Knowing how annuities work helps us understand when and how to use them. As discussed in “Types of Retirement Annuities”, annuities are not all the same. Annuities accumulate cash and payout retirement income benefits. Each function has a different structure and that structure must be aligned with the underlying investment portfolio. Knowledge of how annuities are structured, helps us understand how to optimize their retirement income potential.
When an immediate annuity is purchased the insurance company quickly covers their future liability by laddering commercial bonds. An immediate annuity creates two type of risk for an insurance carrier: interest rate risk and longevity risk. Interest rate risk is the danger of interest rates changing during the annuity holding period. Longevity risk is the chance that the annuitant’s life span will be much longer than expected and therefore total payments will be higher then estimated.
When an insurance carrier issues an immediate annuity, they are accepting an obligation to pay future benefits on known dates and in known amounts for an unknown period of time. These benefits were initially determined based on an estimated interest rate. If interest rates change, the benefit will be either more expense or less expense depending on whether interest rates go down or up.
Insurance companies are in the business of managing morality risk and it’s reciprocal, longevity risk. However, they do not like interest rate risk and seek every opportunity to minimize their interest rate exposure.
For example: XYX Assurance accepts $44,350 from a consumer and promises to pay an annual benefit of $10,000 at the end of each year, which totals to $50,000 in annual payouts. To meet their future obligations, XYZ builds a bond ladder. Laddering bonds is simply the act of purchasing one bond in today’s market that will mature at the exact time when the money is needed for a payout. If interest rates are 5%, a bond ladder for $10,000 at the end of each of the next five years would be as shown below.
Yr. Benefit Cost of Bond
1 $10,000 $9,524
2 $10,000 $9,070
3 $10,000 $8,638
4 $10,000 $8.227
5 $10,000 $7,835
Total $50,000 $43,295
**To simplicity the numbers, we have used discounted bonds for this illustration. A discounted bond is when all interest is collected at maturity.
If I owe $10,000 at year end, I don’t need $10,000. If I can earn 5% on my money, $9,524 will grow to $10,000. In like manner $7,835 will grow to $10,000 in five years. The total promised benefit is $50,000, but the present cost is only $43,295. Any premium the carrier charges over it present cost is profit.
The saving over five years is fairly small from a discounted bond ladder. But over a 20-year period the present cost of a $10,000 benefit would only be $3,769. The longer away the benefit date the bigger the discount.
In summary, the insurance company moves immediately upon receipt of payment to cover their interest rate risk and lock in a profit. It relies on a large number of annuitants to average out its longevity risk. (see Finding the Best Single Premium Immediate Annuity Rates?)
Fixed Interest Annuities
Annuities that are designed to provide retirement income benefits at some future date are call tax deferred annuities and their focus is on accumulating retirement assets that can fund a variety of future benefits. Therefore, instead of discounting the bonds, they compound them at interest. When a carrier receives a premium their investment department purchases investment grade commercial bonds and uses the interest income therefrom to pay interest on the annuity cash value and cash accumulation accounts. If this interest is not withdrawn, it accumulates tax without a current tax liability. Thus the term ‘tax deferred annuities’.
Long term bond rates are normally higher than short term rates, so the insurance company goes out as far out as possible. However, if they go past the surrender period they could end up holding discounted bond who’s book value is less than the annuity cash value. If the annuity owner requests a surrender at that time, the carrier would have a loss.
In most fixed-interest annuities the carrier announces two interest rates: a long term guaranteed minimum and a higher current rate that is based on the present-day bond prices. The current rate quote is usually good for one year. Interest is credited to the account from bond earnings less a management fee and an adjustment for marketing and sales expenses.
For example: John Healthy pays a premium of $100,000 for a fixed interest annuity from XYX Assurance. The policy has a ten year declining surrender. XYZ’s investment department purchases commercial bonds paying 6.2%, which provide an annual income of $6,200. They charge a portfolio management fee of 0.25%, so their net return is $5,950 ($6,200 – $250). This amount is further reduced by amortizing the sales and marketing expenses of policy acquisition over the duration of the surrender charge. In this example we will assume these costs were $8,500 spread over a ten-year period or $850 a year. Net interest credited would be $5,100 ($5,950-$850) or 5.1% the first year. For this reason, over the long term, fixed-interest annuity earnings will always follow commercial bond yields.
Fixed annuities have two important variations. MYGAs and Equity Indexed Annuities. Both are roughly classified by the way the investment department credits policy interest.
A MYGA is a stripped down fixed interest annuity that focuses on intermediate-term yields (3 to 10 years). The interest rate is guarantee for a multi-year period and many retirement features that are common to more traditional annuities are dropped because of their actuarial cost. MYGAs are designed to compete with Bank CDs on yield and still provide tax free accumulations. From the insurance company stand point a MYGA is much like an immediate annuity, in that all the interest obligations are known at policy issue and covered by purchasing bonds that match the MYGA’s interest guarantees. When the premium is collected, the carrier simply locks in their profit and accepts no interest rate risk. (See MYGA – The Guaranteed Retirement Rate Annuity)
Equity indexed annuities go the other direction by offering potentially higher, but more speculative yields. Instead of crediting interest earned from their bond portfolio, the carrier instead uses the interest to hedge a specified stock market index. A hedge is an option to buy stocks at a specified price. Therefore, if the stock price increases, the hedge offers tremendous leverage. However, if the stock declines in price, the money paid for the option is gone. Since the market goes both up and down, the future earnings from this arrangement are unknown. But many experts feel that in the long run, equity indexed annuities will outperform their fixed-interest cousins. (See Equity Indexed Annuities Explained?)
Please work with an expert at matching your individual financial and retirement planning needs to the most appropriate annuity.
Contact us today to find a licensed annuity professional in your area!
Contact us NOW!
Compliance # CSP_1044 20160501