Annuities are exceedingly popular as a means of personal savings in the United States and are becoming more prominent in numerous other markets worldwide. This popularity reflects the continuing aging of populations, lagging confidence in government- sponsored retirement programs, and a concomitant desire to increase savings through a tax-favored vehicle in anticipation of retirement financial needs. Changing demographics, especially in the OECD countries, suggests the possibility of still greater annuity demand as today’s baby boom generation (those who will begin retiring around the year 2010) allocates further amounts to retirement savings.
Nature of Annuities
In the broadest sense, an annuity is simply a series of periodic payments. An annuity contract, then, is an insurance policy that promises to make a series of payments for a fixed period or over a person’s lifetime. The person who receives the periodic payment under an annuity is called the annuitant. A life annuity, also called a pure life annuity, is an annuity whose payments are contingent upon the continued existence of one or more lives; In contrast, an annuity certain is an annuity whose payments are not contingent on the annuitant being alive. A temporary life annuity is a life annuity payable for a fixed period or until the death of the annuitant, whichever is earlier. A whole life annuity is a life annuity payable for the whole of the annuitant’s life.
Purpose of Annuities
Life insurance has as its principal mission the creation of a fund. The annuity, on the contrary, has as its basic function the systematic liquidation of a fund. Of course, most annuities are also accumulation instruments, but this is the mechanism for developing the fund to be liquidated. From a legal viewpoint, therefore, a whole life annuity may be defined as a contract whereby for a consideration (the premium), one party (the insurer) agrees to pay the other (the annuitant) a stipulated amount (the annuity) periodically throughout life. In the absence of an explicit provision to the contrary, the understanding is that no portion of the consideration paid for the annuity need be refunded upon the annuitant’s death. The purpose of the annuity is to protect against the possibility of outliving one’s income—just the opposite purpose of that confronting a person who desires life insurance as protection against the loss of income through premature death.
Each payment under an annuity may be considered to represent a combination of principal and interest income and a survivorship element. Although not completely accurate, one can view the operation of an annuity as follows: If a person exactly lives out his or her life expectancy, he or she would have neither gained nor lost through utilizing an annuity contract. If a person outlives his or her life expectancy under the contract, the additional annuity payments would be derived from the funds contributed by those who failed to survive to their expectancy. Conversely, those annuitants who die before attaining their life expectancies would not have received annuity payments equal to their contributions (plus forgone interest), with the difference between that which they contributed to the insurance pool and that which they received being used to provide continuing income to those who outlive their life expectancies.
As no one knows into which category he or she will fall, the arrangement is equitable and can succeed, from the company’s point of view, through the operation of the law of large numbers. In most jurisdictions, only life insurance companies are permitted to sell contracts that guarantee a life income through liquidation of both principal and interest over a person’s life.