Envestnet Whitepapers

Annuities as an Asset Class for Fee-Based Advisors l 19 © Envestnet 2022 Including mortality rates in the pricing is the secret sauce of the annuity. Retirees could just build a bond ladder on their own and set aside the full present value of their lifetime spending. But because a retiree does not know how long she may live, it becomes necessary to plan for an age well beyond average life expectancy. Annuity owners obtain a discount on the bond ladder pricing because the survival probabilities to each subsequent age indicate whether these payments will need to be made. The annuity price is a survival-weighted present value of potential lifetime payments. Any one individual is either alive or dead. But for a large pool of individuals representing the customer base of the annuity provider, the company can rely on the law of large numbers to evaluate what percentage of customers will remain alive at each subsequent age. If there is only a 10 percent chance that someone is alive at age 100, the insurer only needs to set aside 10 percent as much for that payment as someone who self-manages the risk. This is risk pooling. The bond ladder costs more, with the benefit that the bond ladder supports some legacy if retirement is shorter than assumed with the ladder construction. But the bond ladder does not provide any additional longevity protection beyond the end date of the ladder as assets are fully depleted at that time. With the income annuity, that longevity protection can be provided while devoting less funds to the goal. The life-only income annuity offers the highest payout because it creates the most risk about receiving fewer payments for any beneficiary in the event of an early death. Adding a period-certain payment or a cash refund reduces the potential mortality credits that the annuity owner offers to the risk pool. The higher payout on a life-only income annuity provides compensation for accepting the risk of an early death. Academics who study income annuities generally suggest a life-only income to fully maximize the income-producing power, with legacy goals covered through other means. But cash refund and period-certain provisions are quite popular in practice. Psychologically, for many it is too difficult to overcome the perceived lack of fairness with a life-only income annuity in which one could die shortly after paying the premium and then receive back little in return. Including mortality rates in the pricing is the secret sauce of the annuity. Income Annuity Pricing Pricing income annuities is not as hard as one might think, as the basic recipe requires just three ingredients: 1. Mortality rates (which vary by age and gender) impact how long payments will be made. Younger people will have longer projected payout periods, which means that payout rates must be lower. 2. Interest rates impact the returns the annuity provider can earn from investing the annuity premiums. Higher interest rates imply higher payout rates because the insurance company will be able to earn more interest on the premiums in their general account supporting the annuity payments. 3. Overhead costs relate to extra charges an annuity provider seeks to cover business expenses and to manage risks related to the accuracy of their future mortality and interest rate predictions.

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