Merits and Demerits of Fixed and Variable Annuities

Volatility of Payout

Fixed annuities pay a predetermined benefit amount. That is, there is no risk in receiving lower payouts year to year. This is best for investors who need a high level of assurance in regard to spending.

For investors who don't mind taking on more risk, variable annuities may be a way to increase potential annual spending. The caveat is that they may have to be willing to adjust annual spending depending on how the reference instrument performs.

Flexibility

Fixed annuities make what is usually an irrevocable trade in that investors pay a lump sum of their current wealth in exchange for a set of payments. This typically provides little flexibility as opposed to a variable annuity, which often carries a cash value feature that allows the investor to tap into the contract while still earning the original promised income stream. This clearly creates more flexibility to access value.

Future Market Expectations

An investor will essentially express a future market expectation when choosing a fixed versus variable annuity, albeit perhaps unwittingly. A purchase of a variable annuity that is tied to a reference index or reference rate is a bullish purchase. All else equal, if the investor thought the index would perform poorly or that rates would fall, they would purchase the fixed annuity. There may be other factors at play that drive this decision, such as the need for income certainty, but holding other factors constant can be a powerful learning tool to help readers grasp what the fixed vs. variable annuity choice means in isolation.

Fees

Fees are higher for variable annuities. This is due to the increased complexity of these products. Investors purchasing fixed annuities can easily compare fees by simply selecting the highest-paying annuity at a constant purchase price. Variable annuities often need to be analyzed and compared with more sophisticated pricing tools, and for this reason, are less easily comparable by consumers. This gives insurers more room to avoid competition by creating unique features or to remain competitive with higher fees that are harder to recognize.

Inflation

Inflation over a long time can erode the purchasing power of annuities. Investors who want to hedge against inflation will find no shortage of variable annuities or riders available on fixed annuities that offer this feature. This will, of course, add to the purchase price of the contract. As an example, the payout of an annuity may be indexed to the CPI measure in the US or may simply increase at a flat 1.75% per year, regardless of economic conditions.

Payout Methods

Life annuity: Annuities are paid for the entire life of the annuitant, and they cease once the annuitant dies.

Period-certain annuity: Annuities paid over a specific period of time without consideration of the annuitant's lifespan.

Life annuity with period certain: An annuity with a minimum period of guarantee that is based on a combination of a life annuity and a period certain annuity, so payments continue for the annuitant’s entire life but are guaranteed for a minimum period.

Life annuity with refund: These annuities are similar to a life annuity with period certainty. The main difference is that in lieu of guaranteeing payments for life or for a certain number of years, a life annuity with refund guarantees that the annuitant will receive payments equal to the total amount paid into the contract. This is always equal to the initial investment amount, less fees.

Joint life annuity: When two or more individuals own a life annuity, payments continue until both are no longer living.

These payout methods do not have to be mutually exclusive. A single annuity could theoretically be created by combining the different methods.

Taxation

Taxation of annuities is a complex issue and tends to be highly variable by jurisdiction. It is, therefore, not a core focus of the exam. Generally, an increase in the value of the annuity itself is not taxable. However, payouts from that annuity may be.

Self-Insurance

To self-insure against longevity risk is essentially a do-nothing or status quo plan. Instead of actively purchasing an annuity, the investor simply does nothing and attempts to live off of their portfolio over the duration of their life. This is a popular choice and, in reality, works well for many investors. However, reaching a point of destitution at an advanced age is a serious consequence.

Mortality Credits

Mortality credits are the benefits that survivors receive from those individuals in the mortality pool who have already passed away. In other words, when investors who purchase annuities pass away earlier than expected, there is a transfer of wealth to the insurer and to the other annuitants who live longer than expected and collect more payments. It is important to note that self-insuring against longevity risk misses out on this benefit.

Factors That Favor Annuities Over Self-insurance

In the choice between annuities and self-insurance, the following factors would favor an annuity:

• An extended life expectancy.
• Having a higher preference for lifetime income.
• Less concern for leaving an inheritance.
• More conservative investing style.
• Higher reliance on income from an annuity.

Also, the global shift away from defined benefit pension plans has led to an increased demand for annuities, as many retirees are now responsible for creating their own income during retirement.

Question

Which of the following factors most likely favors self-insurance over the purchase of an annuity?

1. Longer-than-average life expectancy.
2. Greater preference for lifetime income.
3. Having higher guaranteed income.

Solution

The correct answer is: C

Having higher guaranteed income from other sources, such as a defined benefit plan at work, means the investor has less incentive to purchase more guaranteed income and may feel better about skipping the fees associated with annuities in favor of self-insuring using their own portfolio of financial assets.

A is incorrect. A longer than average lifespan would favor the purchase of an annuity. This is due to the fact that the annuitant will be around longer to collect more payouts, which increases their total wealth relative to the fixed purchase price that was paid in the past.

B is incorrect. Greater preference for lifetime income favors annuities since they are guaranteed by the insurer to last all of one's lifetime (provided it is a lifetime annuity). Whereas a portfolio of assets may be spent down with no guarantee of lasting.

Reading 9: Risk Management for Individuals

Los 9 (i) Discuss the relative advantages and disadvantages of fixed and variable annuities