In order to understand how annuities work, consider what would happen if
there were no annuities. If you wanted an income from your pension fund
when your retire, you would have to make regular withdrawals. However this
would create two problems.
- How much income?
- If you draw too little income you would die without having spent all your money, but you would leave money to pass on to your family.
- Yet, if you draw too much you would run out of money and have to rely on your savings or fall back on your family or the State.
- Where to invest?
- If you invest too cautiously your income will be lower, but safer
- if you invest in a more risky way, you might obtain more income if your investments perform well.
Annuities provide the answer
Annuities efficiently convert capital into income by providing a high level of guaranteed income for life with no risk. This
is achieved by investing in fixed interest investments and applying a mortality cross subsidy
When someone buys an annuity, the insurance company works out their normal
life expectancy and calculate the level of their annuity payments. However
not everyone lives to their normal life expectancy and the insurance comapny
makes a profit for them. However the insurance company uses this profit
to pay the pensions of those people who will live past their normal life
expectancy.
This means that those who die before their normal life expectancy subsidises
those who live longer than expected.