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A life annuity is a financial contract in the form of an insurance product according to which a seller (issuer)—typically a financial institution such as a life insurance company—makes a series of payments in the future to the buyer (annuitant) in exchange for the immediate payment of a lumpsum (single-payment annuity) or a series of regular payments (regular-payment annuity), prior to the onset of the annuity. The payment stream from the issuer to the annuitant has an unknown duration based principally upon the date of death of the annuitant. At this point the contract will terminate unless there are other annuitants or beneficiaries in the contract, and the remainder of the fund accumulated is forfeited. Thus a life annuity is a form of longevity insurance, where the uncertainty of an individual's lifespan is transferred from the individual to the insurer, which reduces its own uncertainty by pooling many clients. Annuities can be purchased to provide an income during retirement, or originate from a structured settlement of a personal injury lawsuit.

Contents

Phases

There are two possible phases for an annuity: the accumulation phase in which the customer deposits and accumulates money into an account, and the distribution phase in which the insurance company makes income payments until the death of the annuitants named in the contract. It is possible to structure an annuity contract so that it has only the distribution phase; such a contract is called an immediate annuity. Annuity contracts with a deferral phasedeferred annuities—are essentially two phase annuities, but only having growth of capital by investment in the accumulation phase (now the deferral phase), with no customer deposits.

The phases of an annuity can be combined in the fusion of a retirement savings and retirement payment plan: the annuitant makes regular contributions to the annuity until a certain date and then receives regular payments from it until death. Sometimes there is a life insurance component added so that if the annuitant dies before annuity payments begin, a beneficiary gets either a lump sum or annuity payments.

Deferral

The option to defer the annuity purchase (income drawdown) has the benefit of investment flexibility, but the risk of falling annuity rates as the life expectany of the surviving individual rises (mortality drag). Interest rates and inflation can affect the decision to purchase, as they are reflected in the annuity rates, and also affect secure investment potential by varying bond yields. Inflation deteriorates the buying power of an annuity and can therefore be a concern.

Types of life annuity

With the complex selection of options available, consumers can find it difficult to decide rationally on the right type of annuity product for their circumstances.[1]

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Fixed and variable annuities

Annuities that make payments in fixed amounts or in amounts that increase by a fixed percentage are called fixed annuities. Variable annuities, by contrast, pay amounts that vary according to the investment performance of a specified set of investments, typically bond and equity mutual funds.

Variable annuities are used for many different objectives. One common objective is deferral of the recognition of taxable gains. Money deposited in a variable annuity grows on a tax-deferred basis, so that taxes on investment gains are not due until a withdrawal is made. Variable annuities offer a variety of funds ("subaccounts") from various money managers. This gives investors the ability to move between subaccounts without incurring additional fees or sales charges.

Guaranteed annuities

With a "pure" life annuity an annuitant may die before recovering the value of their original investment in it. If the possibility of this situation, called a "forfeiture", is not desired, it can be ameliorated by the addition of an added clause, forming a type of guaranteed annuity, under which the annuity issuer is required to make annuity payments for at least a certain number of years (the "period certain"); if the annuitant outlives the specified period certain, annuity payments then continue until the annuitant's death, and if the annuitant dies before the expiration of the period certain, the annuitant's estate or beneficiary is entitled to collect the remaining payments certain. The tradeoff between the pure life annuity and the life-with-period-certain annuity is that in exchange for the reduced risk of loss, the annuity payments for the latter will be smaller.

Joint annuities

Multiple annuitant products include joint-life and joint-survivor annuities, where payments stop upon the death of one or both of the annuitants respectively. For example, an annuity may be structured to make payments to a married couple, such payments ceasing on the death of the second spouse. In joint-survivor annuities, sometimes the instrument reduces the payments to the second annuitant after death of the first.

Impaired life annuities

There has also been a significant growth in the development of Impaired Life annuities. These involve improving the terms offered due to a medical diagnosis which is severe enough to reduce life expectancy. A process of medical underwriting is involved and the range of qualifying conditions has increased substantially in recent years. Both conventional annuities and Purchase Life Annuities can qualify for impaired terms.

United States

With a "single premium" or "immediate" annuity, the "annuitant" pays for the annuity with a single lump sum. The annuity starts making regular payments to the annuitant within a year. A common use of a single premium annuity is as a destination for roll-over retirement savings upon retirement. In such a case, a retiree withdraws all of the money he/she has saved during working life in, for example, a 401(k) (tax-advantaged) savings vehicle, and uses the money to buy an annuity whose payments will replace the retiree's wage payments for the rest of his/her life. The advantage of such an annuity is that the annuitant has a guaranteed income for life, whereas if the retiree were instead to withdraw money regularly from the retirement account (income drawdown), he/she might run out of money before death, or alternatively not have as much to spend while alive as could have been possible with an annuity purchase.

United Kingdom

In the UK the conversion of pension income into an annuity is compulsory by the age of 75, and has led to a large market for annuities of various types. The most common are those where the source of the funds required to buy the annuity is from a pension scheme. Examples of these types of annuity, often referred to as a Compulsory Purchase Annuity, are conventional annuities, with profit annuities and unit linked, or "third way" annuities. Annuities purchased from savings (i.e. not from a pension scheme) are referred to as Purchase Life Annuities and Immediate Vesting Annuities. In October 2009, the International Longevity Centre-UK published a report on Purchased Life Annuities (Time to Annuitise[1]) which argued that the PLA market might benefit up to 1.3 million individuals in the UK. Yet, less than 160,000 life annuities are in force with the number of policies having fallen by 65% in 10 years and new business in 2008 amounted to fewer than 1000 sales of life annuities

International

Some countries developed more options of value for this type of instrument than others. However, a recent study reported that some of the risks related to longevity are poorly managed "practically everywhere".[1] Longevity insurance is now becoming more common in the UK and the U.S. (see Futures) while Chile, in comparison to the U.S., has had a very large life annuity market for 20 years. [2]

History

The instrument's evolution has been long and continues as part of actuarial science.[3] Medieval German and Dutch cities and monasteries raised money by the sale of life annuities, and it was recognized that pricing them was difficult.[4] The early practice for selling this instrument did not consider the age of the nominee, thereby raising interesting concerns.[5] These concerns got the attention of several prominent mathematicians[6] over the years, such as Bernoulli, de Moivre, Huygens, Halley and others[5]. Even Gauss and Laplace had an interest in matters pertaining to this instrument.[7]

Continuing practice is an everyday occurrence with well-known theory founded on robust mathematics, as witnessed by the hundreds of millions worldwide who receive regular remuneration via pension or the like. The modern approach to resolving the difficult problems related to a larger scope for this instrument applies many advanced mathematical approaches, such as stochastic methods, game theory, and other tools of financial mathematics.

Future

It is expected that the aging of the boomer generation [8] in the US will increase the demand for this type of instrument and how it might be optimized for the annuitant; this growing market will drive improvements necessitating more research and development of instruments plus increase insight into the mechanics (including dynamics in more than the sense of the dynamical system) involved on the part of the buying public. An example of increased scrutiny and discussion is that related to privatization of part of the U.S. Social Security Trust Fund.

See also

References

  1. ^ a b Longevity Insurance: A Missing Market Adam Creighton, et al. University of New South Wales AU
  2. ^ "NCPA: Baby Boom Retirement Could Cause Annuity Market Explosion" Insurance Newsnet, 12/9/2004
  3. ^ Laboratory of Actuarial Mathematics
  4. ^ J. Franklin, The Science of Conjecture: Evidence and Probability Before Pascal (Baltimore: Johns Hopkins University Press, 2001), 269-272.
  5. ^ a b "From Commercial Arithmetic to Life Annuities: The Early History of Financial Economics, 1478-1776" Goeffrey Poitras, Simon Fraser University
  6. ^ Seminar Series on Quantitative Finance The Fields Institute
  7. ^ Stephen Hawking God Created the Integers: The Mathematical Breakthroughs That Changed History, Running Press, 2005 ISBN 0762419229
  8. ^ "An Income Stream to Last a Lifetime" Anne Kates Smith, Kiplinger

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