An annuity is a contract that turns a lump sum or accumulated balance into a stream of payments over time. It matters economically because it helps households smooth consumption and, in the case of life annuities, insure against the risk of outliving their savings.
Why Annuities Matter
A household planning for retirement faces a difficult problem: it does not know exactly how long it will live. If it spends too quickly, it may run out of money. If it spends too cautiously, it sacrifices current consumption unnecessarily. A life annuity partly solves that problem by pooling longevity risk across many people.
Pricing Intuition
A simplified present-value relationship is:
[ P \approx \sum_{t=1}^{T} \frac{s_t C}{(1+r)^t} ]
where P is the premium, C is the periodic payment, r is the discount rate, and s_t is the probability that the annuitant is still alive at time t. Higher interest rates tend to support higher payouts, while longer expected lifetimes tend to reduce them.
Main Types
Common annuity types include:
- immediate versus deferred annuities
- fixed versus variable annuities
- term-certain versus life annuities
- inflation-protected or joint-and-survivor contracts
Each design trades off income stability, flexibility, and protection against longevity risk.
The Annuity Puzzle
Standard life-cycle theory often predicts more annuity demand than is observed in practice. Economists explain the gap with factors such as bequest motives, liquidity concerns, complexity, adverse selection, and distrust of providers.