Journal Issue

Research: Price variability of life annuities adds a wrinkle to retirement planning

International Monetary Fund. External Relations Dept.
Published Date:
February 2005
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Life annuities are a little used but potentially sound investment for retirees, particularly for those who lack an employer-provided or public pension. With these annuities projected to become more popular in the future, retirees will need to know much more about them. One key thing to keep in mind, says Sandy Mackenzie of the IMF’s Research Department, is that the price of, or premium on, these annuities can fluctuate substantially. That can complicate retirement planning—and even entail hardship.

Why have life annuities attracted so little interest? For one thing, demand for private annuities—which are normally funded and underwritten by life insurance companies—has been crowded out by public pensions. Potential annuitants have also been discouraged by a lack of familiarity with and an understanding of this unusual financial instrument.

Cost can be another factor. Annuities are typically bought by people who expect to live longer than the average. Insurance companies take this into account in pricing annuities, making them relatively unattractive for the population at large. And, finally, tax systems often favor housing and other investments that compete with annuities.

What is a life annuity?

In return for a large up-front payment, nominal life annuities pay recipients a fixed sum, usually monthly, for the rest of their lives. Annuities provide longevity insurance, furnish a predictable income, and impose discipline on the recipient’s spending, since control of the capital is ceded once an annuity is set up.

An indexed life annuity would also provide inflation insurance. The typical public pension system, for example, pays an indexed life annuity. The combination of inflation insurance and longevity insurance is very valuable. At present, however, private financial institutions offer indexed annuities in only a few countries, including Chile, Israel, and the United Kingdom, where the governments have issued indexed debt and have thus assumed the risk of inflation.

Finally, for the long-lived, the return on a life annuity should exceed the rate of return of the financial instruments that back it. The annuity provider pools premiums from a group of annuitants, invests them in bonds, and makes payments only to those who survive from one year to the next. No payments are made to the estates or families of the deceased.

That said, in many countries some fundamental trends are at work that are expected to boost the demand for annuities over time:

Demographicchanges. The absolute number of the elderly and their share in the population in advanced and most emerging market economies will grow rapidly in the first half of the 21st century.

Pressureonpublicpensions. Demographic shifts are expected to exert substantial pressure on public pension systems. This will likely result in cuts in retirement benefits. The adoption of individual accounts could also entail cuts in the public benefit (depending on how payouts from the accounts are regulated).

Adeclineindefined-benefitpensions. In countries like the United States and the United Kingdom, employer-provided defined benefit plans are becoming an endangered species. As defined-contribution pension plans become more common, annuities are likely to become—by choice or requirement—a more important source of retirement income.

Premium variability

Assuming that more elderly people seek, or are forced to seek, life annuities, there is still the matter of fluctuations in annuity prices or premiums. Insurance companies fund annuities with a combination of bonds and equities—in the United States, annuities are backed mainly by bonds. The premium paid per dollar of regular income would in principle be expected to vary with what economists call the yield curve—that is, the relationship between the rate of interest and the maturity of the interest-bearing security.

The yield curve normally slopes upward. When it shifts up across all maturities (or most of them), the premium per dollar of payment goes down, and vice versa. Annuity providers may try to stabilize premiums to gain market share, so premiums may not move in lockstep with interest rates. Over time, however, there is a clear relationship between interest rates and the premium per dollar of income.

People nearing retirement are well advised to obtain a large share of their income from a stable source. Traditionally, a public pension performed this function for many people. With the probable decline in public pensions over time, however, the income of retired people may become both more variable in amount and less guaranteed over time. Annuities may provide a reasonable substitute for public pensions, but without the steady predictability or, unless they are indexed, the inflation insurance that public pensions had provided.

Planning for uncertainty

The price that must be paid for a certain amount of income can vary substantially. By one estimate, in the 1980-93 period, U.S. life annuity prices, or premiums, for 65-year-old men varied from as little as $97,000 to as much as $130,000 for a monthly income of $1,000 (see IMF Working Paper 04/230). For 1990-2002, an IMF study relying on an indirect estimate based on the yield curve found that there was a 20 percent chance that premiums might be either 10 percent or more above their average or 10 percent or more below their average. The apparent decline in variability from the earlier period is likely attributable to the fact that nominal interest rates were less variable in the later period. Of course, the variability of annuity premiums, in and of itself, does not make them fundamentally different from other financial instruments. What is different is that annuities may be called upon to replace some or all of a relatively stable source of income, like a public pension.

Given the potentially valuable role that life annuities can play as a source of retirement income, is there some way to reduce premium variability or mitigate its effects? One possible step is to stagger the purchase of annuities over several years. This strategy could reduce premium volatility, but at a cost. Buying several smaller annuities is likely to cost more than buying one big annuity. Another strategy might be to defer the purchase of the annuity. Premiums should decline as the annuitant ages, but here, too, the option comes with potential costs. The money that would have bought the annuity will need to be temporarily parked in an investment that normally would have a lower yield than the annuity. And neither strategy guarantees a low or even a moderate premium.

For retirees for whom life annuities are the sole or an increasingly important source of retirement income, the irreducible unpredictability of annuity premiums will have to be dealt with. And that means basing retirement planning on conservative assumptions. To avoid unpleasant surprises, retirement planning should assume that premiums will be above their recent average. This, in turn, means that people will have to save more for retirement. And it also means that in the years leading up to retirement, people—or their financial advisor, if they can afford one—will need to become thoroughly acquainted with annuities, and with indexed annuities, if a market develops for them.

The good news is that the financial environment in most countries has been stable, and severe fluctuations in annuity premiums appear unlikely. Moreover, as the annuity market develops, competition may increase, and premiums may decline over time. It is also possible that annuity products may come to differentiate among classes of the population according to their life expectancy, much as life insurance does. This will make annuities more affordable for groups with lower than average life expectancy, who tend to be less well off.

Annuities may provide a reasonable substitute for public pensions, but without the steady predictability or, unless they are indexed, the inflation insurance that public pensions had provided.

—Sandy Mackenzie

So the moral of the story for retirees is that life annuities can indeed play a valuable role in providing secure income, but careful, and conservative, planning must take account of premium variability. There is a moral for governments, too. A stable financial environment may be particularly helpful to retirees, who vote and whose numbers are on the rise just about everywhere.

Copies of IMF Working Paper 04/230, Can the Private Annuity Market Provide Secure Retirement Income? by G. A. Mackenzie and Allison Schrager, are available for $15.00 each from IMF Publication Services. See page 48 for ordering details. The full text is also available on the IMF website (

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