Annuities are a popular way to secure income through regular and ongoing payments across multiple years. They are a popular choice for providing reliable income in retirement. Typically, annuities are purchased from insurance companies. Annuities provide a way of managing the risk of possibly outliving your money in retirement.
What Is an Annuity?
Annuities are investment vehicles that provide the annuitant with reliable and guaranteed income for the rest of their lifetime or over a specific period of time. The Insurance Information Institute lists that annuities have a number of benefits that make them attractive for retirement, such as tax deferral on earnings, protection against debt claims, investment options and a chance for lifetime or term-specific income, among others. They also provide a variety of investment options.
The terms and payments of an annuity depend upon who will be receiving the benefits. The person whose life details provide the basis for the payments is known as an annuitant. An annuitant often owns the policy but an annuitant is not necessarily the policy owner. For example, a spouse or close relative might be an annuitant but not own the policy.
How Do Annuities Work?
In order to receive the benefits of an annuity, you will pay a premium to the insurance company and receive it back either immediately or deferred to a later time. That amount may be a lump sum for immediate distributions, or through payments for later distributions such as after retirement. The typical risks of investing are then passed onto the issuing insurance company and, in the case of a life annuity, that includes the risk of outliving your money.
Annuities offer a lot of customization through fixed or variable investing, immediate or deferred payments and policy riders, to name some. Annuities can provide payments for a specific period of time, often across five, 10, 15 or 20 years, or they can provide lifetime payments. Life annuities that provide payments for the lifetime of the annuitant are probably what most people think of when they consider annuities. These life annuities will provide payments until an annuitant's death, regardless of when that may occur.
How Do Insurers Calculate the Number of Years for Annuity?
If there is no certain way to know when a person will die, you may be wondering how insurance companies can guarantee annuity payments for life. Insurers use actuarial tables to gauge the likelihood an annuitant may get sick, become disabled or die at any given point during their lifetime. An actuarial table is also known as a mortality table and it statistically provides the probabilities around a number of influencing variables, such as gender, age, occupation, hobbies, etc. These tables determine annuity rates.
The information on actuarial tables correlates to the most common questions that insurance companies will ask of customers seeking a policy. If you have ever wondered why an insurance company wants to know whether a person smokes or has an aviation hobby, this is the reason. All of these factors help insurance companies determine how long they will have to pay on a lifetime annuity. Even armed with statistically accurate data, there are no absolute guarantees that an annuitant's life will exactly follow the tables.
Insurers rely on mortality credits to ensure that annuities are paid even if an annuitant outlives their expected lifetime. Insurance companies rely on a variety of annuitants to mitigate the risk posed by annuitants who live long enough to receive more annuity payments than expected. There are also annuitants who die earlier than projected and when that happens, the insurance company pays less than expected. This situation creates mortality credits of unpaid funds that go into a pool to cover the payments for longer-lived annuitants.
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.