How Do Insurance Companies Make Money on Annuities?

Annuities are one of the most powerful retirement products a person can own. Multiple types of annuities exist, each with different features, goals, pros and cons.

Source: Tax Credits

Members of the Baby Boomer generation total 79 million, and retire by the thousands every month, most with existing retirement assets that need to be transferred or managed in some way. The collective investable assets of the Boomers total approximately $8.5 trillion, making this a desirable target market for insurance companies and other retirement services providers.

History

The annuity concept is not new. Annuities were first devised by the Roman Empire as a way to raise capital. Citizens would make a payment to the Empire in exchange for smaller annual payments for the rest of their lives.

In 17th century Europe, many nations used this technique to pay for battles and wars. It was not until the mid 18th century that annuities were available in the United States. Over the centuries, the concept of purchasing a lifetime payment evolved into a powerful and profitable product for both company and consumer.

The Facts

Annuities are highly profitable products for insurance companies. Investors purchasing annuities make large lump sum deposits with the company in exchange for various features and guarantees later in life.

Since most annuities are purchased several years, if not decades, prior to retirement, the insurance company can hold and invest an annuitant’s money with very little danger of having to return it prior to making a profit.

Types

Perhaps the most resented and ridiculed aspect of any annuity contract is the surrender period. The surrender period is a length of time, usually between four and ten years, during which the insurance company will retain a certain percentage of the annuitant’s initial deposit if he chooses to close the account and cancel the contract. This is called a surrender charge.

Most surrender charges decrease as the surrender period elapses, but not always. In some cases, the surrender charges may be as high as 15% and the surrender period as long as 15 years. This is a method insurance companies use to guarantee their profit regardless of whether the annuity is kept or not.

Fees are another tactic used by insurance companies to generate profits from annuities. Recurring monthly, quarterly, or annual fees are deducted from annuity account values. The size and frequency of these fees depends upon the specific features the annuitant added to his contract. More elaborate and attractive features result in higher fees.

The third way insurance companies make money on annuities is through their own investments with customer funds. Insurance companies may purchase various types of securities, stocks, bonds, real estate, etc. with annuity deposits. Regardless of the type of annuity and the guarantees offered in a particular contract, the company’s investment returns are always higher than the interest credited to any one account.

Misconceptions

Just because an annuity is held with a major insurance company, an investor’s money is not necessarily guaranteed. Not all annuities protect against a loss of principal in the event of a stock market decline, particularly in the case of a variable annuity contract. Unless an investor purchases a fixed annuity, or choose the fixed account option within a variable annuity, his money may still be at risk.

Warnings

Annuity contracts are not insured by a bank, the FDIC, the federal government, or any other agency. The safety of any annuity contract’s provisions is based solely on the claims paying ability of the issuing insurance company. It is highly recommended that independent financial ratings organizations be consulted or contacted prior to the purchase of an annuity.

References

Bureau of Labor Statistics
History of Annuities

Resources

Baby boomers make rich targets
Wikipedia
Money Instructor

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This article is a Twisted Nonsense Exclusive! (06/25/2009)