What it means
Someone buys the annuity with a lump sum or builds it up through savings, and the provider promises to pay a set income for an agreed period, such as 10 or 20 years. The word "certain" refers to the guaranteed period.
Because the payments are not tied to how long the recipient lives, the provider does not need to price in life expectancy. That makes the annuity easier to value than a lifetime annuity, as it is simply a fixed set of future payments.
The main risk is the opposite of longevity risk (outliving your money). If the recipient lives beyond the guaranteed term, the payments stop and no more income arrives, so the product suits needs with a clear end date, such as bridging income until a pension begins.
Financial planners use term certain annuities to cover a known period, for example the years between early retirement and the start of state benefits. They also appear in legal settlements, where a defendant agrees to pay a fixed stream over a set number of years.
The value today of the payments depends on the interest rate used for discounting (reducing future money to its value now). The higher the rate, the lower the present value, which is why the same annuity can look cheaper or more expensive as rates move.
Pricing also depends on the provider's own costs and profit margin. Two providers can quote different payments for the same lump sum, so it is worth comparing several quotes.
Inflation is another consideration, because a fixed payment buys less each year unless it is built to rise.
In practice
Real-world examples.
Example
A 60-year-old retires early and buys a 5-year term certain annuity paying $24,000 a year. It covers living costs until her pension starts at 65. If she died during the term, her husband would receive the remaining payments. The guaranteed period lets her plan without drawing down investments in a falling market.
Example
A manufacturing company settles an injury claim by buying a 10-year annuity that pays the claimant $30,000 a year. The company records the obligation at its present value. The claimant gets a guaranteed income without relying on the company's later finances. The structure also gives the company certainty about its total cost.
Example
A parent buys a 4-year annuity paying $12,000 a year to cover university fees for a child. The payments match the known length of the degree, and any leftover would pass to the child if the parent died. The annuity is chosen because the end date is known.
Formula
Calculation
Present value = payment / (1 + r) + payment / (1 + r)^2 + ... + payment / (1 + r)^n
An annuity pays $10,000 at the end of each year for 3 years, discounted at 5%.
Year 1: 10,000 / 1.05 = $9,523.81
Year 2: 10,000 / 1.1025 = $9,070.29
Year 3: 10,000 / 1.157625 = $8,638.38
Present value = 9,523.81 + 9,070.29 + 8,638.38 = $27,232.48
Shortcut: present value = payment x annuity factor, where the annuity factor for 3 years at 5% is 2.72325, so 10,000 x 2.72325 = $27,232.50 (the small difference is rounding).Case study
Seen in the real world.
Larkspur Wealth Planning is an illustrative, fictional advisory firm. A client, Mr Hale, wanted to retire at 60 but could not draw his pension until 65.
The adviser proposed a term certain annuity paying $36,000 a year for five years, priced at roughly $165,000 using the prevailing interest rate. This gave Mr Hale a guaranteed bridge income and left his pension untouched.
Mr Hale liked that the annuity ended exactly when his pension started. The illustrative lesson is that matching a guaranteed payment period to a known gap in income is a simple and effective way to manage retirement cash flow. Mr Hale also noted that the quoted price fell slightly when rates rose, which helped him decide to buy sooner.
Watch out
Common mistakes.
- Confusing a term certain annuity with a lifetime annuity, which pays until death. A life annuity continues for as long as the person lives, which makes it better for longevity risk but harder to price.
- Forgetting that income stops when the term ends, even if the recipient is still alive. The only way to continue income is to buy a new product or draw on other savings.
- Ignoring the discount rate when comparing the price of one annuity with another. Comparing the present values at the same discount rate gives a fair like-for-like view.
Questions
People also ask.
What happens if the recipient dies during the term?
The remaining payments are normally paid to the named beneficiary or the estate.
Is the income guaranteed?
It is guaranteed by the provider, so the strength of the provider matters.
How is it taxed?
Tax treatment varies by country and by how the annuity was funded, so a tax adviser should be consulted.
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