Examining Annuity Premiums

There are different types of annuities available, and various ways to pay for them. Let's take a look at how a purchaser may pay for an annuity and how the premiums are determined.

An annuity purchased with a single lump sum payment is known as a single premium annuity. For the single premium, the company promises to pay the annuitant an amount each payment period (monthly, quarterly, semiannually, or annually).

A second way of buying is with the level premium annuity. Under this agreement the premiums are paid in periodic installments over the years prior to the date that the annuity income begins. Level premiums are, in essence, a method of "forced savings." A common level premium arrangement is the annual premium annuity, in which the premiums are paid in yearly installments up to the time that the annuity benefits begin. However, premiums can also be paid monthly, quarterly, or semiannually.

Like the level premium annuity, a flexible premium annuity's premiums are paid over a period of time (usually years) until the annuity benefits are scheduled to begin. The flexible premium annuity differs, however, in that the purchaser has the option to vary the size of each premium payment, as long as it falls between a set minimum and maximum amount – for instance, between $200 and $10,000. (If an annuity is used to fund an IRA, it must provide for flexible premiums.)

There are five factors used to determine annuity premiums: the annuitant's age and sex, the assumed interest rate, the periodic income amount and any payment guarantees, and company expenses (or load). The annuitant's age is important because the company must determine for how long it's likely to be obligated to make income payments to the annuitant. For example, if Mr. Smith wants to receive $300 a month for life beginning at age 60 and Mr. Jones wants to receive $300 a month for life beginning at age 65, with all other variables being equal, the company will charge Mr. Smith a higher premium than Mr. Jones.

The annuitant's sex is also a factor used in most states to determine premiums. Most statistics show that women live longer than men. As such, it follows that if the annuitant is a woman, the premium will be higher because she's likely to live longer – and will therefore receive more income payments – than a man of the same age. However, some states have adopted unisex provisions that disregard gender in determining annuity premiums. In these states, the premium charged will not differ based on the annuitant's sex.

The third factor used in determining annuity premiums is the assumed rate of interest. Life insurance companies invest premium dollars and earn a certain rate of interest on these investments. When determining premiums for annuities, the companies estimate, or assume, that their invested premium dollars will earn a specified interest rate.

The fourth factor in annuity premium computation consists of the amount of the periodic income (monthly, annually, etc.) and any payment guarantees that the company has made concerning that total amount (or total number of payments) to be paid. For instance, the company may guarantee that no less than 120 monthly payments will be made even if the original annuitant dies before 120 months elapse. Needless to say, the higher the amount of the periodic income payment and the longer the guarantee of that payment, the higher the annuity premium the company will charge.

Finally, as with virtually all other business transactions, annuity premiums contain an amount (called a load) to help offset the company's operating expenses.