31 August 2006
Life Annuities
Posted by selfprofit under: Annuity .
Life annuities
A life or lifetime immediate annuity is used to provide an income for the life of the annuitant similar to a defined benefit or pension plan.
A life annuity works somewhat like a loan that is made by the purchaser (contract owner) to the issuing (insurance) company, who then pays back the original capital or principal (which isn’t taxed) with interest and/or gains (which is taxed as ordinary income) to the annuitant on whose life the annuity is based. The assumed period of the loan is based on the life expectancy of the annuitant. In order to guarantee that the income continues for life, the insurance company relies on a concept called cross-subsidy or the “law of large numbers”. Because an annuity population can be expected to have a distribution of lifespans around the population’s mean (average) age, those dying earlier will give up income to support those living longer whose money may otherwise run out.
A life annuity is most commonly used to transfer the risk that the annuitant will run out of life before the insurance company runs out of money. Sometimes a portion of that money will purchase a life insurance policy which will guarantee that the heirs of the annuitant still receive an inheritance.
Life annuity variants
For an additional expense, (either by an increase in payments (premium) or decrease in benefits) an annuity or benfit rider can be purchased on another life such as a spouse, family memember or friend whose life the annuity is wholly or partly guaranteed. For example, it is common to buy an annuity which will continue to pay out to the spouse of the annuitant after death, for as long as the spouse survives. The annuity paid to the spouse is called a reversionary annuity or survivorship annuity. However, if the annuitant is in good health, it may be more beneficial to select the higher payout option on their life only and purchase a life insurance policy that would pay income to the survivor.
Other features such as a minimum guaranteed payment period irrespective of death, known as life with period certain, or escalation where the payment rises by inflation or a fixed rate annually can also be purchased.
Life with period certain annuities are more palatable to people who have accumulated money and would not like to lose all of it if they were to die soon after annuitization. At least the period certain payments will be made to their beneficiary. However, a viable alternative is to purchase a single premium life policy that would cover the lost premium in the annuity.
Impaired life annuities for smokers or those with a particular illness are also available from some insurance companies. Since the life expectancy is reduced, the annual payment to the purchaser is raised.
Life annuities are priced based on the probability of the nominee surviving to receive the payments. Longevity insurance is a form of annuity that defers commencement of the payments until very late in life. A common longevity contract would be purchased at or before retirement but would not commence payments until 20 years after retirement. If the nominee dies before payments commence there is no payable benefit. This drastically reduces the cost of the annuity while still providing protection against outliving one’s resources.