Do you ever lie awake at night, wondering what would happen if you were to outlive your retirement income? The thought of running out of money at a time in your life when you may be totally unable to replace it may be a major source of worry, especially if your nest egg is relatively small. Fortunately, you are not the first person to have this fear. And several decades ago, the life insurance industry decided to create a vehicle that helps to insure against this risk.
What Is an Annuity?
Conceptually speaking, annuities can be thought of as a reverse form of life insurance. Life insurance pays the insured upon death, while annuities pay annuitants while they are still living. The academic definition of an annuity is a promise by one party to make a series of payments of a specific value to another for a given period of time, or until a certain event occurs (such as the death of the person receiving the payments). As an actual investment, annuities are retirement vehicles by nature. Investopedia defines an annuity as “a financial product sold by financial institutions that is designed to accept and grow funds from an individual and then pay out a stream of payments to the individual at a later point in time.”
Purpose of Annuities
Annuities were originally created by life insurance companies to insure against superannuation, or the risk of outliving one’s income stream. Modern annuity products can also help to pay for such things as disability and long-term care, and they can also serve as tax shelters for wealthy individuals whose incomes are too high to allow them to save money in other retirement vehicles such as Individual Retirement Accounts (IRAs).
History of Annuities
Although annuities have only existed in their present form for a few decades, the idea of paying out a stream of income to an individual or family dates clear back to the Roman Empire. The Latin word “annua” meant annual stipends and during the reign of the emperors the word signified a contract that made annual payments. Individuals would make a single large payment into the annua and then receive an annual payment each year until death, or for a specified period of time. The Roman speculator and jurist Gnaeus Domitius Annius Ulpianis is cited as one of the earliest dealers of these annuities, and he is also credited with creating the very first actuarial life table. Roman soldiers were paid annuities as a form of compensation for military service.
During the Middle Ages, annuities were used by feudal lords and kings to help cover the heavy costs of their constant wars and conflicts with each other. At this time, annuities were offered in the form of a tontine, or a large pool of cash from which payments were made to investors. As investors eventually died off, their payments would cease and be redistributed to the remaining investors, with the last investor finally receiving the entire pool. This provided investors the incentive of not only receiving payments, but also the chance to “win” the entire pool if they could outlive their peers. European countries continued to offer annuity arrangements in later centuries to fund wars, provide for royal families and for other purposes. They were popular investments among the wealthy at that time, due mainly to the security they offered, which most other types of investments did not provide. Up until this point, annuities cost the same for any investor, regardless of their age or gender. However, issuers of these instruments began to see that their annuitants generally had longer life expectancies than the public at large and started to adjust their pricing structures accordingly.
Annuities came to America in 1759 in the form of a retirement pool for church pastors in Pennsylvania. These annuities were funded by contributions from both church leaders and their congregations, and provided a lifetime income stream for both ministers and their families. They also became the forerunners of modern widow-and-orphan benefits. Benjamin Franklin left the cities of Boston and Philadelphia each an annuity in his will; incredibly, the Boston annuity continued to pay out until the early 1990s, when the city finally decided to stop receiving payments and take a lump-sum distribution of the remaining balance. But the concept of annuities was slow to catch on with the general public in the United States because the majority of the population at that time felt that they could rely on their extended families to support them in their old age. Instead, annuities were used chiefly by attorneys and executors of estates who had to employ a secure means of providing for beneficiaries as specified in the will and testament of their deceased clients.
Annuities did not become commercially available to individuals until 1812, when a Pennsylvania life insurance company began marketing ready-made contracts to the public. During the Civil War, the Union government used annuities to provide an alternate form of compensation to soldiers instead of land. President Lincoln supported this plan as a means of helping injured and disabled soldiers and their families, but annuity premiums only accounted for 1.5% of all life insurance premiums collected between 1866 and 1920.
Annuity growth began to slowly increase during the early 20th century as the percentage of multigenerational households in America declined. The stock market crash of 1929 marked the beginning of a period of tremendous growth for these vehicles as the investing public sought safe havens for their hard-earned cash. The first variable annuity was unveiled in 1952, and many new features, riders and benefits have been incorporated into both fixed and variable contracts ever since. Indexed annuities first made their appearance in the late 1980s and early 1990s, and these products have grown more diverse and sophisticated as well. In 2016, sales of annuities were $211.4 billion, according to the Insured Retirement Institute.
Despite their original conceptual simplicity, modern annuities are complex products that have been among the most misunderstood, misused and abused products in the financial marketplace. They also have had more than their fair share of negative publicity from the media.
In the next section we will explore the mechanics of these contracts more thoroughly, along with their basic benefits and the parties involved.