How does an annuity work? What determines your monthly payment?

Good Evening FPO Readers,

An annuity is a financial instrument which can be purchased with a lump sum payment.  In return, the annuity pays a monthly payment to the annuity holder for the remaining life of the annuity.  The payment can be either at a fixed or variable rate and the remaining life can be defined multiple ways, but is most commonly based on the remaining physical life of the annuity holder; and their spouse in the case of a joint annuity.  Since the life of the annuity is tied to your own lifespan, an annuity is more properly classified as an insurance product as opposed to an investment product.  Even though an annuity wraps together both an investing and an insurance element it is possible to break the two apart for analysis.

The below explanation is for a standard, fixed rate annuity.  There are various types of annuities, but the underlying principles described below remain the same.

Think of an annuity as a combination of a long term bond and a reverse cash flow life insurance policy at 0% interest.  What is a reverse cash flow life insurance policy you ask?  It is the same as a normal life insurance policy, but the order of payments switch.  The lump sum is paid up front by you and the monthly payments are paid afterwards to you for the rest of your life.  The opposite of your life insurance policy, right?

The bond element is mostly straightforward.  In the case of a $100K annuity, the bond element would consist of a $100k bond that pays the current market rate for long term, low risk bonds, which is about 1.75% presently.  In this case, the annual simple interest payment would be $1750.

The reverse cash flow life insurance is based on the age of the annuity holder at the time of annuity issue.  The $100k lump sum is exchanged for monthly payments for the rest of your life.  If you live a long time, you come out ahead, otherwise the issuer of the annuity comes out ahead.  The rate of the insurance component is based on market rates, but for a 65 year old man expect a yearly payment of about $4500.

The total annuity payment is $6250 per year or about $521/month.

About Steve @ FPO
Hello FPO readers, I have been writing on financial topics for about 12 years now, but I have only recently reignited the fire of publishing online. I have to say, its good to be back. I am an electrical engineer by trade who enjoys all topics engineering and financial. I started Financial Place Online (FPO) to create a value added financial news and education website that would provide a refreshing daily financial read. Financial Place Online websites are built around the principles of consumer empowerment, leveling the playing field, zero spam tolerance, and none of those annoying sidebar or banner ads. For us, it's all about enjoying a good read.

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