What it means
The idea is to turn savings into an income that cannot run out. The insurer pools the money of many buyers and pays each of them for life, relying on the fact that some will live longer than average and others shorter.
Those who die early subsidise those who live long. The payment amount depends on the lump sum, the age and sex or health category of the buyer under the insurer's rules, and interest rates when the contract is bought.
An older buyer receives a higher income than a younger one for the same sum, since the expected payment period is shorter. Rates change over time, so a quote today says nothing about future quotes.
The word straight signals that there are no extras. Other versions add a guaranteed period, such as 10 years, or continue payments to a surviving partner, and each addition lowers the regular payment.
A straight life annuity has no refund and no survivor benefit, so if the holder dies soon after buying, the insurer keeps what remains. The main advantage is protection against longevity risk, which is the danger of outliving your money.
The main disadvantages are the loss of access to the lump sum, the lack of inflation protection unless purchased as an extra and the dependence on the insurer's ability to pay. Regulated insurers are required to hold reserves, and some countries run guarantee schemes, though protection varies.
For business readers, annuities appear in staff pension arrangements, in settlements and in estate planning. A company that closes a pension scheme may buy annuities for its pensioners, which transfers the risk to an insurer.
Understanding the trade-off between the highest income and flexibility is the key point.
In practice
Real-world examples.
Example
A 70-year-old retiree has $400,000 of savings and wants a guaranteed income to cover basic bills. She uses $200,000 to buy a straight life annuity, which gives her a regular monthly payment. She keeps the remaining $200,000 invested for emergencies and gifts.
Example
A manufacturing company closes its old pension scheme and buys annuities from an insurer for its 300 pensioners. The company pays the insurer a single premium and no longer carries the risk that pensioners live longer than expected. The pension liability leaves the company's balance sheet.
Example
A couple compares a straight life annuity with a joint and survivor annuity. The straight option pays $2,000 a month, while the joint option pays $1,750 but continues to the surviving partner. They choose the joint option because they want income protected for whichever of them lives longer.
Formula
Calculation
Annual payout rate = annual payment / premium paid
Break-even period = premium paid / annual payment
A retiree pays an insurer a premium of $250,000 and receives $1,500 a month for life. Annual payment = 1,500 x 12 = $18,000. Payout rate = 18,000 / 250,000 = 7.2% a year. Break-even period = 250,000 / 1,500 = 166.7 months, which is 166.7 / 12 = about 13.9 years. If the retiree lives longer than that, the total received exceeds the premium, and if not, the insurer keeps the difference. These figures are illustrative only, since real quotes vary.Case study
Seen in the real world.
Calloway Furniture is an illustrative, fictional private company whose founder, aged 66, sells the business for $1,000,000 after tax. He wants stable income but worries about running out of money if he lives into his nineties.
His adviser sets out the options, which include investing the whole amount, a straight life annuity and a mix. He uses $300,000 to buy a straight life annuity paying $2,100 a month, covering his basic costs, and invests the rest for growth and flexibility.
At 90, he has received 24 x 12 x 2,100 = $604,800, which is more than twice his original premium. The illustrative lesson is that a straight annuity works like insurance against a long life, and it is usually best applied to part of the savings rather than all of it.
Watch out
Common mistakes.
- Using all of your savings on a straight life annuity, when the money cannot be recovered and nothing passes to heirs.
- Comparing only the monthly amount between policies, when options such as survivor benefits and inflation protection change the real value.
- Ignoring inflation, which can erode the buying power of a fixed payment over decades.
Questions
People also ask.
What happens when the annuity holder dies?
Payments stop and the insurer keeps any remaining value, so nothing is paid to heirs under a straight life annuity.
Why does a straight life annuity pay more than other types?
The insurer has no obligation to refund money or continue payments to a survivor, so it can pay a higher regular amount.
Is the income guaranteed?
It is guaranteed by the insurer, so the strength of the insurer matters, and many countries regulate insurers and operate some form of protection scheme.
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