What They Are, Types, and How They Work

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What They Are, Types, and How They Work

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Investopedia / Ryan Oakley


What Is an Annuity?

The term “annuity” refers to an insurance contract issued and distributed by financial institutions with the intention of paying out invested funds in a fixed income stream in the future. Investors invest in or purchase annuities with monthly premiums or lump-sum payments. The holding institution issues a stream of payments in the future for a specified period of time or for the remainder of the annuitant’s life. Annuities are mainly used for retirement purposes and help individuals address the risk of outliving their savings.

Key Takeaways

  • Annuities are financial products that offer a guaranteed income stream, usually for retirees.
  • The accumulation phase is the first stage of an annuity, whereby investors fund the product with either a lump sum or periodic payments.
  • The annuitant begins receiving payments after the annuitization period for a fixed period or for the rest of their life.
  • Annuities can be structured into different kinds of instruments, which gives investors flexibility.
  • These products can be categorized into immediate and deferred annuities and may be structured as fixed or variable.

How an Annuity Works

Annuities are designed to provide a steady cash flow for people during their retirement years and to alleviate the fears of outliving their assets. Since these assets may not be enough to sustain their standard of living, some investors may turn to an insurance company or other financial institution to purchase an annuity contract.

As such, these financial products are appropriate for investors, who are referred to as annuitants, who want stable, guaranteed retirement income. Because invested cash is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs to use this financial product.

An annuity goes through several different phases and periods. These are called:

  • The accumulation phase, the period of time when an annuity is being funded and before payouts begin. Any money invested in the annuity grows on a tax-deferred basis during this stage.
  • The annuitization phase, which kicks in once payments commence.

These financial products can be immediate or deferred. Immediate annuities are often purchased by people of any age who have received a large lump sum of money, such as a settlement or lottery win, and who prefer to exchange it for cash flows into the future. Deferred annuities are structured to grow on a tax-deferred basis and provide annuitants with guaranteed income that begins on a date they specify.

Annuities often come with complicated tax considerations, so it’s important to understand how they work. As with any other financial product, be sure to consult with a professional before you purchase an annuity contract.

Annuity products are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract.

Special Considerations

Annuities usually have a surrender period. Annuitants cannot make withdrawals during this time, which may span several years, without paying a surrender charge or fee. Investors must consider their financial requirements during this time period. For example, if a major event requires significant amounts of cash, such as a wedding, then it might be a good idea to evaluate whether the investor can afford to make requisite annuity payments.

Contracts also have an income rider that ensures a fixed income after the annuity kicks in. There are two questions that investors should ask when they consider income riders:

  1. At what age do they need the income? Depending on the duration of the annuity, the payment terms and interest rates may vary.
  2. What are the fees associated with the income rider? While there are some organizations that offer the income rider free of charge, most have fees associated with this service.

Many insurance companies will allow recipients to withdraw up to 10% of their account value without paying a surrender fee. However, if you withdraw more than that, you may end up paying a penalty, even if the surrender period has already lapsed. There are also tax implications for withdrawals before age 59 and a half.

Because of the potentially high cost of withdrawals, some hard-up annuitants may opt to sell their annuity payments instead. This is similar to borrowing against any other income stream: the annuitant receives a lump sum, and in exchange gives up their right to some (or all) of their future annuity payments.

Individuals who invest in annuities cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that they are trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate. Some purchasers hope to cash out an annuity in the future at a profit, however, this is not the intended use of the product.

Types of Annuities

Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. As mentioned above, annuities can be created so that payments continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Immediate and Deferred Annuities

Annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. The immediate payment annuity begins paying immediately after the annuitant deposits a lump sum. Deferred income annuities, on the other hand, don’t begin paying out after the initial investment. Instead, the client specifies an age at which they would like to begin receiving payments from the insurance company.

Depending on the type of annuity you choose, the annuity may or may not be able to recover some of the principal invested in the account. In the case of a straight, lifetime payout, there is no refund of the principal–the payments simply continue until the beneficiary dies. If the annuity is set for a fixed period of time, the recipient may be entitled to a refund of any remaining principal–or their heirs, if the annuitant has deceased.

Fixed and Variable Annuities

Annuities can be structured generally as either fixed or variable:

  • Fixed annuities provide regular periodic payments to the annuitant.
  • Variable annuities allow the owner to receive larger future payments if investments of the annuity fund do well and smaller payments if its investments do poorly, which provides for less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund’s investments.

While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts—usually for an extra cost. This allows them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value.

Other riders may be purchased to add a death benefit to the agreement or to accelerate payouts if the annuity holder is diagnosed with a terminal illness. The cost of living rider is another common rider that will adjust the annual base cash flows for inflation based on changes in the consumer price index (CPI).

Criticism of Annuities

One criticism of annuities is that they are illiquid. Deposits into annuity contracts are typically locked up for a period of time, known as the surrender period, where the annuitant would incur a penalty if all or part of that money were touched.

These periods can last anywhere from two to more than 10 years, depending on the particular product. Surrender fees can start out at 10% or more and the penalty typically declines annually over the surrender period.

Annuities vs. Life Insurance

Life insurance companies and investment companies are the two primary types of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk, which is the risk of dying prematurely. Policyholders pay an annual premium to the insurance company that will pay out a lump sum upon their death.

If the policyholder dies prematurely, the insurer pays out the death benefit at a net loss to the company. Actuarial science and claims experience allow these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit. In many cases, the cash value inside of permanent life insurance policies can be exchanged via a 1035 exchange for an annuity product without any tax implications.

Annuities, on the other hand, deal with longevity risk, or the risk of outliving one’s assets. The risk to the issuer of the annuity is that annuity holders will survive to outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death.

Example of an Annuity

A life insurance policy is an example of a fixed annuity in which an individual pays a fixed amount each month for a pre-determined time period (typically 59.5 years) and receives a fixed income stream during their retirement years.

An example of an immediate annuity is when an individual pays a single premium, say $200,000, to an insurance company and receives monthly payments, say $5,000, for a fixed time period afterward. The payout amount for immediate annuities depends on market conditions and interest rates.

Annuities can be a beneficial part of a retirement plan, but annuities are complex financial vehicles. Because of their complexity, many employers don’t offer them as part of an employee’s retirement portfolio.

However, the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law by President Donald Trump in late December 2019, loosens the rules on how employers can select annuity providers and includes annuity options within 401(k) or 403(b) investment plans. The easement of these rules may trigger more annuity options open to qualified employees in the near future.

Who Buys Annuities?

Annuities are appropriate financial products for individuals seeking stable, guaranteed retirement income. Because the lump sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs to use this financial product. Annuity holders cannot outlive their income stream, which hedges longevity risk.

What Is a Non-Qualified Annuity?

Annuities can be purchased with either pre-tax or after-tax dollars. A non-qualified annuity is one that has been purchased with after-tax dollars. A qualified annuity is one that has been purchased with pre-tax dollars. Qualified plans include 401(k) plans and 403(b) plans. Only the earnings of a non-qualified annuity are taxed at the time of withdrawal, not the contributions, as they are after-tax money.

What Is an Annuity Fund?

An annuity fund is the investment portfolio in which an annuity holder’s funds are invested. The annuity fund earns returns, which correlate to the payout that an annuity holder receives. When an individual buys an annuity from an insurance company, they pay a premium. The premium is invested by the insurance company into an investment vehicle that contains stocks, bonds, and other securities, which is the annuity fund.

What Is the Surrender Period?

The surrender period is the amount of time an investor must wait before they can withdraw funds from an annuity without facing a penalty. Withdrawals made before the end of the surrender period can result in a surrender charge, which is essentially a deferred sales fee. This period generally spans several years. Investors can incur a significant penalty if they withdraw the invested amount before the surrender period is over.

What Are Common Types of Annuities?

Annuities are generally structured as either fixed or variable instruments. Fixed annuities provide regular periodic payments to the annuitant and are often used in retirement planning. Variable annuities allow the owner to receive larger future payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for less stable cash flow than a fixed annuity but allows the annuitant to reap the benefits of strong returns from their fund’s investments.

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Asset-Backed Security (ABS): What It Is, How Different Types Work

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Asset-Backed Security (ABS): What It Is, How Different Types Work

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What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Key Takeaways

  • Asset-backed securities (ABSs) are financial securities backed by income-generating assets such as credit card receivables, home equity loans, student loans, and auto loans.
  • ABSs are created when a company sells its loans or other debts to an issuer, a financial institution that then packages them into a portfolio to sell to investors.
  • Pooling assets into an ABS is a process called securitization.
  • ABSs appeal to income-oriented investors, as they pay a steady stream of interest, like bonds.
  • Mortgage-backed securities and collateralized debt obligations can be considered types of ABS.

Understanding Asset-Backed Securities (ABSs)

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can’t be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans, or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren’t available in any other investment.

Asset-Backed Security (ABS)

How an Asset-Backed Security Works

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use to make more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

Special Considerations

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

  • Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
  • Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
  • Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt. 
  • Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.
  • Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn’t qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

A mortgage-backed security (MBS) is sometimes considered a type of ABS but is more often classified as a separate variety of investment, especially in the U.S. Both operate in essentially the same way; the difference lies in the underlying assets in the portfolio. Mortgage-backed securities are formed by pooling together mortgages exclusively, while ABSs consist of any other type of loan or debt instrument (including, rather confusingly, home equity loans). MBSs actually predate ABSs.

Auto Loan ABS

Car financing is another large category of ABS. The cash flows of an auto loan ABS include monthly interest payments, principal payments, and prepayments (though the latter is rarer for an auto loan ABS is much lower when compared to a home equity loan ABS). This is another amortizing loan.

Credit Card Receivables ABS

Credit card receivables—the amount due on credit card balances—are a type of non-amortizing asset ABS: They go to a revolving line of credit, rather than towards the same set sum. So they don’t have fixed payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually a lock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the lock-up period, the principal payment is passed on to ABS investors.

Student Loan ABS

ABSs can be collateralized by either government student loans, guaranteed by the U.S. Dept. of Education, or private student loans. The former have had a better repayment record, and a lower risk of default.

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

What Is an Example of an Asset-Backed Security?

A collateralized debt obligation (CDO) is an example of an asset-based security (ABS). It is like a loan or bond, one backed by a portfolio of debt instruments—bank loans, mortgages, credit card receivables, aircraft leases, smaller bonds, and sometimes even other ABSs or CDOs. This portfolio acts as collateral for the interest generated by the CDO, which is reaped by the institutional investors who purchase it.

What Is Asset Backing?

Asset backing refers to the total value of a company’s shares, in relation to its assets. Specifically, it refers to the total value of all the assets that a company has, divided by the number of outstanding shares that the company has issued.

In terms of investments, asset backing refers to a security whose value derives from a single asset or a pool of assets; these holdings act as collateral for the security—”backing” it, in effect.

What Does ABS Stand for in Accounting?

In the business world, ABS stands for “accounting and billing system.”

What Is the Difference Between MBS and ABS?

An asset-based security (ABS) is similar to a mortgage-backed security (MBS). Both are securities that, like bonds, pay a fixed rate of interest derived from an underlying pool of income-generating assets—usually debts or loans. The main difference is that an MBS, as its name implies, consists of a package of mortgages (real estate loans). In contrast, an ABS is usually backed by other sorts of financing—student loans, auto loans, or credit card debt.

Some financial sources do use ABS as a generic term, encompassing any sort of securitized investment based on underlying asset pools—in which case, an MBS is a kind of ABS. Others consider ABSs and MBSs to be separate investment vehicles.

How Does Asset Securitization Work?

Asset securitization begins when a lender (or any company with loans) or a firm with income-producing assets earmarks a bunch of these assets and then arranges to sell the lot to an investment bank or other financial institution. This institution often pools these assets with comparable ones from other sellers, then establishes a special-purpose vehicle (SPV)—an entity set up specifically to acquire the assets, package them, and issue them as a single security.

The issuer then sells these securities to investors, usually institutional investors (hedge funds, mutual funds, pension plans, etc.). The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the portfolio of assets.

Sometimes the issuer divides the original asset portfolio into slices, called tranches. Each tranche is sold separately and bears a different degree of risk, indicated by a different credit rating.

The Bottom Line

Asset Backed Securities (ABS) are pools of loans that are packaged together into an investable security, which can in turn be bought by investors, predominantly large institutions, like hedge funds, insurance companies, and pension funds. ABS provide a method of diversification from typical bond mutual funds or individual bonds themselves. Most importantly, they are income generating assets, typically with a higher return than a normal corporate bond, all depending on the credit rating assigned to the ABS.

The underlying assets of an ABS could consist of auto loans, credit card receivables, and even more exotic investments, such as utility bills and toll roads. Such categories of ABS are referred to by different names such as CDO’s (Collateralized Debt Obligations), which are broken down into further sub-categories, such as CLO’s (Collateralized Loan Obligations). However, by far, the most popular and therefore liquid ABS are MBS (Mortgage Backed Securities), which provide an income stream from mortgage payments.

For the investor, ABS provide an income stream in line with the credit rating of the security, and offer an alternative to standard bond mutual funds.

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Assets Under Management (AUM): Definition, Calculation, and Example

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Assets Under Management (AUM): Definition, Calculation, and Example

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What Are Assets Under Management (AUM)?

Assets under management (AUM) is the total market value of the investments that a person or entity manages on behalf of clients. Assets under management definitions and formulas vary by company.

In the calculation of AUM, some financial institutions include bank deposits, mutual funds, and cash in their calculations. Others limit it to funds under discretionary management, where the investor assigns authority to the company to trade on their behalf.

Overall, AUM is only one aspect used in evaluating a company or investment. It is also usually considered in conjunction with management performance and management experience. However, investors often consider higher investment inflows and higher AUM comparisons as a positive indicator of quality and management experience.

Key Takeaways

  • Assets under management (AUM) is the total market value of the investments that a person or entity handles on behalf of investors.
  • AUM fluctuates daily, reflecting the flow of money in and out of a particular fund and the price performance of the assets.
  • Funds with larger AUM tend to be more easily traded.
  • A fund’s management fees and expenses are often calculated as a percentage of AUM.

Understanding Assets Under Management

Assets under management refers to how much money a hedge fund or financial institution is managing for their clients. AUM is the sum of the market value for all of the investments managed by a fund or family of funds, a venture capital firm, brokerage company, or an individual registered as an investment advisor or portfolio manager.

Used to indicate the size or amount, AUM can be segregated in many ways. It can refer to the total amount of assets managed for all clients, or it can refer to the total assets managed for a specific client. AUM includes the capital the manager can use to make transactions for one or all clients, usually on a discretionary basis.

For example, if an investor has $50,000 invested in a mutual fund, those funds become part of the total AUM—the pool of funds. The fund manager can buy and sell shares following the fund’s investment objective using all of the invested funds without obtaining any additional special permissions.

Within the wealth management industry, some investment managers may have requirements based on AUM. In other words, an investor may need a minimum amount of personal AUM for that investor to be qualified for a certain type of investment, such as a hedge fund. Wealth managers want to ensure the client can withstand adverse markets without taking too large of a financial hit. An investor’s individual AUM can also be a factor in determining the type of services received from a financial advisor or brokerage company. In some cases, individual assets under management may also coincide with an individual’s net worth.

Calculating Assets Under Management

Methods of calculating assets under management vary among companies. Assets under management depends on the flow of investor money in and out of a particular fund and as a result, can fluctuate daily. Also, asset performance, capital appreciation, and reinvested dividends will all increase the AUM of a fund. Also, total firm assets under management can increase when new customers and their assets are acquired.

Factors causing decreases in AUM include decreases in market value from investment performance losses, fund closures, and a decrease in investor flows. Assets under management can be limited to all of the investor capital invested across all of the firm’s products, or it can include capital owned by the investment company executives.

In the United States, the Securities and Exchange Commission (SEC) has AUM requirements for funds and investment firms in which they must register with the SEC. The SEC is responsible for regulating the financial markets to ensure that it functions in a fair and orderly manner. The SEC requirement for registration can range between $25 million to $110 million in AUM, depending on several factors, including the size and location of the firm.

Why AUM Matters

Firm management will monitor AUM as it relates to investment strategy and investor product flows in determining the strength of the company. Investment companies also use assets under management as a marketing tool to attract new investors. AUM can help investors get an indication of the size of a company’s operations relative to its competitors.

AUM may also be an important consideration for the calculation of fees. Many investment products charge management fees that are a fixed percentage of assets under management. Also, many financial advisors and personal money managers charge clients a percentage of their total assets under management. Typically, this percentage decreases as the AUM increases; in this way, these financial professionals can attract high-wealth investors.

Real-Life Examples of Assets Under Management

When evaluating a specific fund, investors often look at its AUM since it functions as an indication of the size of the fund. Typically, investment products with high AUMs have higher market trading volumes making them more liquid, meaning investors can buy and sell the fund with ease.

SPY

For example, the SPDR S&P 500 ETF (SPY) is one of the largest equity exchange-traded funds on the market. An ETF is a fund that contains a number of stocks or securities that match or mirror an index, such as the S&P 500. The SPY has all 500 of the stocks in the S&P 500 index.

As of Mar. 11, 2022, the SPY had assets under management of $380.7 billion with an average daily trading volume of 113 million shares. The high trading volume means liquidity is not a factor for investors when seeking to buy or sell their shares of the ETF.

EDOW

The First Trust Dow 30 Equal Weight ETF (EDOW) tracks the 30 stocks in the Dow Jones Industrial Average (DJIA). As of Mar. 11, 2022, the EDOW had assets under management of $130 million and much lower trading volume compared to the SPY, averaging approximately 53,000 shares per day. Liquidity for this fund could be a consideration for investors, meaning it could be difficult to buy and sell shares at certain times of the day or week.

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Average Life: Definition, Calculation Formula, Vs. Maturity

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Average Life: Definition, Calculation Formula, Vs. Maturity

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What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.

Key Takeaways

  • The average life is the average length of time it will take to repay the outstanding principal on a debt issue, such as a Treasury bill, bond, loan, or mortgage-backed security. 
  • The average life calculation is useful for investors who want to compare the risk associated with various investments before making an investment decision.
  • Most investors will choose an investment with a shorter average life as this means they will receive their investment returns sooner.
  • Prepayment risk occurs when the loan borrower or bond issuer repays the principal earlier than scheduled, thereby shortening the investment’s average life and reducing the amount of interest the investor will receive.

Understanding Average Life

Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.

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