New on FinoLib · Volume V: Personal Finance
My latest article is now live on FinoLib, the free finance library I write: Annuities and Long-Term Care Insurance Explained, from Volume V: Personal Finance. It is part 1 of a 2-part guide. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
The idea in plain words
Living a very long time is a risk too. A lifetime income annuity is a contract where you hand over a lump sum and get paid for the rest of your life. Buy one only to close the gap between essential spending and guaranteed income, and only with money you won’t need back. It pays more than a bond because those who die early help fund those who live long. For long-term care, match the tool to your savings: Medicaid as a backstop for modest savings, insurance if a long stay would leave a spouse with nothing, and self-insuring if your assets could pay for three years of care.
Key points
■Mortality credits grow with age: at 85 they add roughly 8 to 11 points a year to a 4% bond yield, which is why late-starting annuities are cheap.
■In the illustrative example, a 7% annuity beats drawing the same income from a portfolio earning 4% if you live past about 87, an age about 36% of 65-year-old men and 48% of women reach.
■Variable and indexed annuities carry layered fees and surrender charges, often starting near 7% and falling over six to eight years.
■A three-year nursing-home stay at 2025’s median private-room rate costs $388,725, and Medicare pays none of the custodial part.
A closer look
Two expensive risks grow with age: outliving your money, and needing years of help with daily living. Insurance exists for both, and both products are widely sold, poorly understood, and sometimes worth it.
An annuity, stripped to its core, is a contract in which you give an insurer money and the insurer promises payments back. The version that insures longevity is the income annuity: you hand over a lump sum and receive a fixed payment for as long as you live. It can pay more than a bond of the same size because of mortality credits — buyers who die early leave their remaining money in the pool, and that money funds the payments to those who live long. You are giving up the lump sum and anything left to heirs in exchange for income you cannot outlive. The main types:
Costs and traps. Simple income annuities have no visible annual fee — the cost is built into the payout. Variable and indexed annuities are different: layered fees can total far more than an index fund’s, and most carry surrender charges — a penalty, typically declining over several years, for withdrawing more than a set amount early. Sales commissions can be high, which is one reason these products are sold more often than they are bought. The guarantee is only as good as the insurer: if one fails, a state guaranty association covers annuity benefits up to a limit — at least $250,000 in present value in most states — so it is worth checking the insurer’s financial strength rating and keeping each insurer’s share within that limit.
A worked example
Worked Example — Compare the Scenarios: Annuity, Same Income From a Portfolio, or the 4% Rule
A 65-year-old has $100,000 to turn into income. Illustrative assumptions: the hypothetical 7% annuity payout from the example above, a portfolio that earns 4% a year, withdrawals at each year end, no inflation adjustment and no taxes. Three choices: (A) buy the annuity for $7,000 a year for life; (B) keep the money invested and withdraw the same $7,000; (C) keep it invested and withdraw $4,000 under the 4% rule (10.2).
Under the hood
Under the Hood: How Mortality Credits Are Made
Picture a pool of people the same age, each putting in $1, invested in bonds earning 4%. At year end the money of those who died stays in the pool and is shared among the survivors. If a fraction q died during the year, each survivor’s return is 1.04 ÷ (1 − q) − 1. The extra above 4% is the mortality credit.
Where Experts Disagree
The standard view: economic theory says retirees should turn much of their savings into lifetime income. Menahem Yaari’s classic 1965 result is that full annuitization is optimal under idealized conditions, and Davidoff, Brown and Diamond (NBER, 2003) showed that complete annuitization can remain optimal under more general conditions and that substantial annuitization is valuable even when markets are incomplete. Its assumptions: fairly priced annuities, predictable spending needs and no strong bequest motive.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume V: Personal Finance
Read the full article on FinoLib
The complete article, Annuities and Long-Term Care Insurance Explained, with every worked example, diagram, quiz and source, is free to read in Volume V, Personal Finance on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance