The amortization process is a complicated mathematical process on how funds are distributed over a length of time. Insurance companies use this process for all of their annuity distributions. While it might be a difficult math problem to overcome, the logic behind it is much clearer. Remember, the actual math is done by computer, making it far more accurate when dealing with fractions of pennies.
Your annuity, regardless of whether it’s a fixed annuity or a variable annuity, gains interest over time. It gains interest while it is in the accumulation phase, where you are supplying a consistent stream of premiums. But what happens to the amount that you have invested after you begin distributions? This is where the concept of amortization comes in. Your money doesn’t just stop gaining interest during the annuitization phase. Interest still accumulates on a regular basis.
This will be more apparent with an example. Assume you have $100,000 in an annuity. If your distributions equal 1 percent of your investment each month, you are going to receive distributions of more than $1,000—even though 1 percent of $100,000 is $1,000. Amortization tables come into play here and raise the distribution amount. Things like your underlying interest rate, the amount you have invested, and your distribution type all dictate these numbers. So you might actually be getting around $1,250 each month instead.
Interest accumulates even when you stop contributing to your annuity. The insurance companies extrapolate where they think your investment will go for the length of time you are going to be receiving distributions. If you choose a straight life distribution, mortality tables come in and help them find an average based upon the general populations life expectancy. The insurance companies don’t know how long you as an individual will live, but they do have numbers that reveal the average life expectancy for the entire population. The law of large numbers allows insurance companies to find out the average age of their clients and they adjust their figures to account for this. Some clients will receive more and some will receive less—but over a large enough sample size these all even out.
So let’s say that your $100,000 annuity has a fixed rate of 3 percent. Untouched, this would be $3,000 per year. If the mortality tables say that you have twenty years, on average, left to live, the $3,000 would build up every year. So after year one you would have $103,000. After year two, you would have $106,090. The interest gains interest here as well, accounting for the additional $90.
But what happens when your yearly numbers start changing? The amortization calculators determine your interest in this instance. Let’s go back to our example and see how this could theoretically work. If you get yearly distributions of $1,250, you would be getting compounded interest on your amount, but it wouldn’t give you interest on the full $100,000 since you have withdrawn $15,000. Nor does it give you interest on the final yearly number of $85,000. The amortization table looks at how much interest is gained per day, and then applies the specific amount at the end of the month or year, depending upon your annuity’s structure. In reality, you are getting interest credited based upon how much you have in your account on a daily basis. The daily interest rate is extremely low—3 percent per year comes out to about 0.008 percent per day. So to find your amortization rate, you need to calculate your balance on a daily basis with that 0.008 percent interest and see where that lands you.
With the original balance of $100,000, this comes to $8 per day on day one. So for the first 30 days, you would earn slightly more than $240. I say slightly more because you are adding 0.008 percent interest every day and that interest is also gaining interest—but this is occurring at such a small rate the difference is less than a penny. The new balance of your account is then around $100,240 at the end of the month. After the $1,250 is withdrawn, your account now stands at $98,990. Then the process repeats itself for the life of your annuity.
This is, as you can see, a complicated method of accrediting interest, but the bottom line is that you will gain interest on your investment even after you begin receiving distributions. The amortization tables will give you a more exact number than the example above, but the math here is based upon the same logic, only simplified so you can better understand where the tables are coming from.