If a person has $100K to spend for retirement, why buy an annuity contract that pays a fixed income like $600 per month when the person can just take out $600 per month from the $100K to spend?
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3 Answers
Annuity contracts are primarily there to insulate you against "mortality risk". Suppose you live longer than average, the contract will keep paying out until you die even if that's more than you could have funded directly with the annuity cost.
Conversely the people that die earlier than average lose the extra money, which is used to fund those that die later (and the annuity company's profits).
The annuity company might also be able to take different investment risks that improve investment returns on average, but that's a secondary consideration.
Some annuities do offer a guaranteed minimium term so that your beneficiaries will still receive something in case you die the next day, but usually this means slightly reduced payments. Similarly, some will offer payments to a spouse in case they outlive you, but again in exchange for a lower payment rate.
answered Jan 18 at 8:30
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11One minor quibble, the insurance company's ability to invest is not a secondary consideration; it's fundamental to the insurance business model. Warren Buffett covered this in detail in one of his annual letters (but sadly I don't remember which year). Basically, it is not necessary for an insurance operation to run an underwriting profit, so long as their underwriting losses are small enough for their investments to be profitable.– NobodyCommented Jan 18 at 16:02
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@Nobody He talks a lot about floats, I know, but more in the context of standard insurance (like against damage etc) rather than annuities. Some of the same arguments may apply here but regardless I think the two aspects can be separated. The individual buying the annuity could also invest on their own. Commented Jan 18 at 16:17
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21Annuities are the converse of life insurance. Life insurance contracts protect against the risk of dying too early. Annuity contracts protect against the risk of living too long. Either way, the insurance company (if its actuaries are competent) make money, but they provide a valuable service: risk management.– jsf80238Commented Jan 18 at 17:29
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6Just to note: If you are looking at annuities, there are some which will let you withdraw the principal and close the account after some number of years, if you decide you don't need the safety net. Presumably those make their profits on investing the money while they have it. You may also want to look at Charitable Remainder annuities, where you make a large donation to a nonprofit now (rather than in your will) and in exchange they pay you sone amount per year until your death; the tax advantages can make this worthwhile.– keshlamCommented Jan 19 at 1:39
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@jsf80238 Yes. I read once that with a life insurance policy, if you live a long time you pay more in premiums than you collect in benefits. If you live a short time, you collect more in benefits than you pay in premiums. So if you die young, you win!– JayCommented Jan 20 at 11:57
The point of an annuity contract is that it gives you a guaranteed income for life.
Say -- just making up numbers, not saying this particular contract is available anywhere -- that you have $100,000, and that statistically you can expect to live another 8 years, or about 96 months.
You could put the $100,000 in a box and take out $1,000 per month. If you then lived exactly the 8 years predicted, over that 96 months you would take out $96,000, and there would be a few thousand left when you died.
But what if you beat the odds and lived 9 years? Then you'll run out of money.
That's where an annuity comes in. Let's say they guarantee you $1,000 per month. Then if you live more than 8 years, the annuity company continues to pay you $1,000 every month, even though they've then used up all the money you gave them. On the other hand, if you only live 7 years, then there's $16,000 left and the annuity company comes out ahead.
In real life you could invest the money and do better. And the annuity company almost surely invests the money. That complicates the math but doesn't change the principle.
The reason to get an annuity is to have guaranteed income for the rest of your life.
In real life, the annuity company almost surely studies statistics to know how long you are likely to live. And if they're not idiots, they offer monthly payments that will result in them making money if you live for an average length of time. You could look at the same statistics, invest your money in the same funds that the annuity company does, and come up with a payment amount that gives you a mathematical expectation of having steady income for life. But the problem is, you're one person, and the amount of time you will live is difficult to predict. The annuity company has thousands of customers, so they can average numbers out. They accept that they will lose money on some customers, but they will make it up on others. If one customer lives to be 120, they will likely lose money on him. But they have enough customers who die young to make up for it. For any one customer, all he cares about is his own life span and financial situation. Knowing that, if 1000 people followed your plan, only 10 of them would have run out of money, doesn't do you much good if you're one of the 10.
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Thank you for your detailed response. What do you mean by "Knowing that, if 1000 people followed your plan (what plan?), only 10 of them would have run out of money, doesn't do you much good if you're one of the 10."? Commented Jan 18 at 17:24
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15@HelloDarkWorld If, instead of getting an annuity, you invest on your own and end up living longer than expected and running out of money, then the knowledge that your outcome was unlikely doesn't change the fact that it happened anyway.– DouglasCommented Jan 18 at 17:33
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And for money you will need in the next couple of years, 'gambling' it on the stock exchange market is probably not the wisest idea for any individual (one would expect a more and more conservative portfolio as one gets closer to death), as any downturn of the market could have an outsized impact on your life (following the general rule of thumb to only put into stocks stuff you won't need for a long time). Commented Jan 20 at 14:12
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@DavidMulder I'd agree more or less. Personally I'm 65, recently retired, and I have most of my money in very safe blue chip stocks. I've basically broken even the last two years. Arguably it would be wise for me to move money to bonds or annuities or something else.– JayCommented Jan 22 at 1:08
While mortality risk is the main reason to buy an annuity (and it has already been covered in the other answers), there is another risk an annuity covers: that you lose your money.
This can happen in several ways, but for older people that danger is real. As you get older you become dependent on others and your judgement may become impaired, especially in the very latest years of life. This may lead to unwise spending and/or falling victim of scammers, gold diggers, caretakers or robbers (mainly in situations where people live more isolated and store wealth at home). In most of the situations I mentioned the losses are very large.
If you buy an annuity, that money can no longer be taken from you.
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1An annuity provides some protection from being victimized, but it really depends on how you are victimized: annuities can often be sold or cashed out, so the protection they provide may be weaker than you might expect. If your goal is to protect yourself from future victimization, I'd recommend consulting an estate attorney .– BrianCommented Jan 19 at 21:04
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There's truth in that. But bear in mind that there are services out there that border on predatory that will buy your annuity for a lump sum. I see TV commercials for one such service all the time. The business in general is legitimate. There are times when someone makes a rational decision, given his financial circumstances, to buy an annuity, and then things change and he needs a bunch of cash now. But mostly I think this is preying on gullible people. ...– JayCommented Jan 22 at 1:11
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Need I say it? If you put $100,000 into an annuity, and the next day you sold the annuity for a lump sum, you would get considerably less than your $100,000 back.– JayCommented Jan 22 at 1:11