What it means
An annuity is a series of regular payments, usually bought with a lump sum from an insurer. Most people think of lifetime annuities, which pay as long as the holder lives.
A years certain annuity works differently, since the number of payments is fixed in advance at, say, 10 or 20 years. Because the payments do not depend on how long someone lives, the insurer does not need to take longevity risk, which is the risk of someone living longer than expected.
The price is therefore closer to a simple present value calculation of a fixed stream of payments, adjusted for the insurer's costs and profit. The structure is straightforward and easy to compare.
A common variant combines the two ideas: a life annuity with a guaranteed period, such as life with 10 years certain. The income lasts for life, but if the holder dies within the first 10 years, payments continue to a beneficiary until the 10 years are complete.
This protects a family from losing the whole investment after an early death. For businesses, a years certain annuity can be used to settle a known liability over a fixed term.
A company agreeing a structured settlement, or funding a fixed-term pension obligation, can buy an annuity that matches the payments it owes. The match reduces the risk that investments underperform.
Choosing between types depends on the need. A years certain annuity suits someone who wants income only for a specific time, such as until a pension begins or a child finishes studying.
A lifetime annuity suits someone worried about outliving their savings. Taxes, inflation and the insurer's strength should also be considered.
Payments are usually fixed in dollars, so rising prices reduce their buying power over a long period, and the buyer depends on the insurer's ability to pay. Tax treatment varies by country and by the type of fund used to buy the annuity, so advice is worth taking before purchase.
In practice
Real-world examples.
Example
A woman retires at 60 and wants a guaranteed income for 5 years until her state pension begins. She buys a 5-year years certain annuity with part of her savings. The income bridges the gap without tying up her money for life.
Example
A company settles a legal claim by agreeing to pay $50,000 a year for 8 years. The finance team buys a years certain annuity from an insurer that matches those payments exactly. The company removes the obligation from its own balance sheet and the risk from its cash planning.
Example
A parent buys an annuity paying a set sum for 12 years to cover a child's education until age 18. If the parent dies early, the payments continue to the child's guardian. The plan keeps the funding intact and the guardian does not have to manage a lump sum. The parent chooses this partly for the certainty it gives the family.
Formula
Calculation
Present value = payment x [1 - (1 + r)^(-n)] / r
Suppose an insurer pays $20,000 a year for 10 years, and the discount rate is 5%. The annuity factor = [1 - (1.05)^(-10)] / 0.05 = (1 - 0.6139) / 0.05 = 7.7217. Present value = 20,000 x 7.7217 = about $154,435. The total of the payments is 20,000 x 10 = $200,000, so the difference of about $45,565 reflects the interest earned during the payout period.Case study
Seen in the real world.
Redwood Mutual is an illustrative, fictional insurer that sells annuity products. A client aged 58 wanted income from age 60 for exactly 10 years, until a rental property loan would be repaid.
The adviser explained that a lifetime annuity would be more expensive for the same income because it paid for life. Redwood quoted a 10-year years certain annuity for a purchase price of $154,000, paying $20,000 a year.
The client chose the fixed period, and her husband was named as beneficiary in case she died early. The adviser also noted that the payments were fixed in dollars, so rising prices would reduce their buying power by the end of the period. The client accepted this because the income was meant to cover a specific loan. The illustrative lesson is that matching the length of the income to the real need can lower the cost.
Watch out
Common mistakes.
- Assuming payments continue for life, when a years certain annuity ends after the stated number of years.
- Believing payments stop on the holder's death, when they continue to a beneficiary for the rest of the period.
- Comparing the total of payments with the purchase price without allowing for the time value of money.
Questions
People also ask.
What is a years certain annuity?
It is an annuity that pays a fixed income for a set number of years, regardless of whether the holder lives.
What happens if the holder dies during the period?
The remaining payments go to the named beneficiary until the period ends.
How does it differ from a life annuity?
A life annuity pays as long as the holder lives, while a years certain annuity pays for a fixed time only.
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