Reducing Risk with an Annuity

Reducing Risk with an Annuity

Is an annuity a good investment option for you?  One of my younger followers had a financial planner suggest that he purchase life insurance and annuities as part of his investment portfolio.  His questions about whether they were good choices for him were the impetus for Financial IQ by Susie Q.  In this post, I will provide descriptions of the key features of annuities, explain their benefits and show how to evaluate whether they are a good fit for your portfolio.

What is an Annuity?

An annuity is contract under which you exchange of lump sum of money for a guaranteed income stream of periodic payments.  There are two broad types of annuities – fixed and variable.  The amount of each payment is constant when you buy a fixed annuity.  If, on the other hand, you purchase a variable annuity, the amount of each payment depends on the performance of a pre-determined investment portfolio.  I’ll avoid the complexities of variable annuities in the rest of this post by focusing on fixed annuities.

An individual and a life insurance company are usually the parties to the contract.  Sometimes, one person can purchase the annuity on behalf of someone else, so a third person (the annuitant) can also be involved in the transaction but isn’t a party to the contract.

For many annuities, you pay a fixed amount up front and, at times determined by the particular annuity, the insurance company gives you a stream of payments.  For others annuities, you pay for the annuity in installments that are completed before the insurer starts making payments to you.

Timing of Annuities

You can choose the beginning and ending times of the payments you receive from the insurer.

Start of Payments

Annuities are often split between immediate annuities and deferred income annuities.  The terms “immediate” and “deferred” refer to the start date of the annuity payments.  The biggest constraint on the start date of the annuity is that you must have paid for the annuity in full before you get your first payment.

You start receiving payments as soon as you buy your annuity with an immediate annuity, hence its name.  The payments on a deferred annuity start at a time in the future you designate.

End of Payments

As with the start date, there are two ways in which the last payment date from an annuity can be determined.  Some annuities have terms, or stated time periods during which payments are made.  Payments on life annuities, on the other hand, are made until the annuitant dies.

When you purchase an annuity with a stated term, you designate someone as your beneficiary.  If you die before the end of the term, your beneficiary usually has the option to receive the rest of the payments and may have the option to receive a lump sum instead.

There is also a hybrid option.  The payments on some annuities end at the later of a stated term or when the annuitant dies.

Comparison

To illustrate, I’ve created four illustrative annuities.  The table below summarizes their key characteristics.

Annuity

Premium Payments

Start Date

End Date

1

Single

Immediate

10 Years

2

Single

Deferred 20 Years

10 Years

3

Over Five Years

Deferred 20 Years

10 Years

4

Over Five Years

Deferred 20 Years

Lifetime

In this table, the number of years the start date is deferred refers to the time between the first premium payment and the first payment received from the insurer.

The chart below illustrates the different time periods from this table.

Annuity Timing Comparison

The end of the time covered by Annuity 4 is uncertain, as you could die before payments start being made, during the 20-year period shown by the green bar, or after the last date shown on the graph.

How is the Price Determined?

The price of an annuity is set by the insurer based on a combination of factors:

  • The expected future payments
  • In the case of life annuities, the probability you will be alive to collect the payment
  • The interest rate used for calculating the present value
  • The insurance company’s provision for expenses and profit

Because the insurance company is taking some or all of the investment or market risk, the interest rate is likely to be lower than the return you can earn in the stock market and possibly lower than some bond yields.

Illustration

As an example, let’s look at a life annuity that starts paying in 10 years when you turn age 65.  The annual payments (usually paid in monthly increments) are $10,000.  The table below illustrates the calculation of the payments adjusted for your mortality.

Age

Annuity Payment

Probability of Dying in Year[1]

Probability You are Still Alive

Expected Value of Payments

55

0

0.8%

99.2%

0

56

0

0.8%

98.4%

0

64

0

1.5%

89.3%

0

65

10,000

1.6%

87.9%

8,788

66

10,000

1.7%

86.4%

8,638

67

10,000

1.8%

84.8%

8,479

68

10,000

2.0%

83.1%

8,312

98

10,000

32.1%

1.6%

162

99

10,000

33.7%

1.1%

107

100

10,000

35.4%

0.7%

69

The insurer then takes the present value of the Expected Value of Payments column by dividing each value in the column by 100% plus the annual interest rate compounded for the number of years between your premium payment and when you receive each payment.  Using a 3% interest rate, the present value of the expected payments for the illustrative annuity is $85,929.

The insurer then determines its expense and profit load.  For illustration, let’s say it is 10%.  It then divides the present value of the expected payments by 100% minus the expense load (or by 90% in this example).  Using these assumptions, you would pay $95,477 for this annuity.

Why Purchase an Annuity?

You might wonder why you would buy a fixed annuity if the insurer isn’t crediting interest at an rate similar to the return you can earn in the stock market and is adding its expense and profit load.  Clearly, both of those factors add to the cost and reduce your return on the money.

The purpose of buying an annuity is to reduce your investment risk.  When you buy a fixed annuity, you are transferring all of your investment risk to the life insurance company.  That is, the insurer is essentially guaranteeing you the return it used in pricing, reduced for the expense load, regardless of what happens in financial markets.

When you buy a life annuity, you are also transferring your longevity risk to the insurance company.  That is, you are also transferring the risk that you will live for a very long time.

The lower investment return and the addition of the expense and profit margins are the trade-off for eliminating your investment and longevity risks.

As noted above, annuities can also be used to provide a stream of income for someone else.  For example, if you have a son or daughter who is disabled and unable to support themselves, you might buy an annuity from some of your assets to provide guaranteed income to your offspring to reduce the financial ramifications of your offspring outliving you or your savings.

Side Bar about Credit Risk

It is important to understand that you are taking on credit risk when you buy an annuity.  If the insurance company goes bankrupt, it may not be able to pay all of your payments as scheduled.  To minimize this risk, you’ll want to purchase any annuities from well-respected, highly rated insurance companies.

Illustration of Risk Transfer

To help you understand the risk you are transferring, I’ll use a life annuity purchased at age 55 with payments of $10,000 a year starting at age 65.  Under one strategy, you buy the annuity.  Under the other strategy, you put the amount of premium in a brokerage account at age 55.  You invest in the S&P 500 and withdraw $10,000 a year starting when you are age 65.  Both strategies have the same cash flows.  You use the amount of the premium to either pay for the annuity or put money in the brokerage account.  You then receive $10,000 starting at age 65 for the rest of your life.

I created 70 time series of annual historical S&P 500 returns.  The first one starts with the return in 1929; the last one in 1998.  For ages 90 and 100, I had 60 time series (the last one starting in 1988) and 50 time series (the last one starting in 1978), respectively.  For each time series, I assumed you invested the annuity premium in the S&P 500 when you were 55 and withdrew the amounts you would receive from the annuity in each year from your investment account.

Comparison of Uncertainty

The graph below compares the range of amounts in your account if you (a) buy the annuity or (b) invest in the S&P 500.

Annuity Risk-Reward Comparison

This type of chart is called a box and whisker plot.  The blue line represents the average of your account balance across all scenarios.  The green boxes go from the 25th percentile to the 75th percentile of the scenarios, while the whiskers go from the 5th percentile to the 95th percentile.

As you can see, at all ages, your account balance is zero if you buy the annuity.  At ages 70 and 80, there is less than a 5% chance your account balance will have fallen below zero if you invested in the S&P 500.  However, by age 90, the lower whisker falls below zero showing that you don’t have enough money to over your withdrawals of $10,000 a year in some scenarios and, by age 100, even more scenarios.

Probabilities of Running out of Money

The probabilities you will run out of money to support the $10,000 cash flows are shown in the graph below.

Annuity Eliminates Risk of Account Balance Going to 0

If you buy the annuity, you will always get your stream of payments (unless the insurer defaults on some or all of its obligation to you).  Similarly, there were no historical time periods during which your account balance would have gone negative by age 70 if you had invested in the S&P 500.  However, in 21% of the historical scenarios, you would have exhausted the assets in your account before age 90.

Is an Annuity an Investment Vehicle?

If I purchased an annuity, I would consider it as part of my investment portfolio.  Annuities have several similarities to bonds.  For both bonds and annuities, you make a payment up front in exchange for a series of cash flows in the future.  Also, credit risk exists for both bonds and annuities.  That is, you might not receive all of your payments if the issuer of the bond or annuity goes bankrupt.

The differences between bonds and annuities, listed below, don’t disqualify an annuity from being considered an investment.

  • You don’t have to pay for an annuity all at once, whereas you make a single payment to buy a bond.
  • The payments from an annuity tend to be constant or relatively constant over time. The cash flows for bonds, by comparison, tend to be small amounts (the coupons) until the maturity date when you get a large payment (the principal).
  • There may be a delay between the time you pay for your annuity and you get your first payment that doesn’t exist for bonds.

A life annuity can be thought of as a blend between an insurance contract and an investment because it not only provides a stream of cash flows, it ensures that you’ll receive the stream of cash flows until you die.  As illustrated above, an annuity is very low-risk, low-reward financial instrument.  If you use one to guarantee that your basic income needs are met, it can allow you to take more risk in other parts of your investment portfolio.

Life Insurance and Annuities

Life insurance and annuities are hedges against each other.  That is, life insurance protects against the risk that you die early, whereas life annuities protect against the risk that you die later.  As you are considering the financial risks you face, you’ll want to consider which risks are biggest for you and/or cause you the most concern.  If your longevity is of concern, you can consider an annuity as a way to transfer that risk.

 

 

[1] Social Security Administration, https://www.ssa.gov/oact/STATS/table4c6.html, March 16, 2021. (Used for illustration only.)



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