An annuity is a type of investment that people use to ensure that their retirement does not outlast their income. You can purchase an annuity with either a one-time payment or payments made over time, with the promise of a certain amount of income each month for the rest of your life starting at a certain point. How the annuity company manages this money has a lot to do with whether it will have enough money to pay the benefits promised in the annuities.
The insurance company uses what it calls a mortality credit to spread its risk in an annuity among many people in a group. For example, if 20 people put $1,000 into a pool, and the person holding the money promises a 5 percent return in one year, the group has collectively invested $20,000 and will earn $1,000 at the end of the year. Dividing that payout over 20 people, each would receive $1,050. If the pool projects accurately that only 19 people will be alive to collect at the end of the year, and you must be alive to collect your portion, the pool only has to pay out a total of $19,950. This difference is the mortality credit. Even if the pool only earned 3 percent on the money, it can pay each person still alive 5 percent and still make a profit.
When Will You Die?
The key to managing money in an annuity and ensuring that funds will be available to pay all of the benefits is to know when people will die. While you cannot predict when one person will die, you can predict with a group of people how many will die after a certain amount of time. Insurance companies use actuaries to look statistically at groups of people, given their age and general health, and determine when the people in the group are likely to die. This statistical management is important to managing annuity money correctly.
To balance safety with a need to compete with other, more interesting investments, insurance companies have introduced variable annuities. With a variable annuity, you can divide your annuity among different types of investments, including fixed-rate and stock mutual funds. With these types of annuities, more of the future payout is based on the return on investment, which can vary. This places more of the risk that the annuity may lose money with the purchaser, removing this risk from the insurance company.
Fees that the insurance company charges for this type of account are tied to how the account is managed. A simple, fixed annuity will have the lowest fees, as it is the simplest type of account to manage. A variable annuity with any type of guaranteed return will carry the highest fees, due to the uncertainty of this type of account. The fees are used to offset the expenses the insurance company incurs with the management of the account, leaving more of the mortality credits to fund the profitability of the insurance company.