Annuity Prices 101: How the Cost of Those Guarantees is Determined

How is an annuity priced? And why should it matter to you? While you may be exploring an annuity for your retirement, many Americans count on fixed annuity contracts as a safeguard against today’s economic uncertainty.

In many ways, retirees and retirement savers have had a rough go in this ever-changing economic climate. Retired Americans have sought to find choices that pay sufficient regular income for their monthly household needs. Risk-averse savers also have been hit particularly hard, as interest rates still remain near historic lows.

Millions of people have found peace of mind by receiving a lifetime income stream from an annuity contract. This type of payout will guarantee someone a fixed sum of money on a regular basis for as long as he or she lives.

But how can you, the annuitant on the contract, know if you are getting a good deal on the annuity (a fair annuity price) when you buy one for your portfolio? There are several factors that enter into how a life insurance company will price its annuity payouts.

To help you receive the best “bang for your buck,” it’s good to understand how these factors can affect the pricing of annuities by insurance companies — and the impact on the annuity payout you will receive.

What Drives Annuity Prices by Insurers?

What variables factor into how annuities are priced? From a high level, annuity pricing is influenced by five overall factors:

• Your initial premium payment
• Mortality rates
• Interest rates
• Insurer business overhead expenses
• The payout option you choose
• Cash reserves held by the insurance company

Let’s go into more depth about each of these factors and their roles in the pricing of annuity contracts accordingly.

The Initial Purchase Payment

This one is rather obvious. If you purchase a $500,000 annuity contract and opt for a straight life-only payout, then your payout will be proportionately larger than if you only purchased a $100,000 contract.

Of course, if you purchase a variable annuity, then your payout will be based upon the contract balance at the outset of receiving payments. So if you purchased a $100,000 contract and it grows to $250,000 before beginning your payout, then your payout will be based on the higher amount.

Some variable annuity contracts use another value — an “income base benefit” tied to an income rider — besides the value of your contract for calculating your payouts. Ask your financial advisor for details if you own a variable annuity.

Mortality Rates

The insurance company has thousands of annuity policyholders. In the case of fixed-type annuity contracts, the risk of all these annuity policies is pooled together. The insurer’s actuaries include mortality rates for each policyholder in their risk and payout calculations.

The younger you are, the lower the payout you will receive. After all, you will most likely be receiving payouts for a longer period of time than an older person. Hence the insurer has a higher probability of paying you longer.

Mortality rates also vary according to gender. Statistically, women usually live longer than men. Because of that, their payouts are usually a little bit lower than for a man of the same age.

Interest Rates

This is probably the single-largest factor when it comes to pricing annuities. Life insurance companies invest their cash reserves primarily in bonds and other fixed-income instruments.

So, when interest rates are high, more income is generated from these investments than can be had when interest rates are low. Higher interest rates translate directly into higher payout rates.

That being said, most insurance companies also look at a complete range of investment alternatives. What’s more, they perform complex stochastic analyses (stress-testing projections) that show what could happen to their bottom-lines in any type of market condition.

The primary barometer for annuity pricing in this regard is the 10-year Treasury rate. Most insurers don’t just invest exclusively in Treasury securities. Many also invest in high-quality corporate bonds or mortgage-backed securities in order to boost the overall yield of their portfolios.

Not only that, insurance companies also provide expansionary capital for private corporations. Those investments can yield competitive returns over time.

Business Overhead Expenses

This is another critical factor for annuity pricing. The life insurance company must be able to meet its own obligations so it can maintain its payouts to its beneficiaries.

Rent, overhead, and office expenses are just some of the costs that insurers pay when it comes to doing business. According to the 2019 Life Insurers Factbook, operating expenses were the second-largest category of total expenditures by life insurers in 2018. Operating expenses accounted for 13% of total life insurer spending.

The Annuity Payout Option You Choose

The annuity payout option you select with your contract also has some influence. If you opt just to receive a straight life-only payout, then your payout will be higher than if you had instead opted for a life with period certain or joint life payout.

The more guarantees that you have with your payout, the lower it will be. For example, if you were to get $800 a month from a straight life payout, then you might only get $675 per month if you add a 20-year period certain onto that.

But, of course, the period certain would also guarantee you 20 years of payouts. That is regardless of whether you live that long or not.

Your beneficiary would receive the difference after you are gone. The lowest form of payout is, therefore, usually a joint life payout with a period certain. The payments must be guaranteed for as long as you both live plus the period certain if you both die within the prescribed time-frame.

Your financial professional can walk you through these different payout options, and each option’s pros and cons.

Cash Reserves

According to law, life insurers must have at least one dollar in cash reserves for every dollar of annuity contracts that are currently in force. However, most companies try to keep more in cash reserves than that.

The solvency ratio can show just how much cash an insurance carrier has in reserves at a given time. For example, if the insurance carrier has $1.25 in reserve for every dollar of annuity premium in force, then its solvency ratio is 1.25.

Choosing the Right Annuity

There are several things that people can do to ensure that they get the best possible annuity for themselves. The first is to shop around and compare the payouts against each other.

Your financial advisor or life insurance broker can run you illustrations. That information will show exactly how much you will get for a given dollar amount and your current circumstances.

You need to focus primarily on the actual dollar value that you will receive over time instead of the payout factor. This factor only determines how many dollars you will get; it isn’t an important number in and of itself.

How You Receive Your Annuity Payouts is Crucial

It’s also important for you to know exactly how you will be receiving your income payout.

If you annuitize your annuity, then you are effectively forfeiting all control over your money in the contract. In exchange, you will receive a set stream of income that will last for the rest of your life. This can happen when you choose a straight-life payout or some other irreversible option.

Of course, the same thing happens when you choose some income riders for a lifetime income stream. Some of these riders won’t let you have control over money in exchange for that income benefit.

Always check the specific terms and conditions of any annuity and income rider options you are choosing. Then double-check them with your financial professional. The details make all the difference.

However, other annuity contracts have income riders that provide you with a guaranteed payout. Not only that, they still allow you to retain some control over the principal in your contract. Again, check the options you are considering for details. If it’s important to you, be sure to check the contract for how much liquidity you might have as well.

Your Choices Also Influence Your Annuity Price

Remember, if you purchase an annuity that has a lot of riders and other features to choose from, each of those things will probably come at an additional cost.

The more guarantees that you choose, the lower your payout will be. After all, the insurance company is shouldering more risk with those benefits.

Remember to incorporate those choices into the illustrations that you request from your financial professional. You might also ask for illustrations without some of those benefits choices to see how they might affect what you pay.

Consult your financial advisor for more information on different annuity options and how they may help you. If you are looking for a financial professional’s guidance now — or you simply want a second opinion of your overall retirement strategy — help is a click away.

At SafeMoney.com, financial professionals stand ready to assist you. Use our “Find a Financial Professional” section to connect with someone directly and request a personal appointment. Should you need a personal referral, call us at 877.476.9723.