Lifetime-annuities–as-easy-to-understand-as-a-mortgage

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Lifetime annuities may seem complicated, but I’ll try and provide an easy comparison to help make them easier to understand – I’ll compare a lifetime annuity to what happens with a home mortgage.   

With a typical mortgage, each payment made by the homeowner consists of two parts: an interest component and a repayment of principal component. Over time, as the principal is paid down, a smaller and smaller component of the fixed monthly payment consists of interest and a larger component goes toward paying down principal.

For example, if you have a $100,000 ten-year mortgage, you will need to repay the entire principal in ten years, averaging $10,000 per year. At a four per cent mortgage interest rate, that will elicit $12,144 in annual payments (or $1,012 monthly), so approximately $2,144 of that will be the annual interest, on average.[1] If the term of the mortgage were 20 years, it would require an average annual principal repayment of $5,000 per year on a four per cent mortgage to extinguish the debt. The total payment, including interest, would be $7,272 (or $606 monthly), so the extra $2,272 would be the average amount of interest paid per year.[2]

With annuities, the monthly payments are analogous to a mortgage, with the main difference being that there are three components instead of two. There are the familiar components of interest and repayment of principal, which work in a similar way to those of a mortgage. Repayment of principal will return the entire purchase price of the annuity over the expected remaining lifetime of the annuitant. For example, if you purchased the annuity at an age where you had an additional twenty years of life expectancy, the annuity would be priced to return that purchase price in monthly instalments over twenty years. If your lifetime income annuity cost $100,000, the principal repayment would average $5,000 per year for twenty years. 

The second component that you receive is an ‘interest credit’ and stems from the interest the insurer earns on the premium paid.

Thirdly, there is also a ‘mortality credit’ component, which effectively represents the unrepaid principal contributed by those annuitants who are no longer alive to receive payments. The amount of a monthly payment funded by mortality credits starts at zero, but increases exponentially over time, funding survivors’ annuity income streams long after capital has been repaid. Generally speaking, the longer you live the more mortality credits you receive.

Above I’ve been referring to average annual principal repayments and average annual interest earnings, although the actual patterns of these payments over time are not level. Neither is the pattern of mortality credits, as shown in the figure below. However, what is important to the annuitant is that the uneven pattern of the three components to each payment, combine to produce level monthly and annual payments.  Generally speaking, the longer you live, the more mortality credits you will receive.

But unlike the mortgage, which may be scheduled to mature in (say) 20 years, the annuity expires only when you do. As the return of principal and interest payments dwindle away, the mortality credits take over and ensure that your payment stream is not interrupted nor reduced.

Composition of lifetime annuity payments

Composition of lifetime annuity payments

Extract from David Babbel and CommInsure whitepaper, Retire Smarter – new strategies towards a comfortable retirement. You can access the paper via our website.

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[1] I emphasised above the word “average”. Over time, as the principal is paid down, a smaller and smaller component of the fixed monthly payment consists of interest and a larger component goes toward paying down principal. The pattern of principal repayment itself within the ten-year term of the mortgage does not affect the total payment, which remains level throughout the mortgage period.

[2] These calculations are verifiable by referencing the link below. To calculate the average annual principal repayment, you take the total size of the loan and divide by the term of the mortgage. To calculate the average yearly interest, you take the total accumulate payments over the entire term of the mortgage, subtract the entire principal, and you get the total interest payable. Divide the total interest by the term of the mortgage to get the average annual interest payable. 

https://www.commbank.com.au/digital/home-buying/calculator/home-loan-repayments

General advice only. This material has been prepared without taking into consideration your personal objectives, financial situation or needs. Before acting on this advice, you should consider whether it is appropriate for you. You should read the relevant Product Disclosure Statement before making a decision to buy or continue to hold a product. The Colonial Mutual Life Assurance Society AFSL 235035.

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