Annuity Insurance: Securing Your Retirement
Annuities are contracts between individuals and insurance companies. For the purpose of securing their retirement, individuals provide investment funds to the companies, who provide the means to enlarge the funds over time. When the individuals retire, the companies distribute income back to them over the remainder of their lives.
For decades, students of annuities have been baffled and amazed by a paradox. Although annuities are offered by insurance companies, they are investment products; they provide future income in return for current saving. Yet despite the fact that their core purpose is to promote investment, annuities provide benefits that function as insurance in the true economic sense. Understanding this paradox is vital to appreciating the value of annuities.
The Logic of Insurance
People buy insurance to avoid risk. For example, a head of household might purchase life insurance in order to offset the risk of dying during his or her working lifetime. If the insured dies, the insurance policy benefit offsets the loss of income suffered by the family. If the insured survives, the risk of premature death has been eliminated at the cost of the premiums paid on the policy. This illustrates the general principle behind insurance – the substitution of cost for risk.
Annuities as insurance
The purchase of an annuity contract redistributes consumption over time by increasing current saving and investment in order to increase future consumption. That is the investment benefit of the annuity. Many benefits of annuities, however, are analogous to those provided by insurance. In each case, the benefit reduces or eliminates a risk. In each case, the annuity holder incurs a cost in order to get the benefit.
The Risk of Dying Too Soon
The most obvious example is the death benefit available in most annuity contracts. Rather than allow any undistributed proceeds to revert to the insurance company, it is common for annuity holders to select a beneficiary or beneficiaries to inherit any undistributed funds in the accumulation account – less any partial withdrawals made earlier – when the holder dies. This allows the holder to kill two birds with one stone – saving for retirement while making financial provision for survivors.
The annuity purchase can be thought of as “annuity insurance.” It is a mixed strategy for dealing with the risk of premature death. At one extreme is the purchase of life insurance, which eliminates the risk at the cost of premium payments. At the other extreme is self insurance; the head of household bears the risk but accumulates assets to cushion its impact. The annuity purchase contains elements of both of these pure strategies. The annuity is an asset. The death benefit is a guaranteed minimum benefit to survivors, although less than would be provided by a life-insurance policy. The death benefit represents insurance in the true sense because it adds to the cost of the annuity contract.
Another way of reducing the risk of premature death is by modifying the annuity distribution plan. The joint life and survivor annuity, for example, continues lifelong annuity payments to the surviving owner of a jointly-held annuity contract. Again, the extra cost of this feature makes it “annuity insurance.”
The Risk of Living Too Long
Annuity holders enjoy the privilege of annuitization, which guarantees the receipt of a lifelong stream of income to the holder. This guarantee solves an age-old problem – how to insure that withdrawals from a finite sum of money will last for the indefinite length of a human lifetime. This is “annuity insurance” because cost substitutes for risk. The true economic cost of annuitization is not embodied in the payments made to the insurance company but rather in the loss of control over the principal suffered by the annuitant in order to obtain the guarantee.
Third parties can use “annuity insurance” to solve problems of longevity risk for employees or citizens. Pensions are a form of annuity, and employers can fund company pensions by purchasing single-premium annuities for employees. Government-run retirement programs are sometimes referred to as “social insurance,” which makes it fitting that private “annuity insurance” take over when the government programs collapse under the weight of their unfunded obligations. Chile is one country that has successfully privatized its public old-age and retirement system using private annuities to substitute for government transfer payments.
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Premature death is not the only risk borne by heads of household, who earn income upon which others depend. Another risk is disability, which would not kill the earner but would reduce or eliminate income-earning capability. Once again, the pure strategy to eliminate this risk is to substitute premium payments for it by purchasing disability insurance directly. Self-insurance would dictate accepting the risk but accumulating assets that could be drawn down in the event of disability. “Annuity insurance” is a mixed strategy, combining asset accumulation with a provision in the annuity contract allowing penalty-free withdrawals by the holder in the event of disability. Since the disability provision increases the expenses of the annuity contract, this is insurance in the true economic sense.
Some purchasers of annuities strive to eliminate still another form of risk – the loss of wealth in liability litigation. Since many states shield assets held in life insurance policies from attachment in liability litigation, business owners and professionals often choose to hold wealth in the form of annuities. If this “annuity insurance” changes the composition of their portfolio – if, in other words, they would hold stocks or mutual funds if forced to self-insure against liability loss – then the lower rate of return they suffer is the true economic cost of the “liability insurance” they are “buying” by purchasing annuities. Alternatively, they may view annuities as the optimal investment choice, in which case the protection against liability loss is a valuable byproduct of that choice.
The three types of deferred annuity – fixed, variable and indexed – all contain various options, features and riders designed to limit the variance of investment outcomes during the accumulation period and set a floor under total accumulations. Risk is defined as variability of possible outcomes, so the intention and effect of these measures is to reduce the risk borne by policyholders. Fixed annuities offer an initial guaranteed interest rate credited to accumulations and often allow holders to exit the annuity without penalty if subsequent interest rates fall too far below the initial guaranteed rate. Indexed annuities offer guaranteed minimum interest rates and accumulations and massage the index number in ways designed to reduce extreme values. Variable annuities offer guaranteed minimum accumulations. Recent Living Benefit riders provide guarantees for withdrawals, accumulations and annuitization. Although the details of the various guarantees differ from one type to another and from product to product, all are intended to reduce the risk of downward fluctuations in holders’ portfolios. Since holders pay for these measures in higher expenses or lower returns, the provisions are indeed “annuity insurance” in the true economic sense.
There are other, more specialized, uses for “annuity insurance.” One of those is an annuity used to pay premiums on an insurance policy – typically, the policy insures a key person in a business and the annuity guarantees that the policy will remain in force regardless of the business’s cash-flow situation.
The foregoing catalogue is illustrative but not exhaustive. The insurance industry has proven remarkably inventive in finding new ways to reduce risk through annuities. The high expenses of the annuity product – a common source of complaint – are the inevitable result of this innovation, since each risk reduced or eliminated has a cost that must be borne.
The Right Strategy
We recognize that buying insurance is the right thing to do in some situations. Insurance is not right for everybody, however. Sometimes there is no risk to insure against; other times, the degree of risk doesn’t justify the cost of the insurance. If each pure strategy – buying insurance and accepting risk – is sometimes correct, it shouldn’t be surprising that the mixed strategy of “annuity insurance” is also right for some people.
Investment and insurance are pillars of a secure retirement. When used properly, annuities are a tool that can solidify each one.
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