What is 'Annuitization'

Annuitization is the process of converting an annuity investment into a series of periodic income payments. Annuities may be annuitized for a specific period of time or for the life of the annuitant. Annuity payments may only be made to the annuitant or to the annuitant and a surviving spouse in a joint life arrangement. Annuitants can arrange for beneficiaries to receive a portion of the annuity balance upon their death.

BREAKING DOWN 'Annuitization'

The concept of annuitization dates back centuries, but it was formalized into a contract offered to the public by life insurance companies in the 1800s. Individuals can enter into a contract with a life insurance company that involves the exchange of a lump sum of capital for a promise to make periodic payments for a specified period of time or for the lifetime of the individual who is the annuitant.

How Annuitization Works

Upon receiving the lump sum of capital, the life insurer makes calculation to determine the annuity payout amount. The key factors used in the calculation are the current age and life expectancy of the annuitant, as well as the projected interest rate that will be credited to the annuity balance. The resulting payout rate establishes the amount of income that will be paid so that, by the end of the payment period, the entire annuity balance will have been returned to the annuitant plus interest.

The payment period may be a specified period of time, or it may be the life expectancy of the investor. If the insurer determines that the investor’s life expectancy is 25 years, then that becomes the payment period. The significant difference between using a specified period versus a lifetime period is that, if the annuitant lives beyond his or her life expectancy, the life insurer is obligated to continue the payments until the actual death of the annuitant. This is the insurance aspect of an annuity in which the life insurer assumes the risk of extended longevity.

Annuity payments based on a single life cease when the annuitant dies, and the remaining annuity balance is retained by the life insurer. When payments are made based on joint lives, the payments continue until the death of the second annuitant. When joint lives are covered, the amount of the annuity payment is reduced to cover the longevity risk of the additional life.

Annuitants may designate a beneficiary to receive the annuity balance through a refund option. Refund options can be selected for varying periods of time during which, if death occurs, the beneficiary would receive the proceeds. For instance, if a refund option for a period certain of 10 years is selected, death must occur within that 10-year period for the refund to be paid to the beneficiary. A lifetime refund option could be selected as well, but the length of the refund period will affect the payout rate. The longer the refund period is, the lower the payout rate.

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