Refresher on Annuity Pricing Mechanics
The Employee Benefit Research Institute (EBRI) recently did a study and found that four out of five workers are interested in some form of guaranteed lifetime income solution, Christopher Maarberg, director, product development, institutional income annuities at MetLife in New York, said at the 2018 PLANSPONSOR National Conference.
“MetLife also conducted a poll in conjunction with The Harris Poll and found that 21% of people who choose a lump sum depleted their lump sum within 5-1/2 years, which is why there is a huge need for guaranteed lifetime income that they are not going to outlive,” he said. “Giving plan participants this option is critical.”
How annuities are priced really comes down to five main factors, says Robert Johnson, professor of finance at the Heider College of Business at Creighton University in Omaha, Nebraska.
“The monthly income you get is calculated at the time of the purchase of the annuity, with interest rates prevailing at the time of the purchase of the annuity being one of the biggest factors determining your monthly payout,” Johnson says. “This is because the annuity provider takes the money you pay them and invests, primarily in fixed income securities, and the higher the rate environment, the higher their expected return.”
Nancy Bennett, senior life fellow at the American Academy of Actuaries in Washington, says the return on the investments “is the single biggest factor in pricing an annuity.” The insurer doesn’t just look at the prevailing interest rate but will “look at a range of investments and do stochastic analysis to see what the profit returns could be in all market conditions,” Bennett says. “They need to know how their profit will change in different market conditions. That is where a lot of the modeling comes in.”
The second factor an annuity provider considers is the age of the purchaser, Johnson says. “The older you are when you buy an annuity, the higher your annuity payments,” he says. “Simply put, you aren’t expected to live as long, so your expected mortality is taken into account. If you have a serious medical condition that makes your life expectancy shorter, your monthly payout will be higher.”
It also matters when the annuitant begins to draw on the income and whether it is a term-certain annuity, says Doug McIntosh, vice president of investments at Prudential Retirement in Newark, New Jersey. Insurers consider the “age at which the individual purchases the annuity and expects to take the income,” McIntosh says. “The longer I wait from the time I purchase to the time I begin to draw income, the more income I can expect. This is because the insurer gets to hold onto that money and invest it for longer, and every minute the annuitant waits to draw down income, they get closer to the time when they will not be drawing down income.”
For instance, with guaranteed minimum withdrawal benefit (GMWB) annuities, there are age tranches that pay different amounts, McIntosh says. “If I start taking the money at age 62, I might get a 3% payout,” he says. “At age 65, that might be 5%, and at age 70, it might be 5.5%. In the case of an immediate annuity, you can either take an immediate or a delayed payout. One form of a deferred income annuity is the qualified longevity annuity contract (QLAC), which typically has the starting date for payout at age 80 or 85.”
With a term-certain annuity, the shorter the term, the higher the payments, Johnson says. “If you elect a 20-year guaranteed payment period, your payments will be higher than if you elect a 25-year payment period,” he says. “If you die before the term is up, your beneficiaries receive the payments for the rest of the term.”
The fourth main factor is the expenses that the insurer faces, Bennett says. There are “the business expenses of operating the insurance company and other regulatory requirements,” she says. “When an annuity is issued, the amount of reserves and capital set aside in the first year are greater than any initial investment. If someone takes out a $500,000 annuity, for instance, the insurance company will need reserves amounting to 105% of that. They have a lot of regulations and requirements they need to comply with, which vary state by state.”
The fifth factor affecting annuity pricing is whether or not the annuitant names their spouse or partner to receive survivor benefits, McIntosh says. “That creates more risk for the insurer,” he says. “With a guaranteed minimum withdrawal benefit, for instance, if you put your spouse on the contract, the fee might increase. Or, the fee could stay the same and the payout will go down. In the case of a traditional annuity where there is no explicit fee, you cannot use the fee as a lever, so the payout will be impacted.”