Mortality Credits

Bertrand notices that the guaranteed lifetime income quoted on a straight life immediate annuity is meaningfully higher, as a percentage of his lump sum, than the yield he could earn on a ladder of high grade bonds of similar quality. His producer explains that this is not because the insurer is taking more investment risk. What is the actual source of the difference?

1. A.Annuity payments are exempt from federal income tax, so the insurer can quote a higher gross figureAnnuity payments are not tax exempt. Only the portion representing return of investment is excluded, and that under the exclusion ratio.
2. B.The quoted payout rate is a projection rather than a guarantee, so it is not comparable to a bond yieldOn a fixed immediate annuity the payment is contractually guaranteed. The difference is structural, not a matter of guaranteed versus projected.
3. C.The insurer invests annuity reserves in equities rather than bonds, producing a higher expected returnGeneral account reserves backing fixed annuities are invested conservatively, predominantly in high grade fixed income. The difference is not an investment story.
4. D.Each payment includes return of his own principal plus mortality credits released by annuitants in the pool who die earlier than expectedCorrect. Return of principal plus pooled mortality credits, not superior investment yield, explain the higher payout rate.

Why: An immediate life annuity pays out of three sources: return of the annuitant own principal, interest earned by the insurer, and MORTALITY CREDITS. Mortality credits arise because the pool is priced on average life expectancy. Annuitants who die early leave behind funds that the insurer uses to keep paying those who live longer. A bond ladder has no such pooling: it returns only principal and interest, and it can be outlived. Mortality credits are the unique economic feature of a life contingent annuity and the reason it can promise a payout rate a bond portfolio cannot match.

Osgar, 70, has a serious heart condition and a shortened life expectancy. He applies for a single premium immediate annuity from an insurer that MEDICALLY UNDERWRITES its immediate annuities. Compared with a standard-health applicant of the same age paying the same premium, Osgar will receive:

1. A.An IDENTICAL monthly payment, because immediate annuity payouts depend only on age, sex and interest ratesThat is true of a standard, non-underwritten SPIA. The stem specifies that this insurer medically underwrites, which is exactly what changes the result.
2. B.A LARGER monthly payment, because his shortened life expectancy means the insurer expects to make fewer paymentsCorrect. Impaired risk annuity underwriting converts a shortened life expectancy into a higher payout for the same premium.
3. C.A SMALLER monthly payment, because substandard health is rated the same way it is rated in life insuranceThis applies life insurance logic to an annuity. Poor health increases the cost of a death benefit but increases the payout on a life annuity.
4. D.A LARGER monthly payment, but only if he elects a period certain rather than a straight life payoutThe impaired risk advantage comes from the life contingency itself. Adding a period certain would reduce, not enable, the higher payment.

Why: Immediate annuity pricing is the mirror image of life insurance pricing. A life insurer charges a poor-health applicant MORE for a death benefit because it expects to pay sooner. An annuity issuer expects to make FEWER lifetime payments to a poor-health annuitant, so the same single premium buys a LARGER monthly payment. That is why medically underwritten (impaired risk or substandard) immediate annuities exist: the annuitant trades medical evidence for higher income.