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Section 3
INDIVIDUAL ANNUITIES

The market for individual annuities has expanded substantially in the last century. To understand its growth, one must recognize the range of different annuity products available to individuals and the risks the products are designed to insure against. Individual annuity products differ in their provisions for asset accumulation and in the terms under which the accumulated principal is dispersed during the liquidation phase. This section describes the primary types of individual fixed annuities and summarizes the growth of the individual annuity market in the United States.

TYPOLOGY OF INDIVIDUAL ANNUITIES

Annuities can be categorized along many dimensions, including the number and timing of premiums, the number of lives covered, the nature of the payouts, and the date at which benefits begin. An outline of the different types of annuities follows:

Method of paying premiums:

Number of lives covered:

Waiting period for benefits to begin:

Nature of payouts:

The simplest individual annuity contract is a single-premium immediate annuity. In return for a single premium payment, the annuitant receives a guaranteed stream of future payments that begin immediately. These payments can end when the annuitant dies (a simple life annuity), when both the annuitant and a coannuitant, such as a spouse, have died (a joint life survivorship annuity), or at the later of a fixed number of years or the date of death of the annuitant (life annuity with stipulated payments certain). These types of annuities address different insurance needs. A simple life annuity is primarily designed to insure annuitants against outliving their resources; a joint life survivorship annuity addresses this risk and also provides retirement income for dependents.

The "payout certain" annuity is often attractive because potential annuitants are unwilling to turn over a capital sum to an annuity provider and risk dying shortly thereafter without receiving many annuity payments. The "fixed payments certain" product overcomes this inhibition by ensuring that payments will be made to the annuitants' beneficiaries for at least a fixed period. The level of the annuity payout associated with a "fixed-payments certain" contract is correspondingly lower than that for a simple life annuity.

Black and Skipper (1994) contrast the pricing of different types of single-premium annuities. They report that a 65-year-old man could expect roughly $7.22 per month in annuity payout per $1,000 premium payment for a fixed life annuity, compared with $6.64 per month for a 10-year certain and continuous annuity (a life annuity with a guarantee of a minimum of 10 years of payments) and $6.19 for a cash refund annuity, which refunds the unpaid nominal amount of the premium in the event that the annuitant dies before the full amount of the initial premium has been distributed. The differences in purchase rates are a function of time and interest rates.

text box 5In addition to the immediate annuities described above, a second broad class of individual annuities is deferred annuities. A single-premium deferred annuity, for example, includes a waiting period between the premium payment and the beginning of annuity payouts. The promised stream of payments for a given premium is greater for a single-premium deferred annuity than for a single-premium immediate annuity, since the premium is invested and earns returns between the date when it is paid and the date when the payouts begin.
A variant on such an annuity, one that provides for multiple premium payments, could represent a saving plan for an individual who plans to use an annuity to draw down accumulated resources. This is known as an annual-payment annuity. It specifies a stream of premiums that the policyholder will pay during the policy's accumulation phase. At the conclusion of this phase or possibly some years afterward, the policy enters its liquidation phase and the annuitant and beneficiaries begin to receive payouts from the accumulated principal. Annual-payment annuities can be useful planning tools for those who are trying to accumulate the resources to receive a substantial annuity during retirement. Single-premium deferred annuities have been the dominant contract in the individual annuity market of the last few decades.

One of the most popular annuity products is the flexible-premium deferred annuity, which permits annuitants to make cash contributions at times of their choosing and allows the accumulated value of these premium contributions to be converted to an annuity at some future date or specified age of the annuitant.

THE GROWTH OF THE INDIVIDUAL ANNUITY MARKET

The annuity business was a small share of the insurance market until the Great Depression. Data compiled by the Temporary National Economic Commission (TNEC) (1941, 112) suggest that, over the period 1866-1920, annuity premiums text box 6averaged only 1.5 percent of life insurance premiums received by U.S. insurance companies. The Great Depression, and the associated financial panic and bank failures, led many investors to seek reliable investment vehicles for their savings. Individual annuities, many offered by insurance companies with long and stable financial histories, were such vehicles, and they grew rapidly during the 1930s. TNEC (1941) data show that 68 percent of all annuity premiums received between 1913 and 1937 were received between 1933 and 1937. In 1934-36, the premium income on newly issued individual annuities exceeded that on newly issued ordinary life insurance for the 26 large companies studied by the TNEC.

As a share of payouts, reserves, or total premium income, annuities were still a small part of the insurance business in the 1930s. They accounted for 1.79 percent of all insurance company disbursements over the 1929-38 period, compared with 24.3 percent for death claims and 23 percent for policy surrender values (TNEC 1941, 324). Annuities, at 8.56 percent, accounted for a greater share of premium income during this period, and individual annuities accounted for 80 percent of annuity premiums. In 1938, annuity reserves were $2.67 billion, compared with $16.83 billion in life insurance reserves.

Although the individual annuity market grew rapidly in the 1930s, it represented only a small fraction of the insurance industry at the end of this period. Many firms that had sold policies during that decade subsequently experienced losses on their annuity contracts for two reasons. First, the rate of return earned on insurance reserves fell during the early 1930s. Long-term interest rates on Moody's AAA corporate bonds averaged 4.68 percent between 1928 and 1932 but 3.45 percent between 1933 and 1940. The real interest rate was much greater than the nominal rate in the early 1930s. The consumer price index fell 20.3 percent between 1928 and 1932, raising the real return to lenders. Long-term interest rates fell below 3 percent in the late 1930s. Because annuities had been sold assuming that prevailing interest rates from earlier periods would remain in force, the drop in rates led to investment earnings below the level needed to service these contracts. Campbell (1969) reports that the net earnings rates of life insurance companies reached a high of 5.05 percent in 1930 but declined for nearly two decades afterward, falling to 2.88 percent in 1947. This was reflected in the poor profitability of annuity contracts.

A second factor in annuity losses was the longevity of annuitants relative to the assumptions that insurance companies used in pricing their annuity contracts. Life expectancy did not improve substantially during the Depression. Life expectancy for white men at age 60 was only 0.2 years longer in 1940 than in 1930. For women, the gain in life expectancy was slightly larger: 0.5 years (Historical Statistics, Series B124-125, vol. 1). But as Gilbert (1948) and the TNEC (1941, 331) explain, the mortality tables that life insurance companies used to price annuities were revised several times during the 1930s to reflect the lower mortality risk for annuitants than for the general public. The mortality experience of female annuitants was particularly overstated by the life tables in use at the beginning of the 1930s.

Gilbert (1948) compares the 1868 American Experience Table of Mortality, long a standard reference in the insurance industry, and the "expectation" table adopted in 1938 for annuity purposes. The tables show large gains in life expectancy at extreme ages, especially for women. The 1868 table combined both men and women to yield a life expectancy of 8.48 years at age 70. In contrast, the 1938 table shows a life expectancy of 15.62 years for female annuitants at age 70. The overly optimistic mortality assumptions built into annuities sold at the beginning of the 1930s contributed to the losses on these products later in the decade.

The annuity contracts that grew in popularity during the 1930s emphasized the role of annuities as retirement savings and investment vehicles. Annual-premium retirement annuities-contracts that allowed individuals to make premium contributions each year, to accumulate a capital fund, and then to choose from a number of payout options at the date of their retirement or another advanced age-expanded particularly rapidly. Retirement annuities were attractive retirement saving vehicles for several reasons. They offered returns that were often greater than those available elsewhere for small investors. They provided an option to purchase an immediate single-premium annuity at a future date, typically at terms specified at the beginning of the accumulation period, if the participant decided that was the best way to decumulate text box 7assets. Perhaps most important, annuities were supplied by secure financial institutions. Gilbert (1948) notes that even though surrender charges could sharply reduce the return on these products for those who redeemed them before maturity, this did not prevent the rapid expansion of the deferred annuity market in the 1930s.

Annuity premiums, the amount an annuitant had to pay to purchase a given payout stream, increased during the 1930s. Gilbert (1948) reports that in 1930 Aetna Life Insurance Company would sell a $100 immediate annual annuity to a 65-year-old man/woman for a premium of $925/$1,040. By 1940, the premiums had increased to $1,220/$1,435.

The individual annuity market expanded throughout the postwar period. As the data in Table 2 show, individual annuity premium payments increased almost every year. However, comparing these premium payments with a yardstick for the size of the economy, such as gross domestic product, can be more revealing. Individual annuity premiums were 0.064 percent (six one-hundredths of 1 percent) of GDP in 1951. They declined to 0.053 percent in 1961, then began to increase: to 0.110 percent by 1971, 0.339 percent in 1981, 0.903 percent in 1991, and finally to 1.21 percent in 1993. The early 1960s thus marked the beginning of the growth phase for individual annuities, with much of the growth concentrated in the period since the late 1970s.

CHARACTERISTICS OF ANNUITY OWNERS

Survey data on the owners of nonqualified annuity products, such as the information collected and reported in Gallup text box 8(1996), provide some insight on the individuals who own these policies. In 1995, the average age of individual annuity holders was 64, and half of these policyholders were retired. Less than one-quarter were under the age of 54. More than 80% of the annuity policyholders had annual incomes of less than $75,000 per year. The majority of those with annuities reported that they planned to use their annuities for retirement income.

Current owners were attracted to annuities for a variety of reasons. Roughly three-quarters of annuity owners cite tax benefits as a primary reason for purchasing their policy. Another 64 percent cite the safety and reliable income associated with an annuity, and more than half indicate that the long-term saving plan associated with an annuity product was an important attraction. A substantial fraction, nearly half, of all annuity holders report that they used a one-time income receipt, such as an inheritance, to purchase their annuity.

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