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Bee-Mail - 18 February 2010

Annuities: Insurance contracts against living longer than our savings

There are plenty of insurance products that we all know about and, at a pinch, could probably have a decent stab at explaining. I’m sure most of us understand life insurance and home insurance and car insurance, even pet insurance and travel insurance. Insurance is something we come across at various stages of our lives on the planet and by and large we know why we might need it and what it’s all about. That is until we get older and end up having to deal with strange insurance products like annuities. Most people, I’m sure, wouldn’t know where to begin if put on the spot and asked to describe an annuity. That, by the way, probably includes most of the people who work in financial services too. Annuities are hard to understand. So, what is an annuity when it’s at home?

Put simply an annuity is an insurance product and, like all insurance products, it is designed to protect people against the effect of unpredictable events. In the case of an annuity people are essentially insuring against living longer than their lifetime savings. An annuitant typically exchanges his or her lifetime pension savings in return for a guaranteed level of income for life; an income that will continue to the day they die however far in the future that may be in any individual’s case.

That is a simplification, of course, and there are many different annuity products available these days to meet some of the various and varied needs of retired people. But in essence the nature of an annuity contract is that it is an insurance arrangement. As such it is a one-way ticket.

Consider a hypothetical group of, say, ten thousand people all aged 65. The group as a whole may have an average life expectancy of maybe another 20 years or so beyond the age of 65, but that does not mean any particular individual within the group can count on that. Some may die soon after the age of 65 whereas others may well live on beyond the age of 85, 95 or even 105. No-one in the group can know their fate with certainty at the age of 65.

For the ten thousand people in this hypothetical group of 65 year-olds it could make good sense for them to pool their lifetime savings to ensure that none of them outlive their savings. Those who die early after making such a contract with the others could be said to have lost out on the deal, as those who live on to a great age could be said to have gained from it, but all in the group could equally be said to have been in receipt of the contracted benefit; an income for life.

In everyday language the nature of an insurance contract like an annuity gets caught up in the way we speak and as a result it is possible to lose sight of what we’re talking about when the subject comes up. The fact that we are all today lucky enough to have the chance of living longer than ever before translates into statements like “Annuity rates are getting worse!” and “Annuities aren’t as good value as they used to be!” and similar.

You might be surprised to know that back in 1866 when the ages at which people died were first recorded the average life expectancy in the UK was just 29. By 1941 that average had increased to 57 and by 1966 to 68. Today it is 80. That doesn’t mean that people in the nineteenth century and the twentieth century didn’t live to the age of 100 or more. Some did, just as some do today. It’s just that the number of people who died early, particularly in infancy and through uncontrolled diseases, in the past had the effect of reducing the average.

The difference today is not really that we are able to live longer than humans have ever been able to live in the past (although there has been some small increase in lifespan), but rather that more and more of us are reaching old age. The average age of death is therefore going up as a result. Annuity rates, of course, reflect that. That’s all.