Annuity

Table of contents

1 Synopsis
2 Lifetime Annuities
3 Variants
4 Investment Basis
5 Actuarial Basis
6 Government Incentives

Synopsis

In finance, an annuity is a series of fixed payments, usually over a fixed number of years; or for the lifetime of a person, in which case it would be called a life-contingent annuity or simply lifetime or life annuity. A hybrid of these is when the payments stop at death, but also after a predetermined number of payments, if this is earlier: a temporary life annuity.

In each case the annuity may be immediate (payments start at the time of the contract) or deferred (payments start at a predetermined later time).

Lifetime Annuities

A lifetime annuity is most often used to provide an income in old age, i.e. a pension. The annuity may be purchased from an insurance company. In a typical annuity contract, an individual would pay a lump sum or a series of payments to an insurance company, and in return receive a fixed income payable for the rest of his life.

The annuity works somewhat like a loan that is made by the purchaser to the issuing company who then pay back the original capital with interest to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the investment relies on cross-subsidy as an annuity population can be expected to have a normal distribution of lifespans around the mean(average) age and therefore those dying earlier will support those living longer. This is known as mortality loss and mortaily gain

Cross-Subsidy remains one of the most effective ways of spreading a given amount of capital and investment return over a life time without the risk of funds running out.

Variants

At a cost to the payments, an annuity can be purchased with addition of another life such as a spouse on whose life the annuity is wholly or partly guaranteed. Other features such as a minimum guaranteed payment period irrespective of death, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.

Imparied life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the payment for the purchaser is raised.

Investment Basis

Because annuities generally give a series of guaranteed payments, they are priced consistently with other guaranteed investments, such as government bonds. These are less risky than other investments, such as the stock market, and offer a lower expected return than these. Sometimes annuities are based on investments expected to give a better return, and the risk of these may vary from funds that incorporate some form of protection (for example by purchasing derivatives) through to pure equity funds based on shares alone. At the riskiest end of the market where the fund is not held in trust, the annuity provider risks going bankrupt and possibly defaulting on the policy, as happened in Japan in the nineteen nineties.

Actuarial Basis

A collection of algebraic shortcuts known as annuity functions are used to model annuities, as well as a variety of other financial arrangements.

Government Incentives

Because of cross-subsidy and the guarantees an annuity can give against running out of income and becoming dependent on state welfare in old age, annuities often have a favourable tax treatment, which may affect how attractive they are relative to other investments.

Annuities are a compulsory feature of certain pension saving schemes in some countries, where the government grants tax deductions, provided that savings are paid into a fund which can only (or mainly) be withdrawn as an annuity. The United Kingdom and the Netherlands have such schemes. From 2003 the tax deduction in the Netherlands is only allowed if, without additional savings, the old age income would be less than 70 % of the current income.

In the United Kingdom a basic rate of tax credit is applied on cetain pension savings regardless of whether an individual pays tax and higher rate tax payers can claim additional rebates. Although a number of different regimes exist, personal pension funds taken out since 1989 must use at least 75% of the fund to purchase an annuity by the 75th birthday of the annuitant. If an annuity is not immediately purchased retirement income up until this age can be drawn from the fund by using Income Drawdown which operates under a strict code of rules and limits according to age and figures said by the Government Actuarial Deparment to prevent the fund being eroded too fast. Income Drawdown carries both the investment risk of the invested pension fund and mortality drag that occurs from the loss of cross subsidy and advancing average age expectancy that occurs in the time over which annuity purchase is delayed.

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