Annuity

An annuity is a financial product that pays a stream of income over time, typically used to provide retirement income. Annuities can be purchased from insurance companies and other financial institutions, and they convert a lump sum into a series of payments, providing insurance against the risk of outliving one's resources.

Types of Annuities

Annuities can be classified in several ways. Immediate annuities begin paying income shortly after purchase, while deferred annuities accumulate value before payments begin. Fixed annuities pay a guaranteed amount, while variable annuities pay amounts that depend on the performance of underlying investments.

Annuities may be life-contingent, paying for the lifetime of the annuitant, or term-certain, paying for a fixed period. Life annuities provide longevity insurance, since the payments continue as long as the annuitant lives, while term annuities provide income for a specified period regardless of survival.

Longevity Insurance

The principal economic function of a life annuity is to insure against longevity risk, the risk of outliving one's assets. By pooling the resources of many individuals, an annuity provider can offer a lifetime income that no individual could guarantee alone, because the risk of living longer than expected is shared across the pool.

The value of longevity insurance depends on the probability of survival and on the cost of the annuity. Individuals who expect to live long, or who are risk averse about outliving their assets, derive the most value from annuitisation. The presence of bequest motives, of health shocks, and of other sources of income affects the optimal degree of annuitisation.

The Annuity Puzzle

The annuity puzzle refers to the observation that, despite the theoretical value of annuitisation, many households annuitise only a small fraction of their wealth. Several explanations have been offered, including the desire to leave a bequest, the presence of other insurance such as social security, adverse selection in annuity markets, and the reluctance of individuals to give up control of their assets.

The puzzle has implications for the design of retirement systems and for the analysis of household behaviour. Policies to encourage annuitisation include favourable tax treatment, mandatory annuitisation of part of pension wealth, and the provision of public annuities through social security.

Actuarial Basis

Annuity pricing is based on actuarial assumptions about mortality, interest rates, and expenses. Mortality tables are used to estimate the probability of survival at each age, and the present value of expected payments is calculated using an interest rate. Expenses and the insurer's margin are added to the price.

Adverse selection is a concern in annuity markets, since individuals who expect to live longer are more likely to purchase annuities, raising the average longevity of the pool and the cost of providing income. The design of annuities and the regulation of markets seek to address this problem, and the pricing reflects the mortality experience of purchasers.

Fixed and Variable Annuities

Fixed annuities guarantee a specified payment, either a fixed amount or a minimum return, and shift the investment risk to the insurer. They provide certainty of income, which is valuable for risk-averse individuals who want to avoid the possibility of a decline in income.

Variable annuities link the payments to the performance of underlying investments, so that the annuitant bears the investment risk. They offer the potential for higher returns but also the risk of lower income if investments perform poorly. The choice between fixed and variable annuities depends on the preferences of the individual and on the terms offered.

Deferred Annuities

Deferred annuities accumulate value before payments begin, providing a way to save for retirement with the option to convert the accumulated value into income later. They may be purchased with a lump sum or with periodic contributions, and the accumulated value grows tax-deferred in many jurisdictions.

The decision of when to annuitise involves considerations of mortality, of interest rates, and of the terms available. Annuitising later preserves flexibility but exposes the individual to the risk of adverse changes in annuity prices and of cognitive decline that impairs financial decision-making.

Annuity Markets

Annuity markets vary in their depth and in their competitiveness across countries. The supply of annuities depends on the availability of long-term assets that can match the longevity of the liabilities, and on the regulatory and tax environment. The demand depends on the incentives created by the pension system and on the preferences of households.

The development of annuity markets is affected by the challenges of pricing longevity risk and by the potential for adverse selection. Measures to support the development of these markets include the provision of public annuities, the regulation of private annuities, and the design of tax incentives.

Public Annuities

Public pension systems often provide annuities through social security, paying benefits for life and pooling longevity risk across the population. These systems address the annuity puzzle by providing mandatory or default annuitisation, ensuring that individuals have some lifetime income.

The design of public annuities involves trade-offs among adequacy, sustainability, and the incentives they create. The level of benefits, the retirement age, and the indexation of payments all affect the adequacy and sustainability of the system, and they shape the behaviour of households and of the labour market.

See also

• Financial Asset
• Rate of Return
• Risk Sharing