How Are Annuities Calculated?

Annuities provide guaranteed income.

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Annuities can be an effective way to manage your income options in retirement. Although you don't know how long you'll live, annuities can guarantee an income for a specified period (a term certain annuity) or for your entire lifetime (a life annuity). Annuities are issued by insurance companies that calculate payments based on economic and demographic factors as well as on the type of annuity.

Life Annuity

A life annuity guarantees to pay you an income for as long as you live. The main advantage is that you cannot outlive your income, and you can match the annuity payment to your consistent income needs. Potential pitfalls include the facts that you are locked in and cannot cancel the annuity for cash, and that the payments cease when you die regardless of when that is. You can protect yourself by adding a guaranteed period, which would result in a lower payment but ensure that even if you died the income lasts for a minimum period, such as 10 years. You also can purchase a joint and last survivor annuity that guarantees income for as long as you or your spouse is alive. You can also add a guaranteed minimum period so that the income continues after both you and your spouse have died. And adding a cost-of-living feature to any life annuity will increase your income to the cost-of-living index each year.

Calculating a Life Annuity

The factors that determine the life annuity payment are your age, mortality statistics, interest rates and the type of annuity. The insurance company calculates the annuity so that the present value of all annuity payments will equal the lump-sum purchase amount. The present value assumes an interest discount factor that the life insurance company uses to reflect long-term interest rates. Mortality statistics also factor in the calculation, because not all annuitants will receive an equal amount of payments. The annuity is calculated so that everyone on average will receive an amount of income at life expectancy that, together with interest, approximates the lump-sum purchase price.

Term Certain Annuity

A term certain annuity guarantees payments for a specific period. Your age does not matter, because the payment duration is fixed regardless of when you die. If you die before period ends, payments continue to your named beneficiary.

Calculating a Term Certain Annuity

Calculating the income from a term certain annuity is easier than for a life annuity, because mortality statistics don't factor into the equation. The payments are calculated so that their present value equals the lump sum of cash used to purchase the annuity. If you purchase a 20-year term certain annuity with a lump sum of $100,000, for example, the insurance company can pay you $493.48 per month at an assumed discount factor of 1.75 percent. You will receive a total of $118,435.20, meaning the annuity will have earned a total of $18,435.20 in interest.

Tax Treatment

Annuity payments from traditional IRAs and 401(k) plans are fully taxable. Taxable interest is spread out over the entire term of a term certain annuity, and over a term equaling life expectancy for a life annuity.