If you're about to retire and own an annuity, you might be considering whether to convert your investment into a series of periodic payments. The process is called annuitization, and depending on which payment option you select, it is possible to receive payments up until you die—even if total payments exceed the value of the contract. But there are pitfalls as well. It's important to understand the math behind annuitization and long-term consequences.
- While annuitization provides a retirement income stream that annuity owners can’t outlive, there are long-term consequences that need to be taken into account.
- Annuitization is generally a good choice for those who expect to live much longer than their projected statistical lifespan.
- To decide if annuitization is the right option, you’ll need to consider your longevity, financial circumstances, risk tolerance, and investment objectives.
How Annuitization Works
Several decades ago, life insurance carriers began offering packaged annuity products to retirement savers as a form of insurance against outliving their income. More recently, some employers are including annuity options in their 401(k) plans, encouraged to do so after provisions in the Setting Every Community Up for Retirement Enhancement (SECURE) Act make it easier to offer annuities through sponsored retirement plans.
One of the key benefits annuities offer is the ability to provide a guaranteed monthly payment to the beneficiary until death, even if the total payout exceeds the value of the contract. In order to obtain this guarantee, however, the contract must be annuitized.
Annuitization is a single, one-time event that occurs between the accumulation and payout phases in an annuity. When the contract owner is ready to begin receiving annuity payments, the insurance carrier converts the accumulation units in the contract into annuity units and computes a mathematical monthly payout based upon several factors, including the value of the contract, the projected longevity of the beneficiary or beneficiaries, and the type of payout selected.
To decide if annuitization is the right move for you, consider the following:
Your Financial Objectives
The reason to choose annuitization is for the payout to be a source of monthly income. Wealthy investors who use annuities as tax shelters will typically opt for other forms of distribution. The majority of annuity owners typically choose either a straight systematic withdrawal or say they don't expect to withdraw funds unless an emergency arises.
A key factor to consider here is how much money you have saved in assets outside the annuity contract. If, for example, you have another $100,000 in liquid savings elsewhere, annuitization may be an appropriate choice because you have other assets to draw upon in the event of an emergency.
It is obviously not wise to convert all your savings into an irrevocable cash flow, even if doing so would provide the greatest possible return on investment. For this reason, most annuity carriers will only allow clients to put 60% to 80% of their assets into annuities.
However, those who are applying for Medicaid could benefit from an irrevocable payout because this will prevent the accumulation value of the contract from being included in their assets during the spend-down process. The rules for this exclusion are complex and vary from one state and insurance carrier to another.
Your Life Expectancy
Annuitization offers different options, allowing you to figure in your estimated lifespan and whether the annuity needs to provide for your heirs.
The financial consequences of substantially under- or over-projecting one’s life expectancy can range from detrimental to devastating.
Let's say you choose a straight life payout of some sort with no period certain clause. If you opt for that straight life payout, you will forfeit the unpaid portion of your contract back to the carrier if there is any principal left when you die. Had you chosen a contract with a period certain clause, that option would have guaranteed payouts for a specific term and would have continued to pay your heirs had you died before the payout period ended.
On the other hand, retirees who chose not to annuitize their contracts and make it past their life expectancy may outlive their savings.
You can improve your odds of making the right decision by researching your projected statistical longevity and comparing this with your own estimate based on such factors including your family’s medical history, and your own current health and lifestyle.
Annuitization is a godsend for those who substantially exceed their projected lifespans. Married couples who want a higher payout without the risk of forfeiture may come out ahead by taking a straight joint-life payout with no period certain of any kind, and then purchasing a joint first-to-die term insurance policy that will pay out a tax-free death benefit to the survivor. Work through the cost implications of the choices you are considering before making a final decision.
An Example of Deciding to Annuitize
Let's take a look at a hypothetical example of a married couple and what they would need to consider to decide whether or not to take the annuitization route.
Jim and Mary are married, and both retired last month. Jim is 68 years old and Mary is 65. They purchase a $100,000 indexed annuity contract that will begin paying them immediate income. They have to choose the payment option.
- If they choose to use an income-benefit rider for protection, they will receive a $5,000 per year minimum guaranteed payout as long as one of them is living—even after the accumulation value in the contract has been exhausted. Their payout may be slightly higher if the markets perform well.
- If they go for a joint-life payout with a 20-year period certain that requires annuitization, the best quote they get is $5,746 per year, which would guarantee total payments of at least $114,920 ($5,746 x 20 years).
Obviously, the annuitized joint-life contract would have paid them the highest monthly amount. However, this payout would have been irrevocable. The income-benefit-rider option, on the other hand, will allow them to withdraw any remaining accumulation value in the contract at no charge once the surrender charge schedule expires.
This example illustrates the trade-off between payout and liquidity. Jim and Mary will need to analyze carefully the likelihood that they might need to access the accumulated value in the contract at some point in the future, such as to pay for medical expenses.
Annuity owners who choose not to annuitize their contracts have several other options. They can simply liquidate their contracts at no cost if they are at least age 59½ and the surrender charge schedule on their contract has expired. They can also pass the entire amount in the contract on to their beneficiaries after their death if they don't need to take distributions while they are living.
Income-benefit riders have become perhaps the most popular alternative to annuitization because they provide a guaranteed stream of income that often exceeds the actual accumulation value of the contract without locking the annuity owner into an irrevocable payout schedule. Contract owners will, therefore, receive a fixed monthly payment that still permits them to withdraw any remaining balance minus any applicable surrender charges or fees.
The Bottom Line
Annuity owners have several factors to consider if they are contemplating whether to annuitize their contract. Current health and projected longevity must be analyzed, as well as their financial circumstances, risk tolerance, and investment objectives—for example, the need for liquidity. Some annuity carriers are also starting to offer a measure of flexibility for withdrawal from annuitized contracts, such as allowing the distribution of future payments within the period certain.