Why are annuities such bad value for most people?

An annuity is a financial contract that pays an income for a fixed period or for a person's (and sometimes their spouse's and dependents') lifetime. The main subject of this article is lifetime annuities.

The first thing to understand about a lifetime annuity is that it is an insurance policy. So like any other insurance policy, you pay to cover a risk. With motor insurance, you pay to cover the risk that your car will be stolen or damaged. A lifetime annuity protects you against the risk of running out of money because you live longer than you anticipated.

A simple example (that ignores any interest on your investment) would be that you have 15,000 and take an income of 1,000 each year from that amount. The money will run out after 15 years. An insurance company might offer an income of 900 a year for the rest of your life, in return for the payment of 15,000. So you are accepting less money to protect yourself from the risk of living more than 15 years and running out of money.

The actual calculation of an annuity rate involves 3 factors; interest rates on long term secure bonds, life expectancy and the insurance company costs.

Interest rates are very low presently and the assumption is that anyone applying for a standard annuity is in very good health because of the availability of "impaired life" annuities (where the payments are enhanced due to illness). This has led to very low rates on offer.

In the example above, 15000 taking 1000 a year, without interest rates, the funds run out after 15 years. However, if interest rates were about 6%, you could draw the 1000 for about 34 years. So if an insurance company thought you might live 15 years, they could quite easily offer you an income of more than 1300 a year. With the present interest rates of 2%, they would only offer about 1000 a year.

So the prevailing low interest rates have created a situation where life expectancy is the primary factor in determining the income paid from an annuity.

So getting back to basics. An annuity is an insurance policy against living too long. To be slightly more accurate, it is an insurance policy against living longer than the insurance company thinks you will. Now you wouldn't buy an insurance policy against something that would never happen and you probably shouldn't buy an insurance policy against something that is highly unlikely to happen, unless the consequences were catastrophic. In the case of the annuity, taking out one when the insurance company thinks you will live 20 years, (and interest rates are low), is unlikely to be insurance you will significantly benefit from. You have just purchased a very low fixed income investment.

Once again a simple example. If the insurance company thinks you will live 20 years and you actually live for 22, you have given up some of your income for 20 years to benefit for just two years at the end of the time period. In contrast, at the other extreme if the insurance company thinks that you will only live 5 years and you actually live for 7, you will benefit greatly from additional income and not have suffered a reduced income for many years.

There are of course people who are very risk adverse and want the security of fixed payments and that is the correct choice for them. However, for most, until interest rates increase significantly, lifetime annuities will be poor choices particularly for those with high life expectancies.

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