In today’s episode, we’re going to talk about how it’s possible for annuity companies to offer guaranteed lifetime income annuities. Have you ever wondered about that? It’s not uncommon for people to express skepticism, often saying to me, “This sounds too good to be true.”
In fact, someone just said that to me this morning. And my response to that is always, “Hey, look, it’s not magic. It’s just math.”
Insurance Companies vs Government & Pension Managers
It’s no different than Social Security or a defined benefit pension, with the exception that life insurance companies do it a lot better than the government or pension managers. The reason life insurance companies excel in this area is that they are for-profit businesses. They don’t offer these guarantees out of kindness; they do it to make a profit, and the competition in the market ensures they remain efficient and effective.
In contrast, government-run programs are often plagued by corruption and inefficiency. They compel you to participate in their annuity schemes, which have been mismanaged from the start. For instance, Social Security has been raided to fund various other projects, and recent projections indicate it may become insolvent in the next decade. Pension plans, on the other hand, are often mismanaged with unrealistic return expectations and outdated mortality tables that fail to account for increasing life expectancies.
This mismanagement has led to instances where pension funds, like those of the Teamsters and coal miners, have required federal bailouts to avoid insolvency. This is not a criticism of the union workers, who have diligently contributed to these systems throughout their careers and deserve their pensions. Instead, my point is that these pension funds are often overseen by individuals who either lack competence or integrity.
How Insurance Companies Manage Longevity Risk
Guaranteed Lifetime Income annuities are based on longevity risk. This means that the primary risk for life insurance companies is that policyholders will live longer than expected, leading to extended payout periods. However, life insurance companies are uniquely positioned to manage this risk because they operate on both sides of the longevity risk spectrum.
On one side, they offer term life insurance, which covers the risk of policyholders dying too soon. On the other side, they provide guaranteed lifetime income annuities, which cover the risk of policyholders living longer than anticipated. This dual exposure allows them to effectively balance their overall risk portfolio. For example, if people start living significantly longer, the companies may pay out more in income annuities but will simultaneously collect more premiums from term life policies that don’t result in early claims. Conversely, if there is an unexpected rise in mortality rates, they may face higher term life payouts but will benefit from reduced longevity risk on the annuity side.
Because they operate on both sides of the same risk coin, they can neutralize the longevity risk associated with guaranteed lifetime income annuities. This natural hedge is a key reason why life insurance companies are able to offer such robust and reliable lifetime income guarantees.
The Concept of Mortality Credits and Risk Pooling
Mortality credits are a fundamental component of how guaranteed lifetime income annuities work. Essentially, they represent the additional return you get from an annuity because some people in the pool will not live as long as others. This allows those who live longer to benefit from the funds of those who don’t.
And the next point, which is risk pooling, further supports this concept. Risk pooling involves combining the premiums paid by a large group of people into one pool. Actuaries then apply the law of averages and the law of large numbers to this pool. They can accurately predict how many people within the pool will live to a certain age, even though they cannot predict exactly who will reach that age.
This statistical approach is why the payout rates on annuities are higher when you’re older—you are bringing less longevity risk to the table. By pooling the risk among a large number of people, life insurance companies can ensure that they have enough funds to pay out lifetime income to those who live longer, while also maintaining profitability. This system of mortality credits and risk pooling is what allows life insurance companies to offer and manage guaranteed lifetime income effectively.
Impact of Interest Rates on Guaranteed Income Annuities
The next factor that plays into income annuity pricing is interest rates. As of June 2024, we are experiencing a high interest rate environment. This situation means that annuities are currently offering higher guaranteed payouts than I have seen in a long time.
However, don’t be discouraged if you are reading this at a time when interest rates are lower. Even when rates were at historic lows, annuities still provided significantly more guaranteed income than what you could safely withdraw from a managed portfolio.
Interest rates are a crucial factor, but they are not the only one. Annuity companies also benefit from the law of large numbers and their ability to achieve better returns on their bond portfolios than individual investors. When they invest, they are doing so with billions of dollars, allowing them to secure better rates and hold bonds for longer durations than you or I could manage personally.
This ability to leverage large sums of money and invest for the long term is another reason why life insurance companies can offer such attractive guaranteed lifetime income annuity solutions.
The Role of Capacity in Guaranteeing Lifetime Income
Then the last factor that plays into how these work and how to get the highest guarantees out there for your particular age range is something called, “capacity.” When an insurance company provides a quote for guaranteed income, they have a limited number of mortality credits they can offer for each age group. This limitation means that a company might be the top payer for a 65-year-old today, but not for a 60-year-old or a 70-year-old. And if you check back a week later, that same company might not even be in the top 10 for 65-year-olds anymore because they’ve reached their capacity for that age range.
What happens next is that another company steps in to take that spot. This dynamic nature of capacity is why it’s crucial to work with an independent advisor who can use third-party software to check which company is offering the highest income at any given time. I’ve said it many times before—”I am completely agnostic when it comes to these annuity companies. I don’t care which one we use as long as they are financially stable, provide excellent customer service, and offer the highest guaranteed lifetime income annuity benefits available at that time.“
In fact, I use multiple third-party software tools to compare all the top-paying companies side by side. This year alone, I’ve placed business with 11 different companies because the top payers keep changing.
In the podcast episode, I go quite a bit deeper into how this process works and include plenty of examples, so if you’re still trying to wrap your head around how guaranteed lifetime income annuities work, then I highly recommend you give it a watch or listen.
Podcast Episode 32: How Annuity Companies Can Offer Guaranteed Lifetime Income Annuities
Download Podcast Episode 32: How Annuity Companies Can Offer Guaranteed Lifetime Income Annuities on Apple Podcast