Why buy an annuity contract when you have money to spend?

Question

If a person has $100K to spend for retirement, why buy an annuity contract that pays a fixed income like $600 per month when the person can just take out $600 per month from the $100K to spend?

Answer 1

Annuity contracts are primarily there to insulate you against "mortality risk". Suppose you live longer than average, the contract will keep paying out until you die even if that's more than you could have funded directly with the annuity cost.

Conversely the people that die earlier than average lose the extra money, which is used to fund those that die later (and the annuity company's profits).

The annuity company might also be able to take different investment risks that improve investment returns on average, but that's a secondary consideration.

Some annuities do offer a guaranteed minimium term so that your beneficiaries will still receive something in case you die the next day, but usually this means slightly reduced payments. Similarly, some will offer payments to a spouse in case they outlive you, but again in exchange for a lower payment rate.

Answer 2

The point of an annuity contract is that it gives you a guaranteed income for life.

Say -- just making up numbers, not saying this particular contract is available anywhere -- that you have $100,000, and that statistically you can expect to live another 8 years, or about 96 months.

You could put the $100,000 in a box and take out $1,000 per month. If you then lived exactly the 8 years predicted, over that 96 months you would take out $96,000, and there would be a few thousand left when you died.

But what if you beat the odds and lived 9 years? Then you'll run out of money.

That's where an annuity comes in. Let's say they guarantee you $1,000 per month. Then if you live more than 8 years, the annuity company continues to pay you $1,000 every month, even though they've then used up all the money you gave them. On the other hand, if you only live 7 years, then there's $16,000 left and the annuity company comes out ahead.

In real life you could invest the money and do better. And the annuity company almost surely invests the money. That complicates the math but doesn't change the principle.

The reason to get an annuity is to have guaranteed income for the rest of your life.

In real life, the annuity company almost surely studies statistics to know how long you are likely to live. And if they're not idiots, they offer monthly payments that will result in them making money if you live for an average length of time. You could look at the same statistics, invest your money in the same funds that the annuity company does, and come up with a payment amount that gives you a mathematical expectation of having steady income for life. But the problem is, you're one person, and the amount of time you will live is difficult to predict. The annuity company has thousands of customers, so they can average numbers out. They accept that they will lose money on some customers, but they will make it up on others. If one customer lives to be 120, they will likely lose money on him. But they have enough customers who die young to make up for it. For any one customer, all he cares about is his own life span and financial situation. Knowing that, if 1000 people followed your plan, only 10 of them would have run out of money, doesn't do you much good if you're one of the 10.

Answer 3

While mortality risk is the main reason to buy an annuity (and it has already been covered in the other answers), there is another risk an annuity covers: that you lose your money.

This can happen in several ways, but for older people that danger is real. As you get older you become dependent on others and your judgement may become impaired, especially in the very latest years of life. This may lead to unwise spending and/or falling victim of scammers, gold diggers, caretakers or robbers (mainly in situations where people live more isolated and store wealth at home). In most of the situations I mentioned the losses are very large.

If you buy an annuity, that money can no longer be taken from you.