Thanks to our friend, Will Selden, for asking what discount rates are currently being used by insurance companies to price life annuities in his March 28, 2022 blog post SWAG on Annuity Discount Rate. Based on his analysis, Will notes that current annuity pricing appears to be based on higher interest rate assumptions than in the past few years. This is not terribly surprising as interest rates in general have increased since the Federal Reserve signaled that it would raise the Federal Funds interest rate and would probably continue to do so into 2023. For example, the 10-year constant maturity Treasury rate has increased by almost 70 basis points during the month of March. All things being equal, higher assumed interest rates translate to higher monthly life annuity benefit amounts per dollar of premium.
The stated intention of the Federal Reserve to continue to increase interest rates in 2022 and into 2023 raises the question of whether those considering purchasing annuities should wait at least until the Federal Funds interest rate has stabilized. We suggest that potential SPIA customers track the movements of annuity purchase rates over time on websites like ImmediateAnnuities.com (or other sources) before making a purchase.
In this post we will
- Discuss the assumptions and other factors generally involved in annuity pricing.
- Solve for implied interest rate (or investment return) assumptions used for pricing purposes that are approximately consistent with current SPIA quotes and life expectancies (50% probability of survival) based on the mortality assumptions recommended in this website from the Actuaries Longevity Illustrator, and compare these calculations with similar calculations performed in April, 2020, and
- Solve for implied investment return assumptions for planning purposes that are approximately consistent with current SPIA quotes and the recommended (default) Lifetime Planning Periods (25% probability of survival).
In addition to cautioning our readers that they may wish to wait on purchasing a life annuity at this time, the major take-aways from this post include:
- It appears that implied interest rates used to price life annuities have increased recently, but since rates of inflation have increased even more, we are not inclined at this time to change the default assumptions used in the Actuarial Financial Planner.
- Implied interest rates used to price life annuities for older annuitants (those age 75 and older) appear to continue to be lower than younger annuitants, possibly resulting from of a combination of factors, including shorter duration, more assumed anti-selection by insurance companies, less competition for annuity sales at the older ages or other factors, and
- Implied interest rates for those planning to live longer than their life expectancy can be significantly higher than implied interest rates used to price life annuities, and may actually increase for older annuitants vs. younger annuitants.
Assumptions and Other factors generally involved in Life Annuity Pricing
There are two basic assumptions involved in the pricing of SPIAs:
- Mortality rates (which generally differ for males and females), and
- The interest rate (or rates) that the insurance company believes it can earn on private placement bonds that it issues to fund the expected annuity payments.
Insurance companies are not required to disclose the assumptions they use to price life annuities. And while life annuities are priced approximately based on life expectancies (50% probability of survival under an assumed mortality table), there can be many other factors which can influence the price of a SPIA other than the basic assumptions noted above, including:
- Payment forms
- How the product is sold
- Expense assumptions
- Profit objectives
- Insurance company capacity for new business
- Annuity reserve requirements
- Competition pricing
- Anti-selection assumptions
- Group sales vs. individual sales, etc.
Given the above, it is not an easy task to take today’s SPIA quotes (for example, those listed on ImmediateAnnuities.com) and back into the specific interest rate (or mortality assumption) used to develop the quote. And we certainly can’t tell you what the specific assumptions various insurance companies use. However, if we assume a specific mortality assumption, we can solve for an implied interest rate that is approximately consistent with the annuity quote.
But if we have an annuity quote, why do we want to know what the pricing assumptions might be? Well, there are at least two reasons:
- The pricing assumptions can be helpful in informing purchasing decisions, and
- The pricing assumptions can give us an indication of the assumptions that may reasonable for the purpose of comparing the present value of a household’s non-risky investments and the present value of the household’s essential expenses (like we suggest be done in the Actuarial Financial Planner)
In this post, we will examine the implied interest rate assumptions built into current quotes from ImmediateAnnuities.com and compare the quotes and the implied interest rates with the results of a similar exercise we performed in April of 2020 and discussed in our post of April 11, 2020.
The second column of the tables below show monthly life annuity quotes for males of different ages per $100,000 of premium from Immediateannuities.com as of April 10, 2020 and April 1, 2022. Life expectancies shown in third column are 50% probabilities of survival from the Actuaries Longevity Illustrator (ALI) for non-smoker males in excellent health (which is the mortality table we use in our workbooks). The fourth column shows our calculation of the fixed investment rate of return that would be earned if a person bought the annuity and died at his current age plus his life expectancy from the ALI table (in months). This investment return is net of insurance company expenses and profits (but not net of taxes). These rates are nominal rates and not real (net of assumed Inflation) rates.
Implied Interest Rates based on ALI Life Expectancy as of 4/10/20200 | |||
Current Age | Fixed Monthly Life Annuity for Male ($100,000 Single Premium | Life Expectancy in Months (based on AAA Longevity Illustrator 50% planning horizon for a non-smoking male in excellent health | Implied Interest Rate |
55 | $ 399 | 396 | 3.0% |
60 | $ 436 | 336 | 2.9% |
65 | $ 489 | 276 | 2.7% |
70 | $ 561 | 216 | 2.2% |
75 | $ 692 | 156 | 1.2% |
80 | $ 887 | 108 | -0.9% |
Implied Interest Rates based on ALI Life Expectancy as of 4/1/2022 | |||
Current Age | Fixed Monthly Life Annuity | Life Expectancy in Months (based on AAA Longevity Illustrator 50% planning horizon for a non-smoking male in excellent health) | Implied Interest Rate |
55 | $444 | 396 | 3.8% |
60 | $486 | 336 | 3.8% |
65 | $542 | 276 | 3.8% |
70 | $622 | 216 | 3.5% |
75 | $754 | 156 | 2.6% |
80 | $954 | 108 | 0.4% |
The more recent table shows that annuity quotes from ImmediateAnnuities.com have increased since April of 2020 and so have the implied interest rates, since life expectancies using the AAA Longevity Illustrator have remained essentially constant. As noted above, the implied interest rates consistent with the ALI mortality table for older non-smoking annuitants in excellent health are much lower than for younger annuitants, indicating that insurance company pricing for older annuitants assumes longer life expectancies and/or assumes lower interest rates due to shorter assumed durations.
The table below tells a different story for individuals who live until their 25% probability of survival rather than their 50% probability of survival. It can be argued that these implied rates of return are more applicable to individuals considering an annuity purchase if their plan includes living longer than their life expectancy.
Implied Interest Rates based on 25% Probability of Survival as of 4/1/2022 | |||
Current Age | Fixed Monthly Life Annuity | Lifetime Planning Period (based on AAA Longevity Illustrator 25% planning horizon for a non-smoking male in excellent health) | Implied Interest Rate |
55 | $444 | 468 | 4.3% |
60 | $486 | 408 | 4.6% |
65 | $542 | 348 | 5.0% |
70 | $622 | 276 | 5.2% |
75 | $754 | 216 | 5.9% |
80 | $954 | 168 | 7.1% |
It is interesting to note that implied interest rates (or rates of return) for older annuitants are higher than returns for younger annuitants on this revised basis. This is because moving from 50% probability of survival to 25% probability of survival generally adds about five years to the expected time of death, and an additional five years is a much more significant increase for an 80-year-old than it is for a 55-year-old (and may explain why insurance companies may be more likely to assume greater anti-selection by older annuitants in their pricing).
Conclusion
While recent increases in interest rates have increased the amount of monthly life annuity that may be purchased with a given premium amount and has increased implied interest rates (or rates of return) on life annuities, it may be wise to wait until the Federal Reserve has finished increasing the Federal Funds interest rate before purchasing an annuity. We plan to continue to monitor implied rates of return on annuities in this blog (on both a pricing and planning basis).
