Annuity Prices

Annuity pricing can be confusing and a detailed discussion is beyond the scope of this buying guide.

A simple way to think about annuity pricing is to make a comparison to life insurance.  It is generally understood that life insurance is more expensive as one gets older and “closer to death” because the insurance company is paying claims when the policyholder dies.  In other words, term life insurance is less expensive for a 20 year old than a 40 year old.

Annuity pricing is basically the reverse of life insurance pricing.  The risk to the insurance company is that you will live longer than expected—not that you will die earlier than expected.  All other things being equal, the longer the annuity payments last the more expensive the annuity.  For example, a pure life annuity with payments guaranteed for life is naturally more expensive than a 5 year term certain.

You need to think of annuity prices in terms of the amount that the annuity pays out:

• Lower annuity payouts equate to higher annuity prices.
• Higher annuity payouts equate to lower annuity prices.

There are, of course, many other factors beyond mortality rates that impact annuity pricing such as interest rates, capital markets volatility, hedging costs and sales expenses.

Annuity price comparisons can be difficult because there are so many different types of annuities, and each of the annuity types come with many different options.  Apples-to-apples comparisons of annuities can be challenging.

However, price comparisons can be made with simpler annuities such as single premium immediate annuities.  In this case, the comparison is based on the amount of the annuity payout.  This can be a monthly dollar amount or a percentage that reflects yield or ratio of the payout to the premium.

In addition, there are a handful of tools that are useful for thinking about annuity valuation and making comparisons of similar annuities.  Included among these calculations are money’s worth, internal rate of return and annuity equivalent wealth.

Money’s Worth

Money’s worth is a measure that is based on the expected present value of the annuity payouts divided by the cost of the annuity.  In other words, it shows the “value per premium dollar” or how the discounted value of all future annuity payments compares to the amount of money required to buy the annuity.

The money’s worth calculation is based on three core factors:

• The amount of the annuity payout
• Interest rates
• Mortality rates

Money’s worth is useful because it shows how the actuarial value of an annuity compares to the value that a buyer receives in the annuity market.

Money’s worth is not the same as an internal rate of return (IRR) calculation.  An IRR calculation shows the rate at which the present value of annuity payments equals the cost of purchasing the annuity.

Annuity Equivalent Wealth

Similar to money’s worth, annuity equivalent wealth is a calculation used to assess the economic value of an annuity.

Annuity equivalent wealth is the amount of money that would be required to produce the same level of economic utility as an annuity. 

For example, what amount of wealth would be equivalent to a $75,000 of fully annuitized wealth?  For a “risk averse” person, the answer is typically greater than 1—for instance, 1.4 which would result in $105,000 in annuity equivalent wealth.