Anatomy of an Annuity
By: Marvin Snyder
An annuity is a regular series of periodic payments, usually annually but in pension cases monthly, usually payable as of the first day of each period (month), usually in a fixed amount unless there is a COLA - cost of living adjustment, usually payable for the life of the recipient - a lifetime or straight life annuity. If the annuity is to begin right now or if has begun and is already in pay status, it is known as an immediate annuity. If it is to start at some future date it is a deferred annuity.
The present value of an annuity may be thought of as its current price. In the case of a deferred annuity, the value is the single premium paid now to an insurance company for a contract paying a future benefit. That is what the annuity is currently worth. If the annuity is in pay status, it is worth what it would cost now to purchase a contract to buy the remaining stream of future benefit payments.
The value of an annuity is based on the following factors: Mortality, Interest, Age, Sex, Benefit, and the Terms and Conditions of Benefit Payment. The actual purchase price of an annuity will vary not only with these factors but also with the pricing philosophy of the insurance company including its commission schedule, loadings for contingencies, allowances for office expense and overhead, etc. There may be hidden costs, such as surrender charges if the annuity contract is terminated before it goes into pay status.
The concept of interest appears in annuities in two separate and distinct respects. First: The interest rate or rates used in constructing the actuarial basis of the annuity play a prominent role in determining its present value. This is true of both deferred and immediate annuities; the following relationship always occurs: the lower the interest rate, the higher the present value. In reverse, also true of course, the higher the interest rate, the lower the present value.
Second, a deferred annuity is often marketed as an investment vehicle. In this respect the future pension benefit is not as important as the internal investment yield credited to the individual who bought the contract. Banks compete with insurance companies in selling tax deferred investment annuities, advertising the "high" interest rates.
Investment contract annuities are not used to determine the value of pensions. The present value of a pension, payable now or in the future, is the current sum of money that would provide that future stream of payments, based on the assumptions and factors used by the actuary.