actually offer moves with market interest rates and with the buyer's age, so any rate printed in an article is a snapshot rather than a fact about the product. Left in your own hands at 4 percent a year and drawn down monthly, that pot pays out for 303 months, just over 25 years, handing over $158,967.88 before it reaches zero. Bought at 65, it runs dry at 90. A life annuity bought with the same $100,000 pays the same $525 for as long as you live, whether that turns out to be 12 years or 40.

The insurer can promise that because the money left behind by buyers who die early stays in the pool and funds the ones who do not. Actuaries call the difference mortality credits, and no portfolio can copy them, because no portfolio inherits from the investors in it who died. Two qualifications belong next to that. The credits are one reason a life annuity can pay out above what a bond of comparable safety yields, but not the whole reason: a bond hands its capital back at maturity, while an annuity spreads the same capital through the payments, which lifts the annual figure on its own. And the credits arrive net of the insurer's expenses, capital charge and profit, the loading that sits inside every insurance premium, so the buyer collects less than a fairly priced pool would pay.

An immediate annuity starts paying almost at once: a single sum goes in and the income begins within a year. A deferred annuity has two separate phases, and running them together is the most common way to misread the product.

In the accumulation phase you pay money in, as one sum or as a stream, and the balance grows: at a rate the contract sets in a fixed deferred annuity, or with whatever the chosen sub-accounts do in a variable one. Nothing is being insured yet. Taking the fixed case, this phase is plain compounding, which is exactly what the calculator at the top of this page computes: $500 a month for 20 years at 5 percent compounded monthly reaches $205,516.83, of which $120,000 is money paid in and $85,516.83 is credited growth.

The insurance begins only at the second phase, annuitisation, when that balance is converted into an income. Until then a deferred annuity is a savings contract with an insurance company on the other side of it, and the longevity protection everyone talks about has not started.

Two shapes sit at the edges of this. A single premium immediate annuity skips the accumulation phase entirely: one payment in, income out. A deferred income annuity does the reverse, taking money now for an income that begins at an advanced age and paying nothing at all in between. That second shape buys the most longevity cover per dollar spent, because the promise costs the insurer nothing unless you live to collect on it.

How the accumulation phase is taxed is a fact about a country rather than about annuities. In the United States, growth inside a deferred contract is generally tax deferred until money comes out, and what is taxed on the way out, and at what age withdrawals stop attracting an extra charge, is set by the tax code rather than by the insurer.

This is the most misread number in the product. Take an illustrative contract paying $6,300 a year for life in exchange for $100,000. The payout rate is 6.3 percent. It is not a 6.3 percent return, because the payment is not interest. It is interest, plus a slice of your own capital handed back, plus a share of what the pool inherited from the buyers who died.

Divide the price by the income and one crossover appears: 100,000 over 6,300 is 15.873, so it takes 16 payments before the money handed over has come back. That is a count of dollars rather than a return, and it should not be read as one. It ignores what those dollars could have earned in the meantime, and every payment contains some interest from the first one onwards, so it is wrong to read the payments before the 16th as pure return of capital.

The return the contract actually delivers is the rate that makes the payments worth the price, and it is not knowable until the buyer dies.

One price, one contract, five different answers. Every figure in that last column is nominal, before inflation, which is a different thing from a real rate: at 3 percent inflation the first three rows are all still losses in what the money buys, and only the last two leave the buyer ahead of prices. The figures also treat the income as one payment a year on each anniversary; monthly payments lift each of them slightly, because the money arrives sooner. The internal rate of return calculator runs any lifespan through the same arithmetic.

The spread is the product rather than a flaw in it. An insurance contract pays most to the people the insured event happened to, and here that event is a long life. It also means a payout rate cannot be set beside a bond yield, which returns capital separately at the end. That comparison makes annuities look generous at the point of sale, and the same error running backwards makes them feel expensive later.

What varies between contracts is who carries which risk.

A fixed annuity promises a stated amount. The insurer backs it with a portfolio, mostly bonds, and carries the investment risk of that portfolio. You carry the inflation risk, because what is promised is an amount of money rather than an amount of purchasing power. The rate quoted depends heavily on market interest rates on the day of purchase, since that is the day the insurer buys the bonds that fund the promise.

A variable annuity pays an income that moves with investment sub-accounts you choose. You carry the investment risk, so the income can fall. Charges stack here in a way worth adding up before comparing anything: a mortality and expense charge on the contract, the expense ratio inside each sub-account, an administration charge, and a separate charge for any optional guarantee.

A fixed indexed annuity credits interest by a formula tied to an index, with a floor at zero on that credit and a ceiling above it. If the cap is 8 percent and the index gains 15 percent, the credit is 8 percent; if the index falls, the credit is nothing rather than a loss, though a floor on the credit is not a floor on the account value, since any rider fee is still charged in a year that credits nothing. Participation rates and spreads do the same job by a different route, and the index is normally counted on price alone, so dividends are left out. The insurer pays for this by spending the interest its bond portfolio earns on options, which is why caps move when interest rates and option prices move.

Riders that guarantee a minimum income can sit on top of any of these, and they are priced. The cost comes out of the credited rate or out of the payment, so a guarantee never arrives free.

Two things are handed over with the money.

The first is liquidity. Once a contract is annuitised, the sum is generally gone as a sum: you own an income, not a balance you can call on. During the accumulation phase of a deferred contract money can usually be taken out, but a surrender charge applies on a schedule that starts at several percent and steps down to zero across a stated number of years, often with a small charge free withdrawal allowed annually. Many contracts add a market value adjustment, which moves the amount handed back in the opposite direction to interest rates, because the insurer has to sell bonds to pay you.

The second is the purchasing power of a level payment. A fixed annuity that pays $6,300 a year pays $6,300 for ever, and prices do not hold still. At 3 percent inflation the 20th payment still reads $6,300 and buys what $3,488.16 buys today: 44.63 percent of it has gone, and nothing has gone wrong with the contract. Level means level in money.

Contracts written with an escalating payment, rising by a fixed percentage each year, or linked to a published inflation measure where that is offered, answer this by starting lower. They start lower for an unremarkable reason: the same price has to buy a stream that gets bigger later. The options that protect somebody else lower the opening income too, but for a different reason. A joint life form that continues to a survivor, a guarantee period, or a cash refund of whatever has not been paid out each takes back out of the pool exactly what the pool was using to pay the survivors, so what is bought is less longevity insurance and more return of capital. The real return calculator puts a real rate on any of them.

An annuity is a claim on one company. There is no fund with your name on it and no custodian holding your units, only a contract, so the income depends on that insurer still being able to pay in 30 years. That is counterparty risk, and an insured bank deposit carries it differently.

Three things sit against it. Insurers are reserve regulated, and the assets backing fixed contracts sit in a general account subject to rules on what may be held. Credit ratings give an outside read on the same question, though they are opinions that tend to move after the facts do rather than before. And some countries, by no means all of them, run an industry funded protection scheme behind their insurers: in the United States, state guaranty associations cover annuity contracts up to limits set state by state, which is why a large purchase is sometimes split across several insurers so each sits inside the protected amount. In the United Kingdom, long term insurance contracts fall under the Financial Services Compensation Scheme. Elsewhere the scheme may be narrower, or may not exist at all. Limits and terms are revised, so read the current ones for the country the contract is written in rather than a figure quoted in an article.

A variable annuity differs in one respect worth knowing. Its sub-account assets sit in a separate account, insulated from the insurer's other creditors, while any guarantee written on top of them is a promise from the general account. The investments and the guarantee therefore carry different exposures to the same company.

One more risk is about timing rather than solvency. Annuitising everything on a single date ties the whole income to the interest rates of that date, since that is what the insurer prices against. Buying in stages across several years spreads that, at the cost of leaving part of the pot carrying the longevity risk for longer. Which trade fits a given situation turns on facts about that person, which is what a licensed adviser is for.