Two Kinds of Annuity Buyers

By Brad Thomason, CPA
 
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Today we’re going to talk about annuities and the people who buy them.
 
Quick point of clarification: I’ll be discussing fixed annuities, not variable annuities.  Variable annuities are a hybrid insurance product and registered security, all wrapped into one.  They are often hopelessly complicated, and frequently maligned because they tend to have high fee structures.  By contrast, fixed annuities are not exactly the simplest things in the world; but they are nonetheless pure insurance contracts that don’t seem like they are trying to be the Swiss Army knives of the financial product world.
 
A fixed annuity is an agreement with an insurance company to receive income in exchange for a lump sum (or in some cases, a series of payments).  Because these are multi-year commitments, there is always some sort of interest being paid, in one form or another.  Frequently there are multiple payout options for a particular contract, at least at first glance.  Substantively however, there are really only two options:  income for life, or income for some shorter period of time (of which there may be more than one shorter period offered).
 
Understanding what is going on here is fairly simple if you recall that the reason insurance exists in the first place is to transfer risk away from the person paying for the insurance. 
 
People who select to receive income for some period less than life (e.g. once a quarter for ten years, monthly for five years, etc) are essentially taking out the contract in order to collect interest.  The rate on annuities is frequently higher than for CDs and Treasury Bonds, so the risk being shifted is the risk of being able to find something that pays a higher rate.  Insurance companies have money managers, bond traders, and so forth already on staff.  By taking out the contract, the annuity purchaser is essentially getting access to the work these people do, rather than having to do it (or find someone to do it) themselves.
 
However, people who choose the income-for-life option are addressing a very different risk:  the risk of living too long and running out of money.
 
Let’s say that a 65 year-old person expects to have enough money to live on for the next 20 years.  On the one hand, that’s a good thing.  Twenty years of apparent security is a lot more than most people have.  Then again, people can and do live past 85.  What happens then?
 
Well, if the person owns an annuity for which the life income option has been selected, the annuity payments will continue past 85.  The insurance company will be legally obligated to keep paying out as long as that person is alive, just as they are legally obligated to replace a car if it gets stolen, or a roof if a tree falls through it.  In the more extreme case, where the person lives another fifteen or twenty years past 85, he/she will continue to receive income far in excess of what the original savings amount could have (safely) produced had the annuity contract not been entered into.
 
Again, the thing that is being insured, in this case, is the risk associated with living too long.  Which may be a very expensive proposition, depending on how long it lasts.
 
What happens if the person doesn’t live past 85?  Same thing that happens if no one steals your car or all of your trees behave themselves.  The insurance company keeps the premiums, and you had years of peace of mind of knowing that they were on the hook if the bad thing happened.
 
So those are the two basic uses of annuity contracts (with numerous variations on the themes, accepted).
 
When you articulate a pair of options people inevitably ask you which is better.  In this case, there isn’t an answer to that question; at least not in the spirit that the question is posed.  Think of annuities, instead, as a tool capable of doing a couple of different jobs.  If you are in the market to complete either one of those jobs (i.e. interest earnings, or income you can’t out-live) then an annuity contract is a tool you want to take a look at.  It might be the best tool for the particular job that you are interested in, and even if not, it might be a sensible one to use alongside some of the other financial instruments/products out there.