Annuity Payouts: Why Are They Higher than Bond Rates?

I often write about the usefulness of lifetime annuities — especially fixed, immediate, inflation-adjusted annuities — in retirement planning. (I find them helpful because they provide a relatively-high, predictable level of income.)

On occasion, people will tell me that they don’t want to buy a lifetime annuity. Instead, they plan to “build their own annuity” using bonds and other fixed-income investments.

Not annuitizing is perfectly fine. If you have enough savings to get by with a typical stock/bond portfolio, more power to you. But “building your own annuity” is not possible.

Sources of an Annuity’s Payout

The payout from a lifetime annuity comes from three sources:

1. Your principal being paid back to you over time,
2. The return on the investments that the insurance company buys with your principal, and
3. Mortality credits.

The first two are not unique — you can get them just as well from bonds or bond funds. The third income source, however, is only provided by an annuity.

What’s a Mortality Credit?

Imagine that 1,000 65-year-old male investors each decide to purchase a lifetime annuity on the same date. The insurance company knows that it has to plan to make payments for, on average, 21 years for each annuitant. (Because a 65-year-old male has a life expectancy of 21 years.)

Of course, what really happens is this:

• Some annuitants will live beyond their life expectancy, and the insurance company will have to make payments for more than 21 years.
• Some of the annuitants will die before their life expectancy, thereby allowing the insurance company to use those annuitants’ money to fund the payments for still-living annuitants.

In other words: If you live beyond your life expectancy, annuities let you spend dead people’s money. (The portion of the annuity’s payout that’s composed of funds from deceased annuitants is known as the “mortality credit.”)

In turn, if you end up dying before your life expectancy, it will be your money that funds the payout for the annuities of still-living annuitants. That is, other annuity-owners will get your money rather than your heirs.

But that’s what makes the whole gig work. That’s precisely the reason that annuities provide for a significantly higher safe withdrawal rate than you can get from other fixed-income investments.