What are annuities?

Jack Woida

They are the reverse of blended payment loans.A mortgage is a blended payment loan.  By blended payment, I mean that the periodic payments (usually monthly) blend both a principal payment and an interest payment.The way a mortgage works is that you borrow a certain amount of money.  Let's say $100K.  Then you make monthly payments to pay the interest on the loan, plus repaying a portion of the amount borrowed, ie: the principal.At the beginning of the loan, almost all of the payment goes toward interest, but a tiny fraction goes towards paying off the principal. On the next payment, there's slightly less principal outstanding on the loan so the interest payment is a little less and slightly more of the fixed monthly payment goes toward reducing the principal.This process goes on over the lifetime of the loan and towards the end of the loan, almost all of the fixed monthly payment goes toward paying the principal and almost none of it to paying interest, because there's very little principal remaining to pay interest on.For example, a 25 year $100,000 mortgage at 5% annual interest would have 300 monthly payments of $584.59.  Here's how much of each monthly payment would go to principal and interest: ​And here's how much principal would still be owing on the loan after each payment: ​After 25 years, or 300 monthly payments, the loan is fully paid off and you have paid a total of $75,791.95 of interest.Now, for an annuity we just reverse the whole process.  Instead of borrowing money from someone and paying them fixed monthly payments, you give someone money, and they pay you fixed monthly payments, the same thing as if you were the person holding the mortgage, who had lent the money and is now receiving the interest payments.  In fact, technically, a mortgage is a form of annuity.So for example, say you have saved $100,000 for your retirement and you give it to someone who promises to pay you a 5% annuity over 25 years.  In this case you would get 300 monthly payments of $584.59.  After 25 years you would have been paid pack your $100,000 plus an additional $75,791.95.The difficulty with all of this is that the person who takes your money in return for a promise to pay you back monthly payments with interest must invest your money at a higher rate of return then they pay you.  This is how they make their money.So for example, if they promise to pay you a return of 5%, then they believe they can invest your money at 6% or higher.  In other words, an annuity typically pays returns that are below what you could typically get in the open market.There are many different ways you can structure the term of an annuity.What I've described above is a fixed term annuity where the lifetime of the annuity is fixed, exactly like a mortgage.  But this doesn't have

to be the case.  Life insurance companies for example can offer an annuity, often used for retirement purposes, where you make monthly payments into the annuity during your working years, and then they make monthly payments back to you after you retire that continue to death.  In this case the duration of the annuity is unknown in advance, so the insurance companies use actuarial tables to figure out how long people live on average and set their payments accordingly.

There can also be perpetuity annuities that can theoretically make periodic payments forever.  This is often used by philanthropists to endow some institution or position.  For example it's reasonable to expect a long term rate of return of 5% on a conservatively invested portfolio, so by donating $1M it's possible to set up an annuity of $50K a year in perpetuity.

Chris Bartolotta

The way I typically explain annuities to the uninitiated is that they are essentially the opposite of life insurance. A life insurance policy protects against the financial consequences of your death, whereas an annuity protects against the financial consequences of a long life. They usually do this by taking a lump sum of cash from you, then immediately starting payments to you of an agreed-upon amount monthly or annually, guaranteed for your lifetime, no matter how long you live. The act of converting your chunk of cash into a stream of payments like this is called "annuitization," and as such, the type of contract I've just described is known as a "single premium immediate annuity," or SPIA. This type of contract has been around for centuries in one form or another. My favorite annuity-related quote I've stumbled across is from Voltaire, who died in 1778: "I advise you to go on living, solely to enrage those who are paying your annuities. It is the only pleasure I have left."The amount of your payment in this type of contract is based on your life expectancy, which in turn is based on your age and gender - there is usually no medical underwriting involved like there is with life insurance. The idea is that you'll have the security of a guaranteed income, even if you live to be 150.This is the simplest type of annuity, and there are several others out there. The bulk of annuity sales are in indexed and variable products, which are a bit more complicated and probably warrant their own answers.

The mistake you will often see is that annuities are very frequently compared to investments: "How much money can I invest into this annuity, and what kind of return can I get?" This usually leads to inflated expectations as far as what the contract is supposed to do, and in turn a lot of the rhetoric you'll see about annuities being products that are "sold, not bought." The bottom line is that you don't buy an annuity to get rich; you buy it to guarantee that you'll never be poor.

Category: Annuity

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