What it means
The basic bargain is that the buyer gives the insurer a sum of money and receives a stream of payments for life, whether that turns out to be 5 years or 40. The insurer can afford to do this by pooling many people together.
Those who die early subsidise those who live long, and this pooling is sometimes called mortality credit. Payments depend on the buyer's age, the amount paid in, prevailing interest rates and any options chosen.
Older buyers receive higher payments for the same price because the insurer expects to pay for fewer years. Options include payments that rise with inflation, guaranteed minimum periods and continuing income for a surviving spouse, and each option reduces the starting payment.
The income can start immediately, in which case it is an immediate annuity, or at a future date, in which case it is deferred. Pension schemes and individuals use whole life annuities to turn a pot of savings into a predictable income.
Companies sometimes buy them in bulk to take pension obligations off their balance sheets, a process called a buy-out. The main trade-off is flexibility.
Once the lump sum is paid, it usually cannot be taken back, and if the buyer dies soon afterwards the insurer may keep the balance unless a guarantee period was bought. This is why people often split their savings between an annuity for essential spending and flexible investments for everything else.
Because the income depends on the insurer, its financial strength matters. In many countries there are protection schemes if an insurer fails, but limits apply.
Compare quotes from several providers, and check what happens to the income if the buyer's health or circumstances change. Tax treatment varies widely.
Part of each payment may be treated as a return of your own money and part as taxable income, and the rules differ by country. Seek advice before buying.
In practice
Real-world examples.
Example
A retiring manager uses $240,000 of her savings to buy an annuity paying $15,000 a year. Together with her state pension, the income covers her basic living costs, and she keeps the rest of her savings invested. She reviews the split every few years in case her spending needs change.
Example
A pension scheme for a manufacturing company buys annuities for all its retired members from an insurer. The company's balance sheet then no longer carries the pension risk, and the finance director records the settlement in the accounts.
Example
A couple chooses a joint life annuity that continues paying two-thirds of the income to the survivor. The initial payment is lower than for a single-life annuity, but it protects the surviving spouse. Their adviser shows them that the reduction is roughly the price of that protection.
Formula
Calculation
Break-even period (years) = price paid / annual annuity payment
Suppose a 65-year-old pays $240,000 for a whole life annuity that pays $15,000 a year. The break-even period = 240,000 / 15,000 = 16 years. If the buyer lives beyond age 81, the total payments exceed the price paid, and if the buyer dies earlier, the insurer has paid out less than the purchase price. This ignores the time value of money, so the true break-even is somewhat longer.Case study
Seen in the real world.
Hartwell Trading is an illustrative, fictional company with a small pension scheme of 40 retired members. The trustees worried about the cost of paying pensions if members lived longer than expected, and asked the finance director to explore a buy-out.
An insurer quoted $9,600,000 to take on all payments, which together came to about $720,000 a year. The break-even period was 9,600,000 / 720,000 = 13.3 years, so the insurer was pricing in an average remaining life well beyond that.
The company paid the premium from a mix of scheme assets and a one-off contribution, and the risk of members living longer passed to the insurer. The illustrative lesson is that a life annuity swaps uncertainty about lifespan for a fixed price, so the decision turns on how much risk the buyer is willing to carry. The trustees also kept a small reserve for members whose benefits were still being confirmed, because late changes to records are common in older schemes.
Watch out
Common mistakes.
- Putting all retirement savings into an annuity, which removes flexibility and access to the money for emergencies.
- Ignoring inflation, when a fixed income buys less each year unless an inflation-linked option is chosen.
- Accepting the first quote, when rates differ between insurers and health or smoking status can raise the payment.
Questions
People also ask.
What happens when the annuitant dies?
Payments normally stop, unless the buyer chose a guarantee period or a survivor benefit. Both options lower the starting income, so they should be chosen deliberately.
Is a whole life annuity the same as whole life insurance?
No, insurance pays a sum when you die, while an annuity pays you an income while you live.
Can I cancel after buying?
Usually not, though some contracts allow a short cooling-off period during which the buyer can change their mind and receive a refund. After that window closes, the decision is normally final.
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