So, annuity companies, how do they make money? There's a reason that annuity companies have significant buildings and that they do very, very well. Why? It's because they know when we're going to die. Property and casualty companies, however, don't know when the hurricane's going to hit. They don't know when the tornado's going to hit.
So lets start with defining life expectancy. Life expectancy is the projected amount of time you're going to live based on, today. And annuity companies have these little actuaries locked in these rooms that are figuring out these stats on how long you're going to live.So when they, they the annuity company, issue a policy that's a lifetime income guarantee, you buy an immediate annuity, or deferred income annuity, or QLAC, or whatever, they're going to say, "Okay, we're going to accept that risk, that longevity risk, the fear of you outliving your money. And we, the annuity company, are going to pay you for the rest of your life based upon your life expectancy." So, thinking from the annuity company standpoint, how are they making money on that? They take in your money, and then they dole it back to you based on your life expectancy.
However, they usually invest the lump sum into bonds. Typically, it's investment-grade bonds. Annuity companies aren't better than banks but they're, in my opinion, more regulated. They have more handcuffs on what they can do with the money. For example, if you buy a fixed annuity-like an index annuity, a multi-year guarantee annuity, a QLAC, a qualified longevity annuity contract, a deferred income annuity, or a single premium immediate annuity the annuity company, by law, has to keep 100% of your money on hand. They have to invest it in grade bonds. That is a lot different than banks, where banks can loan out your money and do other things a little bit more aggressively, than annuity companies. So annuity companies aren't any more innovative than banks. They're not any better than banks. They're just more handcuffed.
Annuity companies can also buy bonds that the public can't buy. They can buy shorter-term bonds and they can buy institutional offerings. Also, annuity companies can get access to bonds that the public cannot buy. So they're making some interest and getting access to some interest rate products that the general public can not get, which is good because they're backing up your money. I got a call the other day where someone said, "Well, I bought this index annuity, and it's got a cap on it." Cap, meaning limitation. So the limitation was 4%, and the market's got 12 so this guy was convinced the annuity can't be capped at 8. Wrong, incorrect, incorrect 100%.
A lot of people think that the annuity company's keeping the spread; they are not keeping the spread. With annuity companies, they're trying to make 1 to 2% on your money, but they're trying to do it on a massive amount of people's money. So think about it. They bring in billions and billions and billions of dollars. They base their payments on life expectancy, knowing when we're going to die. They're holding onto the majority of that money while they're doling out the payments, and they're investing in fixed-rate instruments that are investment grade that you can't get. It's not a bad deal. Now, are they infallible? No. Are there bad people at annuity companies? There are bad people in every industry.
Now, if those annuity companies go out of business, then, there will be anarchy. However, my point is, I think annuity companies are pretty safe. I'm not pounding the table that they're all safe, but I'm saying comparatively, they are in good shape if you look at their balance sheets across the board. So how do they make money? They take your money in; they try to hit bunt singles with the money and then dole it out from a lifetime income stream standpoint, based on your life expectancy.
All right, here's another way annuity companies make money. When you buy an index annuity, variable annuity, or multi-year guarantee annuity, those are, in essence, categorized as a deferred annuity. So you're deferring a specific period. And there are surrender charges on those policies. So if you bought a ten-year index annuity, ten-year surrender charge index annuity, and the surrender charges every year declined and let's say it's nine the first year and eight the second year, seven the third year, and on and on and on. There are surrender charges because they're making up for the commissions they pay to the annuity agent and they're making up for administrative costs and some of the guarantees they had to lay into that policy. These surrender charges primarily come from if you back out during the middle of that surrender charge period.
So, once again, how annuity companies make money is not a profit center for them; that stems from getting some of their money back. There's a lot of costs that go into, say, a 10-year product. Sometimes the annuity companies break-even point might be at year four, or year five, and the surrender charges are in there to make up for that. So the point of the matter is, annuity companies are innovative. These companies are more regulated than banks. They buy fixed instruments that you and I can't buy and when you're buying a lifetime income product, they're keeping the money. They invest the money in those fixed instruments that are investment-grade bonds which are more innovative when they're giving back the money to you over your life expectancy, which, in my opinion, is a good move.
Never forget to live in reality, not the dream, with annuities and contractual guarantees! You can use our calculators, get all six of my books for free, and most importantly book a call with me so we can discuss what works best for your specific situation.