Annuity Policies

Annuities are insurance policies that pay their beneficiaries for as long as these beneficiaries are alive. They solve the problem of planning consumption in a world with uncertain lifetimes and indemnify individuals against the risk of outliving their resources. In return for an initial capital payment, a life annuitant is assured of receiving a constant income stream for the remainder of his life. The annuity provider (an insurance company) pools mortality risk across individuals and offers each annuitant a payout that in theory exceeds the income he could earn if he invested his annuity premium in a financial asset, such as a bond. The annuity's additional return derives from the mortality risk facing the annuitant pool. The insurance company does not pay out the full amount of the annuity premium to annuitants that die earlier than the aggregate mortality experience would suggest. The principal that the insurance company does not pay out to those who die unexpectedly early permits a higher payout for those who remain alive.

Annuities are sometimes referred to as “reverse life insurance.” A life insurance policyholder pays the insurer each year until he or she dies. When the insured individual dies, the insurance company pays a lump sum to the beneficiaries of the life insurance policy. With annuities, the annuitant makes a lump-sum payment to the insurance company before the annuity payout begins. In return, the insurance company makes payments to the annuitant until the annuitant’s death.

By James M. Poterba