What is an annuity or supplementary pension?

An annuity is a sequence of several (usually identical) payments made at regular intervals.

The number of payments can be fixed (for example: a consumer loan repayment is an example of an annuity with a fixed number of fixed payments made monthly); but it may be due to the occurrence of an event (for example, in insurance, annuities are traditional, terminated from the moment of the death of the insured), according to Beinsure Life & Annuity Insurance Market review.

An additional pension paid by a pension fund, employer, or insurance company is also an annuity.

On the other hand, an annuity is a way of fulfilling financial obligations, when one payment is replaced by a sequence of several payments, which are adjusted for the depreciation of the value of money over time. For example, in life insurance, the insurance payment in the event of the death of the insured can be replaced by periodic payments over several years.

A synonym for the term “annuity” is an annuity.

Classification of annuities

I. The first characteristic of an annuity, which largely determines its other characteristics, in particular risks, is the nature of the annuity payer. For example, you can highlight:

1. Insurance (Paid by insurance companies);
2. Pension (Paid by pension funds);
3. Financial (paid by banks and other financial organizations);
4. Paid by other legal entities;
5. Paid by individuals (usually repaying loans and paying for purchases in installments).

Of course, this classification is very conditional, since, for example, an insurance company can pay an annuity not related to its insurance activities …

II. Natural is the classification of annuities on the basis of urgency:

1. Term annuities, i.e. fixed number of payments.
2. Term annuities with the possibility of early termination. (For example, loans with the possibility of early repayment)
3. Perpetual annuities (pensions paid until the death of a pensioner)
4. Annuities in which not only the number of payments is not fixed, but also the start time of payments should be singled out as a special group. (Example: disability pension.)

III. According to the frequency of payments, annual, monthly, quarterly, etc. can be distinguished. annuities.

The original form of annuities was annual, and now the most common form is monthly.

IV. In terms of payments and exposure to inflation, the following varieties can be distinguished:

1. Fixed annuities, i.e. all payments are the same;
2. Currency annuities, in which payments are tied to one foreign currency or a basket of currencies to protect against inflation;
3. Indexed, i.e. the amount of payments is tied to the inflation index;
4. Variables for which the amount of payments is tied to the yield index of financial instruments.

Risks associated with annuities and pensions

For the payer and the recipient of the annuity, the risks are different and we will list them separately.

Annuity Payer Risks

We consider only insurance and pension annuities, so the risks inherent in other types of annuities are not listed here.

1. The risk of long life of the recipient of the annuity.
2. Risk of low profitability of financial instruments.
3. Risk of low inflation leading to low returns.
4. Investment risks associated with lagging behind the prices of financial instruments from inflation.

Annuity recipient risks

1. The risk of insolvency of the annuity payer.
2. Risk of premature death.
3. The risk of surviving until the expiration of the annuity contract.
4. Risk of high inflation.

Features of variable annuities

Here we will consider the features of only those annuities, the amount of periodic payments for which will change over time (in an unpredictable way), and after the start of annuity payments.

First, despite the variability of the annuity, the amount of payments during the policy year, often coinciding with the calendar year, does not change. Those. the amount of payments in the next year is calculated at the end of the current year.

Secondly, despite the linkage of the annuity to the inflation index or to the financial index, the recipient of the annuity is interested in stability. Therefore, he should be given guarantees of profitability, and at least not a decrease in pension payments.

Thirdly, an annuity implies very high liquidity of investments of a pension fund or an insurance company, so a fairly large part of the investment must be made in debt securities, which means INSUFFICIENT protection against inflationary risks for the payer and a small guaranteed return for the recipient of the annuity.

Fourthly, a variable annuity implies a large redemption commission due to the lower liquidity of investments.

What determines the cost of an annuity?

As elsewhere in life insurance, the main factors that determine the cost of an annuity are demographic factors. Among them, the most important are gender (annuity is more expensive for women) and the age at which the annuity is paid.

If the annuity is deferred, then the age at which the contract is concluded is also important. The limited term of an annuity payment (usually an annuity is paid for at least 10 years) has a relatively small impact, since the life expectancy of a pensioner after the end of the annuity is small; those. the cost of a limited annuity is close to the cost of an indefinite one.

Important factors in determining the cost of an annuity will be the return on investment, the risks in the financial market and the level of inflation.

Because annuities are relatively shorter contracts than life insurance policies, short-term interest rates and financial market liquidity become important when evaluating annuities.

Additionally increase the price of the annuity:
1. The possibility of terminating the contract with the return of the unpaid amount;
2. Payments in case of death of the recipient of the annuity;
3. Protection against inflation.

Inflation Protection

The recipient of the annuity is usually a pensioner who has no other means to maintain the usual standard of living. Therefore, the recipient of an annuity needs maximum protection against any risks and, in particular, against the risk of inflation, which, provided the payer is sufficiently reliable, turns out to be the main one.

Therefore, the pensioner is willing to pay for inflation protection, and is more willing to pay for it than the policyholder in other types of long-term insurance. Therefore, it is also beneficial for the insurer to offer inflation-protected annuities.

Among the ways to protect against inflation are:

1. Annuity with growing payments . This option reduces the impact of inflation on the welfare of the pensioner, but does not protect against inflationary risks, i.e. from fluctuations in the rate of inflation.

2. Annuities linked to financial indices . The idea behind these annuities is that the performance of financial markets depends indirectly on the rate of inflation, i.e. an increase in inflation will inevitably cause an increase in the yield of financial instruments. However, it is known that:

a) the growth of the profitability of financial markets lags behind inflation in time;

b) profitability in the financial market is not fully correlated with inflation.

Therefore, protection against inflation will not be complete, and the recipient of the annuity is exposed to financial risks.

3. Indexed annuities. Those. annuities, the amount of payments in which is explicitly indexed depending on inflation. Unfortunately, such annuities will be unnecessarily expensive for policyholders, since they shift the entire risk of inflation to the annuity payer, and since the latter has no way to completely avoid this risk, he must include in the price of the annuity and the payment for inflation risk and additional. premium for the possibility of misjudging this risk.

Who needs annuities?

Anyone who has savings that they want to turn into a permanent income for the rest of their lives; and who do not have the desire, skills or ability to manage these savings personally, and also have a desire to avoid financial risks.