Insurance Annuities: Protecting Your Retirement

Today the word "annuity" refers to an investment contract between an insurance company and one or more individuals. Originally, however, the word denoted the stream of lifelong payments from insurance company to annuity holder that represented the final phase of the contract.

This highlights a fascinating conceptual duality that is unique in financial economics. On the one hand, annuities are recognized as investments even though they are issued by insurance companies. On the other hand, certain benefits and features of annuities function as insurance in the true economic sense. Nowhere does this notion of “insurance annuities” stand out more clearly than with lifetime annuities.

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Archetype of Insurance Annuities: The Lifetime Annuity

In its classic form, the lifetime annuity is a series of level, regular income payments made by an insurance company to an annuity holder. The holder purchases this payment stream either with a single premium or with many regular premiums spread out over time. The payments last for the duration of the holder’s life, terminating at death, when all remaining value in the contract reverts to the insurance company.

This arrangement is a mirror image of the classic life-insurance policy, which insures against the holder’s dying prematurely. By making premium payments to the insurance company, the holder eliminates this risk (which would otherwise be borne by those depending on income earned by the holder), substituting instead the cost of the premiums. The lifetime annuity insures against the risk that the holder’s ratio of consumption to wealth will exhaust the latter during the holder’s lifetime. This risk is not to be taken lightly, since nobody can predict how long they will live.

The cost of taking out this insurance, in the form of an annuity, is an implicit one; it is the difference between the lower income received from a lifetime annuity and the higher income available from riskier investments such as stocks and mutual funds. Insurance is the substitution of cost for risk; cost is the highest-valued alternative foregone; risk is variability of possible outcomes. The lifetime annuity eliminates the risk by guaranteeing income for life; the purchase of the annuity forecloses the option of purchasing higher-paying stocks or mutual funds; this foreclosed option is the real economic cost of acquiring the “insurance annuity.”

Additional Insurance Annuities: Death-Benefit and Minimum-Guarantee Features

The classic lifetime annuity implies the forfeiture of remaining value to the insurance company. Perhaps inevitably, annuity holders sought to capture any remaining accrued value in the contract for their heirs. (The notion of accrued contract value stems from the fact that the insurance company invests funds received from annuity contract purchasers. In deferred annuities, this value increases during the accumulation period before being disbursed during the distribution period.) By incurring additional expense, the annuity holder can provide a death benefit to one or more beneficiaries named by the holder.

This death benefit is very closely analogous to that provided by life-insurance policies. It is tied to the value of the annuity contract, however, rather than directly to the life-insurance need of the holder. Typically, the minimum death benefit will be the sum of payments made to the annuity or remaining contract value, less any partial withdrawals made by the holder. The value of the benefit presupposes a life-insurance need by the holder; that is the risk being mitigated by the death benefit, which is the insurance feature. The cost is the additional expense borne by the holder in the annuity contract.

Annuities commonly possess various kinds of minimum-guarantees. As retirement products intended to provide income when no employment income is forthcoming, annuities are designed to protect principal and provide a positive return. Hence, fixed annuities provide minimum guarantees for credited interest, the initial interest-rate term and credited income; variable annuities increasingly guarantee minimum withdrawals and income; indexed annuities put a floor under income and reduce index-related variations in credited interest. In all cases, the insurance provided is the reduction in variability of outcomes, which is the risk insured against; the cost is the resulting higher expense built into the contract.

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Insurance Annuities for Professionals

Business owners and professionals, such as doctors and lawyers, are particularly exposed to liability litigation. Since many states protect life-insurance assets from attachment in liability lawsuits, professionals often choose to hold wealth in the form of annuities. The limited liquidity of these assets orients them mostly toward retirement. Variable annuities are particularly suitable for younger professionals, whose portfolios are weighted toward growth. In these cases, the insurance is the liability shield provided by the annuity asset; the risk is the potential loss of assets to attachment in litigation; the cost is the higher level of expenses associated with variable annuities compared to (say) direct mutual-fund or exchange-traded-fund investment. Higher expenses produce a lower net return for the investor.

Insurance Annuities for Liability Plaintiffs

It is interesting to note that annuities offer insurance features to liability plaintiffs as well as (prospective) defendants. Liability judgments are often intended to replace periodic income (wage, salary or entrepreneurial) lost to injury or death. As a practical matter, this lost income is often vital to providing for the retirement of plaintiffs. Structured settlements or verdicts will often order a defendant to purchase an annuity to provide the functional equivalent of this periodic income. The court is legally bound to insure payment of this income to the best of its ability. It is legally desirable to have payment guaranteed by a responsible fiduciary such as an insurance company, rather than simply require the loser to make payment over time. The future is uncertain; an insurance company is a better bet to supply the money than any individual, let alone somebody who has committed a legal wrong. In this case, the insurance is the guarantee of future payment and the risk is the uncertainty that the defendant will cough up the money on schedule. The intriguing aspect of this situation is identification of the economic cost. Because economics does not differentiate morally between the winner and loser of the lawsuit, there is no basis for assigning a cost to the transfer between them. Really, the economic cost is the alternative use to which the resources devoted to litigation could have been put; this includes not just the purchase of the annuity but the other costs as well.

Summary

Among the insurance features provided by annuities are retirement-income insurance, life insurance, liability insurance and legal settlement insurance. In these cases, the features of insurance annuities provide the attributes of insurance within the annuity contract. Those attributes involve the reduction or elimination of variability in outcome. The essence of insurance is the substitution of cost for risk. Sometimes the cost of insurance annuities is explicit, sometimes implicit. Despite the fact that annuities are investment products, their insurance benefits are substantial indeed.

Of all the complications associated with annuities, none are as intriguing and complex as the interaction between investment and insurance that occurs throughout the range of annuity products. The last word on this fascinating relationship has yet to be written.

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