Dr. Menahem Yaari turned the economic world upside down when he stated in 1965 that a retiree who wanted to maximize his income would put all of his money into a lifetime income annuity and that there was no other alternative that could guarantee a more optimal solution.
The reason for this has to do with “Mortality Credits” (MCs). By combining your money with others in what is known as a risk pool you can get higher payouts and more income than a person can typically get by trying to maximize income on his or her own.
To really understand annuity payments you have to understand Mortality Credits.
You may not have heard that term, Mortality Credits, before. There are only two types of companies that can offer Mortality Credits. They are life Insurance companies and Annuity Companies.
- Can banks offer MC’s? – NO
- Can Mutual Funds? – N
- Can stocks? – NO
- Can real estate? – NO
- Can Gold or silver? – NO
- Can Oil or gas? – NO
Real quick, before we get into mortality credits it would be beneficial to get a clear picture of how an annuity works.
There are two phases to an annuity:
- The Accumulation Phase – This is where we save and invest our money into an annuity. It is usually some kind of deferred annuity, meaning we are deferring the income until some time later. It will grow and compound during the accumulation phase.
- The Payout Phase or what is called Annuitization – This is where you lock in an income stream that is similar to a pension. The idea being you can create an income you can never outlive and which can be guaranteed for life.
By the way with today’s modern day annuities, one does not have to annuitize in order to generate income. There are pros and cons to Annuitization that we’ll discuss.
When you Annuitize you begin taking a guaranteed income, you get a steady paycheck. This can be monthly, quarterly, semi-annually, or annually.
There are three parts to every income check you receive:
- Principal: Some of each check is part principal (also known as the exclusion ratio as this part of the check is excluded from taxes).
- Interest: Part of the income check includes interest earned on your annuity.
- Mortality Credits: Only an annuity company can pay Mortality Credits.
Let’s see if I can explain MC’s this way:
Suppose we have five women who enjoy vacationing together. Each year they meet and go on a cruise.
One night at dinner one of the ladies had a bright idea to put $100 into a box. When one of them dies, the remaining friends will split the money.
During the following year, one of the ladies died which left 4 remaining.
After they divided up the money in the box, they each had an additional $25 dollars, they divided the deceased’s $100 amongst the 4 survivors, or $25 each. This represented a 25% increase to their original $100.
That is the best definition of Mortality Credits. In essence, they got a 25% return on their money with no risk.
Mortality Credits have nothing to do with the rate of return or an investment portfolio or market returns; they are simply the results of mortality. Fact is some people die and some people live.
When you talk about mortality, it is the average age that a man or a woman lives to, but it’s an average. If life expectancy for a male is 82 years old, 50% won’t live to the average age and 50% of them live longer.
Mortality credits left by those that die early continue to pay out income to those that live longer.
If you look at mortality on an individual basis no one knows when you are going to die, but when looked at in a pool of say 1000 or 10,000 lives, actuaries have a pretty good idea of how many will live to age 85 and how many will not.
Insurance and annuity companies are very good at projecting mortality on a pool of policy owners.
If you have a guaranteed lifetime income annuity the longer you live the more mortality credits you will get as part of your annuity payout.
The highest payout you can receive from an annuity company is called a “LIFE–ONLY” Payout 0ption.
This Life–Only Payout is guaranteed to pay as long as you live, even if you live to be 150 years old. However, at death, the payments stop. This can be a good choice if you live a long life, receiving payments greater than your initial investment.
However, you could leave some money on the table, similar to the women in our example that died, and you could get less than your original investment back. Remember this is only if you choose the LIFE-ONLY option.
What happens to your money when you die?
If you don’t live as long as you thought you might, your funds go to provide mortality credits for those that lived. It’s a pooled risk. You were all in it together and those that live longer receive greater benefit.
Now keep in mind, this is not a profit center for the annuity company. Often times I’ll hear something to the effect that if I die all my money goes to the annuity company!
All payments are actuarially calculated and income is distributed to those who live longer – not to the pockets of the insurance or annuity company. Death is not a profit center for an annuity company.
The risk is actually on the annuity company in analyzing, through actuaries, how many people will live beyond their life expectancy and how many will not.
Mortality Credits are amazing when you think about it. This is why payout rates can be so much higher than any other fixed or conservative investment without the risk of running out of money.
Here is something interesting. Studies have shown that very few actually annuitize their annuities with the Life–Only Option (only about 8%).
Before you think that the Life–Only Option is the only way to get a guaranteed lifetime income, it’s not. There are many options. All the other options basically assure that you or your beneficiary will get the money you invested.
Life with Period–Certain Option is another choice when annuitizing.
Common time frames are 5 years, 10 years, 20, and even 30 years. This means you can get a guaranteed income for your life and if you die before the Period–Certain time frame you chose is over, your beneficiary will continue to get the payout until the Period–Certain time is complete.
Example: Suppose I took a life with 10 years period certain option. What this means is that my income check will come to me for my entire life, no matter how long I live. However, if I died in year 5, my beneficiaries would continue to get my income payments for another 5 years (10 years certain). Now if I lived longer than 10 years, in theory, I got all my money and then some. If I died after 10 years, the income would stop at my death.
Then there are several Joint Options. You can have Joint-Life Option with 100% of the payment going to you during your lifetime, and then to your spouse for this or her lifetime.
You can have Joint–Life Option with 50% option. This means you get a payout for your lifetime and your spouse would get 50% of the payout after your death throughout their lifetime.
As you can see there are several options and you should understand the pros and cons of each. Making an informed decision that is best for your situation is imperative as once you turn on the Annuitization Option and have chosen your method of payout it is permanently locked in with no way of changing it.
Now every situation is different and this certainly isn’t a blanket statement or recommendation to Annuitize your annuity. As I said earlier, you can simply take out a fixed amount or a percentage of your account value without Annuitizing as well.
This may be good for those who have plenty of guaranteed income and simply use this money at their leisure.
Every retiree faces the same risks when it comes to taking income from their investments and savings.
- Investment/Market risk
- Withdrawal Rate Risk
- Sequence of Return Risk
- Inflation Risk
- Deflation Risk
- Longevity Risk
We better take a look at each of the risks and how they can impact you.