CAI Home > Resources > The History of Annuities in the United States

Section 1
INTRODUCTION TO ANNUITIES

Annuities are contracts that provide periodic payments for an agreed-upon span of time. They include annuities certain, which provide periodic payouts for a fixed number of years, and life annuities, which provide such payouts for the duration of one or more persons' (the annuitants') lives. The principal insurance role of annuities is to indemnify individuals against the risk of outliving their resources.

Consider the choices confronting a retiree who has accumulated assets by saving over time, through inheritance, or as a result of company contributions to a pension plan. Assume that he expects no future income other than the return on his capital and that he has no desire to leave a bequest. How should this individual deplete his assets each year? If he knew for certain how long he would live, this retiree could compute the time profile of consumption that would just exhaust his wealth when he died. But the fact that the individual does not know his date of death complicates the choice of a consumption profile. If he consumes relatively little in the first few years of retirement, he will make adequate provision for a very long life. There is a chance, however, that he will die with a large sum of remaining capital. Alternatively, if the individual consumes aggressively in the near term, the prospect looms of having to reduce consumption later if he lives longer than expected.

Annuities solve the retiree's consumption problem. In return for an initial capital payment, he is assured of receiving a constant income stream for the remainder of his life. The annuity provider can pool mortality risk across similar individuals and thereby can, with the principal left behind by those who died sooner than expected, insure those who live longer than expected. As a result, the annuitant's payout from the annuity contract can, in theory, exceed what he could earn if he invested the amount of his annuity premium and then consumed only the income flow.

The annuity payout rate rises based on the annuitant's prospective mortality risk and on the rate of return that the annuity provider can earn on invested assets. Younger individuals, because they are expected to receive payments for a longer time period, receive lower annuity payouts than older annuitants do for a given amount of capital invested. Higher rates of return generate greater income per dollar of capital and also make possible the offering of higher payout rates to annuitants. As an example of an annuity contract, consider a 65-year-old man who plans to spend $100,000 to purchase an immediate life annuity. The Annuity and Life Insurance Shopper (April-June 1995, 13) reports the payouts on immediate annuities offered by a number of insurance companies. These range from $727 per month ($8,724 per year) to $908 per month ($10,896 per year); this illustrates both the typical payout level on annuities and the substantial disparity in annuity terms across different providers. For a 65-year-old woman, the annuity payout per $100,000 investment ranges from $638 per month to $833 per month. Her lower payout reflects the greater life expectancy for women than for men.

Annuities are sometimes referred to as "reverse life insurance." With life insurance, the policyholder pays the insurer each year until he or she dies, after which the insurance company pays a lump sum to the insured's beneficiaries. With annuities, the lump-sum payment is from the annuitant to the insurance company before the annuity payout begins, and the annuitant receives regular payouts from the insurer until death.

Most annuity contracts have an accumulation phase and a liquidation phase. During the accumulation phase, capital builds up; this capital is dispersed during the liquidation phase. In the case of the single-premium immediate annuity considered above, there is no accumulation phase. Annuitants make lump-sum payments of the accumulated capital that they wish to draw down to the annuity provider. During the liquidation phase, the annuitants receive payouts contingent upon their survival or in accord with other terms specified in the annuity contract. In many annuity contracts, payouts are specified as a guaranteed minimum, with the opportunity for a dividend if mortality experience or rates of return on insurance company investments prove better than expected.

Many annuity products exhibit long accumulation phases, so they operate in part as saving vehicles. Although annuities are unique in their provision of income streams contingent on remaining alive, they compete with other financial products as a means for asset accumulation.

Annuities have historically been offered by insurance companies, which pool the mortality risk across many individuals and thereby achieve a more predictable cash flow than if they offered an annuity to only one individual. The same principles that underpin risk reduction in life insurance sales apply to the provision of annuity payouts. The annuity supplier must have sufficient capital and be sufficiently long-lived to ensure that annuity payouts will still be paid if the annuitant lives for many years. One of the current regulatory battles in the United States concerns whether banks and other financial institutions that provide saving vehicles should be permitted to underwrite annuities. A key question is whether any entity which sells annuities or assumes a mortality risk with respect to annuities should be subject to state insurance department scrutiny.

ANNUITIES AND THE VALUE OF INSURANCE

Annuities can make consumers better off by providing insurance against the possibility of reaching extreme old age with very low remaining financial resources. To illustrate this proposition, Kotlikoff and Spivak (1981) calculated the gain in lifetime utility for a 30-year-old man who faces mortality risk and can purchase an actuarially fair annuity, one for which the expected discounted value of annuity payouts equals the purchase price of the annuity. The utility gain from purchasing an annuity on these terms is equivalent to the utility gain from a 30 percent increase in the present discounted value of his lifetime earnings. The utility gains are even larger for older individuals, for whom uncertain longevity represents a more immediate source of risk.

Friedman and Warshawsky (1988) contrast the consumption profiles that individuals with and without access to actuarially fair annuity markets will choose. They show that an individual without annuities who lives to age 85 will rationally choose to consume only 73 percent as much at age 85 as was consumed at age 65. At age 95, this individual will be consuming less than half as much each year as at age 65. If he or she had annuitized personal wealth at age 65, consumption would be the same at all of these dates. This general pattern is reduced but not reversed by the inclusion of realistic institutional features such as an assured minimal income in old age from Social Security.

One important distinction among annuity products concerns the nature of the payout stream, in particular whether the payout is a fixed nominal amount for the duration of the liquidation phase. Historically, most annuities provided fixed nominal payouts. Yet many individuals who purchase annuities are presumably interested in ensuring for themselves a minimum level of purchasing power, or real income, for the remainder of their lives. (Real income is income adjusted for the effects of inflation.) Inflation, which is uncertain when the annuity is purchased, can reduce the real value of the annuity payout. The utility gain for an individual with access to a market for real annuities is greater than that associated with access to a nominal annuity market. Diamond (1977) points to the absence of markets for purchasing power-adjusted annuities as one of the important rationales for government-provided retirement income programs. The recent introduction of Treasury securities that guarantee returns after inflation may lead to changes in this situation. In particular it may facilitate the introduction of purchasing power-adjusted annuities by some insurance companies.

Variable annuities, one class of annuity products, are designed to reduce the risk of inflationary erosion of real benefit payments. They have been one of the most rapidly growing insurance products of the last two decades. Variable annuities offer the opportunity to link payouts to the returns on an underlying asset portfolio. If the underlying assets provide a hedge against inflation, so will the payouts on the variable annuity. Variable annuities, however, do not always provide an inflation hedge. The weak performance of the U.S. stock market during the 1970s, when inflation rates were substantial, provides an example of one period during which variable annuities with payouts linked to the stock market did not provide a hedge against inflation.

STATISTICAL OVERVIEW OF ANNUITY MARKETS

Tables 1 through 3 present an overview of the significance of annuities in the U.S. insurance market. Table 1 presents the value of insurance company payouts on life insurance policies and on annuities over the period 1940-93, converted to 1994 dollars by adjusting for the effects of inflation. Although annuities represented less than 10 percent of the combined payouts on life insurance and annuities in the period before World War II, they grew more rapidly than life insurance in the five decades tracked in the table. By the early 1990s, annuity payouts constituted nearly 40 percent of combined payouts.
Table 2 reports the premium income received by insurance companies for annuity policies over the 1951-93 period. The table shows both the substantial growth of real annuity premiums, particularly between 1951 and the mid-1960s, and the breakdown of annuity premiums between individual and group policies. Although premiums on group policies were three to five times greater than the premiums on individual policies throughout the 1950s and 1960s, individual annuities have grown more rapidly in the last two decades. In 1993, the latest year for which data are available, premiums for individual and group annuities were almost equal. This reflects both the decline in the growth of defined benefit pension plans and the rapid expansion of individual annuity products, particularly variable annuities. By comparison, life insurance premiums (measured in 1994 dollars) were $38.7 billion in 1951, more than seven times greater than annuity premiums. In 1993, life insurance premiums were $96.9 billion, or roughly 60 percent of annuity premiums.

Statistics such as those reported in Table 2 may understate the actual significance of annuity contracts. As Murphy (1950) notes, virtually all permanent life insurance contracts other than term life accumulate cash value. This accumulated value can be used to purchase an annuity. Such policies are classified as life insurance policies, but they can also be viewed as partly annuity products. Provisions regarding withdrawals and annuity conversions are almost always specified in the life insurance policy at the time of purchase.

Table 3 presents information on the reserves that insurance companies hold against future payouts on annuities and life insurance policies. In part, this reflects the growth of term life insurance, for which revenue requirements are lower than for other types of life insurance. The data span the 1967-93 period, and show the rapid growth of annuities over this period. Whereas total annuity reserves were less than half of life insurance reserves in the mid-1960s, they have grown to more than twice the value of life insurance reserves in 1993. The data on annuity reserves are divided into individual annuities, which have grown most rapidly over this period; group annuity reserves, which have increased by more than a factor of five since the data began; and reserves for supplemental annuities, which have declined in real terms. Supplemental annuities are typically purchased in association with life insurance policy payouts.

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