Does an Annuity Make Sense with Low Interest Rates?

Today we have the advantage of hindsight. We know if you didn't buy your annuity in 1990 you missed out on a darn good rate!

If you're thinking, "Oh, but I'd settle today for an 8% annuity in a heartbeat, today's rates can only get better," hold that thought because I'll show you data at the end of this article which indicates otherwise.

The cost of waiting

What about the idea that if you waited a year or two you'll be older and therefore get more income due to your reduced life expectancy? This reasoning is not completely correct, too.

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The first problem with it is -- sure, you're older so you may collect a higher monthly payment. But, for a shorter period of time! You'll have missed years of payments which you will never be able to make up.

Perhaps even more significant is that waiting causes you to forfeit some "Mortality Credits." Remember that annuity payments are comprised of two elements: interest rates and age-based (life expectancy) factors. A mortality credit is an actuarial term referring to the extra income you earn from other buyers of annuities with the same insurance company who are predicted to pass away before you. So with mortality credits you receive up front a portion of the premiums buyers who are predicted to die before you "lose".

[The following discussion on mortality credits is attributed to Dr. David Babbel of the Wharton School]

An example of mortality credits

"Immediate annuities (a.k.a. lifetime income annuities) are priced to reflect the remaining life expectancy of the purchaser at the time of purchase. For example, if a healthy 65-year-old male purchases a lifetime income annuity, and it is estimated that he has a 20-year life expectancy, the annuity provider will price the annuity by planning to make monthly payments for the next 20 years, give or take. Say that the annuity premium is $100,000. That would mean that the annuity provider could pay back $5,000 per year to the annuitant (or, 20 x $5,000 = $100,000) over the ensuing twenty years, if interest rates were zero. If the annuitant lives longer than 20 more years, the annuity will continue paying, as the annuity provider will undoubtedly have some annuitants who expire before reaching their life expectancy.

"In addition, insurers carry surplus funds to cover cases where their estimates of life expectancy may be too low, and they are required to price with margins to cover their expenses and to build surplus for the future and remain solvent. Therefore, again with zero interest rates, the insurer would likely offer less than $5,000 per year payments in order to cover expenses. However, if interest rates are positive, they will offer higher payouts than $5,000 -- perhaps as much as $6,000 or $7,000, again depending on interest rates.

"The older you get, the higher the mortality credits supposedly become...or not. The reason they would increase is that as you age, there are fewer years left that the annuity provider can expect to be making payments. For instance, if you wait to annuitize until you are 70, the annuity provider might expect that it will need to make payments for an additional 17 years (the life expectancy decreases less than one year for each year that passes -- a phenomena called survivor bias). Again, to make things simple, assuming zero interest rates, the provider could make annual payments of $100,000/17 = $5,882, or more than 17% higher. Of course, these figures would need to be reduced to cover expenses and preserve conservative pricing margins, but would also be adjusted upward if interest rates are positive at the inception of the annuity.