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 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.
The concept of annuitization dates back centuries, but life insurance companies formalized it into a contract offered to the public by 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 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 calculations to determine the annuity payout amount. The key factors used in the calculation are the annuitant's current age and life expectancy, and the projected interest rate the insurer will credit to the annuity balance. The resulting payout rate establishes the amount of income that the insurer will pay so it will have returned the entire annuity balance plus interest to the annuitant by the end of the payment period.
The payment period may be a specified period or 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 their life expectancy, the life insurer must continue the payments until the annuitant's death. 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 insurer retains the remaining annuity balance. When payments are based on joint lives, the payments continue until the death of the second annuitant. When an insurer covers joint lives, 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. Annuitants can select refund options for varying periods of time during which, if death occurs, the beneficiary would receive the proceeds. For instance, if an annuitant selects a refund option for a period certain of 10 years, death must occur within that 10-year period for the insurer to pay the refund to the beneficiary. An annuitant may select a lifetime refund option, but the length of the refund period will affect the payout rate. The longer the refund period is, the lower the payout rate.