What is... | March 19, 2014

What is an annuity?

When saving money for a home deposit or new car, we typically have a firm monetary figure as an aim. But when saving for retirement, the situation is a bit different.


 No one can be sure exactly how long retirement will last and, therefore, it can be difficult to judge if too little – or too much – money is saved to cover it.
An annuity is one way to address this challenge and manage the risk of outliving your resources, made more urgent by increased life expectancies, uncertainty about future interest rates and state pension changes in many countries.

Even the Romans had annuities
In its simplest form, an annuity is bought for a certain sum then payments of a fixed amount of money are made each month to the holder until they die.
In his 2008 analysis of annuity market issues, Argentinian economist Dr Gustavo Ferro wrote that the origins of annuities date back as far as ancient Rome, when annua promised a stream of payments for a fixed term, or a lifetime, in return for an up-front payment. Ferro writes that the modern annuities market, in which private insurance companies sell insurance contracts to individuals who wish to avoid the risk of outliving their resources, emerged in the 1700s.
These days, annuities are popular in some countries, while in others there is only a small or no market.
Defined benefit (DB) pension schemes effectively provide people with an annuity when they retire however, as Ferro writes, the shift towards defined contribution (DC) schemes is putting annuities increasingly in the spotlight.
Discussion of annuities is part of what was termed “pension decumulation” in the paper Annuities for an Aging World (or the process by which retirees finance their consumption during retirement) as opposed to the much-analysed “accumulation” (saving and investing) phase.

Insuring against “longevity risk”
Someone who lives until their nineties or beyond will need more money than a person with a similar retirement lifestyle who lives until age seventy.
The uncertainty of how long retirement will be is known in financial circles as “longevity risk”. Like all investments, annuities carry a degree of financial risk.
One of the risks is that the holder of the annuity dies at a younger age (at seventy, for example, when they might have had five years of payments) and does not get as high a return as a holder who lives much longer (until ninety, when they might have had 25 years of payments).
People who live longer get more income from their annuity – so it is similar to taking a bet of survival to a ripe old age.
Some types of annuities will also insure against other risks, with perhaps the best known being the policies that have payments linked to inflation – protecting against an environment where inflation rises rapidly and eats away at spending power.

Falling rates?
The British Queen Mother died aged 101 in 2002 and researchers write there will be several million centenarians by 2050.
The fact that humans are living longer is a wonderful thing for many people however one of its implications relates to how retirement is funded and the amounts annuities will regularly pay.
As the eZonomics article How to survive falling annuity rates says, companies that sell annuities need to ensure they have enough money to pay the person who survives to 101 as well as those who die earlier.
With people living longer, the amount paid by annuities has tended to decline and contributed to the debate about the most effective ways to use money saved for retirement.

Shop around
Whether an annuity is the right fit for a retiree will depend on individual circumstances.
The decision may be impossible, difficult or costly to reverse, so taking time to fully research it – and getting expert advice, as required – is a good idea.
Shopping around to compare policies to see which company – or companies – offers the best rate for individual circumstances is another helpful step. There are many choices, with, for example, “enhanced annuities” existing in some markets for people with medical conditions or certain lifestyle factors, or the option to go for a policy offering guaranteed payments for a set period even if the policy holder dies earlier.
Online annuity calculators may provide another avenue to help inform this important decision.

InvestingRetirementPensions

eZonomics team
.(JavaScript must be enabled to view this email address)

Have your say

Should banks incentivise you more to boost your savings?