I thought everyone knew how annuities worked.
I was wrong.
Finance students learn the basic annuity calculation really early on in their first term. Because everyone I work with, and many people I socialize with, knows what an annuity is and how to find its value, I tend to assume that everyone does. But they don’t!
Because annuities are so foundational to finance, I thought it would be a good idea to talk about them. The annuity calculation is used to find loan payments and many types of retirement benefits.
The basic definition
An annuity is a stream of regular payments over a specified time period. The equation looks forbidding, but it really isn’t:
Let’s say you’re borrowing money. You’re agreeing to make a stream of regular payments for 5 years if you’re buying a car or 30 years if you have a home mortgage. In other words, the bank is buying an annuity from you.
The amount of money that you are borrowing is the present value, and the payment is a function of the interest rate and the number of payments that will be made. Each payment covers the interest accumulated to date and a reduction in the total amount owed. Interest will accumulate until the loan is paid off, so your total payments will exceed the amount borrowed.
(Every time someone on social media posts something about student loans and wants someone to “explain it like I’m 5” why they paid twice the amount they borrowed and still owe money, I want to throw my phone across the room. I will explain it like you’re a grownup: interest accumulates on the outstanding balance. If you pay the loan off early, you will pay less interest. The best way to screw your lenders is to pay your loan off in full and on time.)
If you buy an annuity from a financial services company, the process is reversed. You give them money, and they give you a regular stream of payments. The payments are larger than the number of payments divided by the cost of the annuity because each payment includes both interest and repayment of the principal that you turned over. If pay $100,000 for an annuity that pays once a month for 10 years (120 payments) at 6% interest, you will receive $1,104.68 per month.
Bankrate has a handy calculator you can use to find a simple annuity’s value. You can buy them from insurance companies. Start by looking at the web site of whatever financial services companies you already use.
What about life annuities?
A life annuity pays out for the rest of your life. These are offered by insurance companies, which take on the risk of you living longer than the mortality tables suggested. On the other hand, if you die the day after you buy the annuity, the insurance company keeps the money. (Unless you pay extra for a guaranteed return of premium.)
These are a common way to manage retirement income because life annuities are relatively cheap. You take part of your retirement savings, buy a fixed life annuity, and get regular income for the rest of your life. Easy, peasy.
Immediate versus deferred annuities
So far, I’ve been talking about immediate annuities, which start paying when you buy them. You can also buy deferred annuities by paying for them now but not collecting the first payment for several years. I did this a few years back as a substitute for long-term care insurance. I won’t collect until I turn 80. In the meantime, the amount that I paid is invested to generate a return that will increase the amount of that first payment.
To go back to the loan example, a student loan is a lot like a deferred annuity: the student borrows the money now but doesn’t have to start paying until graduation or otherwise leaving school. Payment can often be pushed off during grad school or military service, but the interest continues to accrue. Each year of student loan deferment increases the size of the eventual payment.
From simple and cheap to complicated and expensive: Fixed versus variable annuities
So far, I’ve been talking about fixed annuities, which generally pay more than bonds—but not much more. Insurance companies invest the money in relatively low-risk things like real estate and corporate financing.
But the payment on a fixed annuity doesn’t go up with inflation. Also, many people buying a deferred annuity would like a larger average return than they can get from typical insurance-company investments. These folks can opt for variable annuities, which invest in mutual-fund like accounts that take on more risk in the pursuit of greater returns. This adds to the cost.
In summary:
Fixed annuities are a cheap way to guarantee income for a fixed amount of time.
Fixed, life annuities are cheap way to get guaranteed retirement income, but if you die early, you may not get your money’s worth.
If you want to make sure a life annuity returns at least the premium paid, you’ll pay extra.
If you want an annuity with payments that keep up with inflation, you’ll pay extra.
If you want a deferred annuity that generates a better return than the bond market, you’ll pay extra.
In other words, annuities quickly go from reliable basic transportation to fully loaded luxury vehicles, with costs varying accordingly. Because the commissions on the fancier models are higher, salespeople may push you to buy far more than you need.
Few of these are inherently good or bad (except for indexed annuities, which are generally so terrible that I didn’t mention them until now.) Just make sure you aren’t paying for more than you want or need.
Got any thoughts or questions? Share them in the comments.