Therefore, if a retiree dies shortly after purchasing a policy, they would have been better off investing on their own.

On the other hand, if a policyholder defies the odds and lives to the ripe age of 105, it would appear that he made a good decision. After the insurance company pays out the proceeds from the initial sale, the monthly benefits come out of its own pocket.

The appeal of straight life annuities for retirement planning is understandable: retirees can transfer both longevity risk and market risk to an insurance company. Even if the markets collapse, it’s not possible for policyholders to outlive their monthly benefits. Rather, policyholders’ chief risk would become the solvency of the insurance company they purchased the policy from.

One of the most attractive elements of annuities is mortality credits. To explore, let’s examine the insurance company’s perspective. After selling an annuity, the company is bound to pay the policyholder monthly benefits until they die. The insurance company knows how old the policyholder is, and with the help of trained actuaries also knows their life expectancy.

Now, even though the insurance company knows the policyholder’s life expectancy, the policyholder’s life span is highly variable. The actuaries might expect the policyholder to live another 25 years, but there’s always the chance of dying tomorrow or living to age 105. In other words, the company has little confidence in their prediction of a single policyholder’s lifespan.

Given the high degree of variability, there’s a great amount of risk to the insurance company for selling the one annuity contract. The contract will be profitable if the policyholder lives for another two years.

But if he lives for another forty, the contract would be unprofitable since all the principal would be used many years before he passes. The insurance company must compensate for this risk, and the only way to do so is to offer a lower monthly payment in the initial contract, preserving the principal for a longer period of time .

That being said, insurance companies do not sell annuity contracts to only one person at a time.

In fact, they often deal in the tens of thousands. And the more contracts they sell, the more certain they are that some percentage of policy owners will pass away each year.

While the insurance company still has no idea whether our single policyholder will die tomorrow or forty years from now, in a group of 10,000 they have a pretty good idea of how many

policyholders will. And based on actuarial tables they can predict these numbers with a high degree of accuracy — when the group of policyholders is large enough.

This law of large numbers has important implications for potential annuity buyers. The more certain the insurance company is how many of its policy holders will die each year, the less risk the company retains in making monthly income promises. And when marketing annuity contracts, insurance companies tend to pass this benefit back to policyholders through higher monthly income payments, known as mortality credits.

This is a major benefit to annuity contracts, as insurance companies have the luxury of spreading mortality risk across thousands of people.

It should be noted that some annuities come with the ability to add other options, like death benefits, to the policy. On the surface, such an addition is appealing. In reality, it actually negates one of the major advantages of annuities in the first place: the mortality credits.

Mortality credits are offered because the insurance company has a pretty good idea how many policyholders will die each year.

Some policyholders, let’s call them Group A, will live longer than expected. In Group A, the insurance company will run out of principal and be forced to pay monthly benefits out of pocket. They are unprofitable. Fortunately, they are balanced by the profitable Group B.

Group B dies before their life expectancies, leaving leftover principal for the insurance company to use freely in its general account.

Let’s say the insurance company now offers a death benefit to policyholders’ beneficiary of choice. When this happens, the equation falls out of balance. Death benefits paid to beneficiaries present a new outflow from the insurance company’s general account, which must be offset by an inflow somewhere else.

Such is the tradeoff in annuity contracts: any advantage, option, or rider added to the contract that benefits the policyholder must be balanced somewhere else. Usually, this is in the form of lower monthly benefits and mortality credits.

Otherwise, it would be unprofitable to the insurance company. For those awake at night worrying about outliving their assets or the next drop in the markets, annuities might deserve serious consideration. For others, retaining flexibility, control, and opportunities for growth of their retirement funds may be more important.

One thing is certain. Annuities can be very opaque, and come with hefty commissions, sales charges, and unexpected costs. Retirees must be sure to pore over the fine print, and be wary of adding custom options and riders. In the end they can be very expensive.