Trading a Pile of Money for a Promise of Income for Life

Insurance Against Living Too Long

The scariest outcome of retirement isn't dying prematurely. It's living a long time and running out of money before your years are up. annuity Attacks you fear directly. Give an insurer a lump sum and it promises to pay you income for as long as you are alive whether that be two years or forty

This is longevity insurance the mirror image of life insurance. Life insurance pays out if you die prematurely. An annuity pays out if you live a long time. They both exist because neither of us knows in advance which side of the average we will fall on

This is the part that most explanations leave out. An annuity is not just a bond that carries a different label. It contains a source of return that has nothing to do with interest rates stock markets or anything that an individual investor can buy on the market. That source is called mortality credit and it's the only reason a group of strangers can promise something that none of them could promise alone

How the Simple Version Works

The purest version is an immediate-income annuity. You hand over a lump sum and the insurer begins paying you a fixed income immediately for life. The size of the check depends on three things: how much you paid your age when you started and current interest rates

The insurer can make this promise because it is not betting on one person. It is collecting thousands of them. Some annuitants die in the second year without having collected almost anything. Others live to be ninety-eight and collect for decades. Across the group the insurer pays based on the average life expectancy of the group while each individual is protected against his or her own personal unknowable life expectancy

That pooling mechanic is doing more work than he's given credit for. He's not simply averaging risk the way an insurer averages car accidents. He's actively transferring wealth in real time from the estates of people who die prematurely to the checking accounts of people who are still alive. That transfer has a name and understanding it is the difference between seeing an annuity as a decent savings product and seeing it for what it really is

The Mortality Credit: The Only New Return in the Room

If you strip out everything else about an annuity the fees the riders and the marketing one mechanism remains: the mortality credit. It's the increase in your payments that comes solely from the fact that some of your pool mates die before you

Here's the simple version. Imagine that a group of people of the same age each give a sum of money to the insurer. At the end of each year the insurer adds up how much was left in their accounts for the people who died that year. Instead of that money disappearing or going into an estate it is redistributed to the survivors in addition to the interest generated by the common fund. The survivors get a return made up of two parts: the ordinary interest which anyone could earn on their own.alone and the credit of mortality which no one can earn alone

That's why I would reject the instinct to describe an annuity simply as a bond with a built-in useful life feature. The bond return part can be replicated yourself with a Treasury or corporate bond ladder. The mortality credit part cannot be replicated not with any amount of skill or capital because it is not a return on an asset at all. It is a return that only exists within a group of people who share the same mortality risk and have agreed through contract to redistribute it

Credit also grows with age and this is more important than most people realize. A sixty-five-year-old's peer group dies at a low annual rate so the mortality credit added to a payment at age sixty-five is small. A ninety-year-old's peer group dies at a much higher annual rate so the mortality credit included in a ninety-year-old's payment is large. That's a structural reason why annuity payout ratesThey increase much faster with age than interest rates alone would explain. Mortality credit takes up an increasing share of the work each year you are alive to collect it

A Worked Example: What the Pool Actually Pays

Let me isolate the mortality credit from everything else by eliminating interest entirely. Suppose for the sake of illustration that one hundred people of the same age each contribute ten thousand dollars to a one-year pool. That's a million dollars with the insurer with no interest borne just to see the mortality mechanism on its own

Now suppose as a clearly illustrative assumption and not as an actual figure from a mortality table that five percent of this group are expected to die during the year. That's five people out of every hundred. Each of them had ten thousand dollars in the common fund so together they gave fifty thousand dollars to the common fund: five times ten thousand equals fifty thousand

That fifty thousand dollars does not disappear and does not go to the estates of the five people who died because in a contingent annuity you negotiated that claim at the time you purchased.It is divided ninety-five among the survivors. Fifty thousand divided by ninety-five is five hundred twenty-six dollars and thirty-two cents. Each survivor started with ten thousand dollars and ends the year with ten thousand five hundred twenty-six dollars and thirty-two cents assuming the return on investment is zero anywhere in the example

Five hundred and twenty-six divided by ten thousand is about 5.26 percent. That's this illustrative year's mortality credit and let's look at what produced it: neither a clever trade nor a market call nothing more than the redistribution of dead companions' account balances among the living. In the actual product this credit is added to any interest the insurer earns on its bond portfolio which is why annuity payout rates for older buyers may seem surprising.generous compared to what a bond ladder would pay on its own. Now imagine operating this same mechanic for thirty years instead of one with the mortality rate increasing each year as the group ages. That cumulative compounding transfer from the deceased to the living is largely what makes the lifetime income of an annuity worth more if you live a long time than the same money managed on your own

Why You Cannot Build This Yourself

This is the part that really matters for anyone thinking about whether an annuity is worth considering. You can buy a Treasury bond yourself. You can build a ladder of bonds yourself matching maturities to the years in which you expect to need cash ensuring a known payment on a known date. That approach provides real certainty on its own terms. What you can't do no matter how much money or spreadsheet skills you have is share your own mortality risk with that of a few thousand strangers

A bond ladder is sized based on your personal worst case. If you can live to be one hundred you either build the ladder long enough to cover the hundred years which means putting away more money than you'll probably need or you accept the risk of running out of money if you land in the long tail. There's no one to share that risk with. You're a party of one

An annuity fund doesn't have that problem because the ultimate risk of a person living to be one hundred is absorbed by all members of the fund funded largely by mortality credits generated by people who die earlier than average.alone.It is the only genuinely new return source in the entire product

Case Study: Executive Life and the Promise Behind the Promise

All of this mortality-matching math depends on an assumption lurking quietly underneath: that the insurer will actually be there decades later to pay. That assumption isn't automatic and the clearest lesson about what happens when you fail is Executive Life Insurance Company of California

During the 1980s under CEO Fred Carr Executive Life built its investment portfolio largely around high-yield junk bonds obtained largely through Michael Milken's operation at Drexel Burnham Lambert. For a time this worked allowing Executive Life to offer some of the most competitive annuity and life insurance rates in the country because a riskier bond portfolio backing the promises could support higher credit rates. When the bond marketJunk bonds collapsed in the late 1980s the value of that portfolio fell with it. California regulators seized Executive Life in April 1991 in what was at the time one of the biggest insurance company failures in U.S. history

The people caught in the middle were not abstract bondholders. Many had structured settlement annuities lifetime income streams given to injury victims specifically because that income was supposed to be as safe and boring as money. Suddenly those payouts were in doubt. The company spent years in rehabilitation its policies were eventually transferred to a successor insurer and state guarantee associations the industry-funded backstops that exist for exactly this scenario stepped in to limit thedamage. Most policyholders eventually recovered the vast majority of what they were promised but it took years of uncertainty to get there and it happened to people who had chosen an annuity specifically because they wanted to stop thinking about the risk

The lesson I draw from this is not that annuities are secretly dangerous. It's that the credit risk in an annuity is different from the credit risk in a single bond that you yourself own. When you buy a Treasury you can look for exactly what backs it. When you buy an annuity you are relying on an insurer's entire balance sheet its reserves its investment options its capital cushion on a promise that may not be tested for thirty or forty years. State guarantee associations exist as a backup similar in spirit.to how the FDIC backs bank deposits but the coverage limits and process vary by state and are worth checking before assuming the promise is ironclad

Where the Value Gets Lost

Simple immediate income annuities are a small portion of what is actually sold. The industry primarily sells complicated products packed with features: minimum income guarantees market-linked returns death benefit riders withdrawal options that let you change your mind later. Each feature seems reasonable on its own. Each also costs something and the cost is often hidden where a buyer without actuarial experience has almost no chance of finding it

Each rider you add is functionally a small insurance policy layered on top of the annuity and each layer takes a bite out of the mortality credit before it reaches you. A death benefit rider for example promises your heirs to get something in return if you die prematurely which sounds like good coverage. But think about what that actually does to the mechanism in the last few sections: It gives back some of the lost balance that was supposed to fund survivors' mortality credits. You're paying to undopartially the exact grouping that made the product worth buying in the first place

These loaded products tend to carry high fees surrender charges that punish early withdrawal and terms that are really difficult to evaluate in parallel. They also tend to be sold aggressively because they pay large commissions in the same way that whole life insurance does. The core idea longevity insurance funded by mortality credits is sound. The version most often sold is the one that is so loaded that the fees eat up much of what made it worth buying

Where This Breaks

I have argued that mortality credits are a genuinely new source of return that is not available anywhere else. Let me argue the other side because the arguments for annuities are much weaker under certain conditions

The first problem is adverse selection and it's the one that surprised me most when I first researched how insurers actually value these things. You might think that the mortality credit calculation would use the same life expectancy tables that apply to the general population. Not so. People who choose to buy annuities are on average healthier and live longer than the general population because someone who suspects they won't live long has little reason to give an insurer a lump sum in exchange for an income ofInsurers know this and price annuities using beneficiary mortality tables which assume a longer life expectancy than the general population experiences. That means that the mortality credit included in the price being quoted is already less than gross pooling math would suggest because the insurer has adjusted the assumption to protect against exactly the buyers it hopes to attract

The second problem is your own health information. If you already know something about your own life expectancy a family history of a serious illness a diagnosis that the insurer doesn't know or can't fully use the pool math works against you. You would be handing over a lump sum to subsidize the mortality credits of people who are likely to survive you with little chance of raising enough to make it worthwhile. The entire product depends on you being a reasonably average member of the pool. If you have real reason to think notIf so the math stops favoring it specifically although it still works well for the group as a whole

The third problem is inflation. An immediate fixed annuity promises a level nominal payment for life not a real level payment. Inflation-adjusted versions exist but they pay a noticeably lower initial income for the same lump sum because the insurer is pricing in the additional risk it is assuming. Thirty years of inflation even modest can quietly and greatly reduce the purchasing power of a level payment. The guarantee is real. It is a guarantee on the dollars not on what those dollars canbuy

The fourth issue is liquidity. Once you make the annuity that money is usually gone. No emergency fund no adjusting your plan if your circumstances change unless you pay more for a liquidity rider and as noted in the section on riders each rider taxes part of the mortality credit for which you purchased the product in the first place

How I Actually Think About This

My reading and I want to be clear that this is a way of thinking about the mechanism more than any kind of recommendation is that the mortality credit is the only part of an annuity worth paying close attention to. Everything else about the product I can get elsewhere often cheaper

If I were thinking about whether the concept makes sense for someone's situation the first thing I would want to know is how much of your fixed non-negotiable expenses - rent food basic insurance - are already covered by Social Security or a pension. My intuition is that the arguments for mortality pooling become stronger specifically for the portion of spending that is not covered by those other guaranteed sources not for an entire portfolio. Converting all savings into an annuity wastes the flexibility that a bond ladder or portfolio gives you.ordinary for a mortality credit that might not even be necessary if fixed costs are already handled elsewhere

The second thing I would like to know is if the simplest version is available an immediate income annuity with no riders because every layered feature is a fee worth paying and I have found that most of them are not once you really compare what they cost with what they add

The third thing given the case of Executive Life is that I wouldn't treat the insurer as interchangeable. Financial strength ratings from agencies like A.M. Best exist for a reason and since the entire promise is based on a balance sheet held over decades I'd rather check that rating than assume that every insurer offering a similar quote carries equivalent risk. I've also seen the idea of splitting a planned annuity purchase among two or three insurers rather than one the same instinct that makes people spread deposits amongbanks and it seems to me a reasonable way to reduce the credit risk of a single insurer without giving up the mortality pooling mechanism itself

What I keep coming back to is that an annuity is not a single financial instrument. It's a bond return plus a mortality credit plus typically a bunch of fees for features that most buyers probably don't need. Once I mentally separate those three pieces the decision becomes much easier to reason through even if I still find the fee layer really difficult to evaluate from the outside

The Bottom Line

An annuity converts a lump sum into lifetime income by pooling the mortality risk of many people and the mortality credit the transfer of lost balances from those who die prematurely to those who live a long time is the only part of the product's performance that an individual cannot replicate on his or her own not with a bond ladder nor with any skill.interest alone. But the promise is only as good as the insurer's bottom line as Executive Life demonstrated in 1991 and the price you quote already has an adverse selection against you before you even sign. The simple immediate income annuity stripped of riders and fees is where the mortality credit really reaches the buyer. The elaborate versions the industry prefers to sell exist primarily to tax that credit down the road