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Annuitization is the process of converting a sum of cash into a series of payments spread over time. Despite the name, most annuities are not annuitized, meaning annuity holders choose not to convert their principal into payments, but rather elect other ways to receive, manage or invest their cash accounts.
Only about 5 percent of all annuities sold in the United States in 2018 were annuitized, according to figures provided to Annuity.org by the LIMRA LOMA Secure Retirement Institute. This means that roughly 95 percent were not irrevocably converted into a stream of payments.
Many economists and financial experts suggest that people use a portion of their retirement savings to purchase income annuities as replacements for pensions, which have long been a means of guaranteeing regular income in retirement.
The lifetime income these insurance products provide protects retirees from outliving their savings and frees them to spend their remaining funds as they see fit — without worrying about making the money last.
“Annuitization is good, but you give up a great deal of control, and it isn’t very popular amongst retirees,” said Jonathan Summers, senior annuity consultant at Senior Market Sales. “It ends up feeding some of the horror stories of annuities for those that don’t know the repercussions when they annuitize an asset.”
Summers said a lot of the new developments in annuities over the course of the last decade have been focused on avoiding annuitization of annuities. These include the introduction of riders, or contract provisions, to provide income without requiring annuitization. Summers said the main reasons people buy annuities now are safety and growth, rather than income.
Pros and Cons
Like many financial decisions, annuitization of annuities has benefits and disadvantages, which should be considered when you’re planning for retirement. The main benefit is that the income payments are guaranteed as long as the annuitant is alive, even after the amount of the initial purchase price and any earnings have been exhausted.
One downside is that, barring any added riders or added contract provisions, an income annuity’s payments cease upon the death of the annuity holder and potentially his or her spouse.
For participating annuities, such as lifetime annuities, if the annuitant dies before the cash balance has been spent, the insurance company uses the money to pay other annuitants from the pool of participants who outlive their cash balances. This process is known as mortality credits, and it is why annuity issuers are able to continue making payments to people who live longer than expected. Like other types of insurance, annuitized money is pooled to spread risk.
The other disadvantage for many people is that once an annuity is annuitized, the cash value of the purchase is gone. There is no way to access the underlying principal or get a refund. The main alternative here is to sell future annuity payments to a third party at a discount.
Finally, once an annuity enters the annuitization or payout phase, the accumulation phase stops. During the accumulation phase, the cash value of the annuity can increase according to the investment strategy detailed in the annuity contract.
Why Are So Few Annuities Annuitized?
“I would say the reason why is that a lot of policies are purchased as insurance,” Summers said. “It’s there if and when they need it. A lot of other products that we write that aren’t annuitized, it’s not for income. It’s more for safety and growth. And if we need it, we’ll get after it. We take withdrawals out.”
Summers said many people take withdrawals from their annuities without annuitizing them.
There are different ways to structure your annuity payments and determine how long they will last.
- A single life or life only annuity provides payments for the life of the annuitant.
- A joint-life annuity pays through the lifetime of both the annuitant and another person — typically a spouse. These payments will usually be smaller than those with a single life annuity.
Period certain annuitization provides payments for a set number of years. This could continue after death if death happens before the period has concluded. If the period is shorter than your life expectancy, the payments should be larger than those provided by a life annuity.
Life with period certain annuities provide payments for at least a set number of years, even if the annuitant dies. If the annuitant dies before the period of years, the payments for that time go to a beneficiary. If the annuitant lives longer than the set period, the payments continue until death. The payments in these cases are typically smaller than payments from a life annuity.
The general rule is the higher the number of potential payments, the lower the dollar amount of the payments. So people with higher life expectancies at annuitization can expect to receive lower payments.
When to Annuitize
Summers said most annuity contracts will specify a deadline for deciding when to annuitize. The deadline is somewhat unlimited because it’s usually by the age of 95, he said. If you haven’t annuitized by then, the contract will annuitize at that age. Some contracts don’t allow annuitization for the first five years, he added.
“Different companies with different products will have it done differently,” Summers said. Some annuity contracts provide a window of time in which the money can be annuitized before it’s put into a lockdown period.
Lifetime Benefits Rider vs. Annuitization
Almost 30 percent of annuities sold in 2018 had a provision similar to annuitization called a living benefits rider. These riders allow for a stream of payments that is smaller than the payments provided through annuitization.
The tradeoff is that these annuity holders have access to their original cash balance, something not available after annuitization.
According to Summers, most traditional income annuities have restrictions on or do not include any death benefits, meaning there is no provision for beneficiaries. He gave an example that for $200,000, you may be able to purchase an income annuity that provides a lifetime stream of monthly payments amounting to about $10,000 a year.
At the same time, the cash value of the purchase price is gone. It’s a straight-up purchase of an insurance policy that provides income and protects against the possibility of outliving one’s savings.
“It’s a set-it-and-forget-it lifetime deal,” Summers said. “It’s kind of like a pension. Once you trigger your pension benefit, you can’t go back five years later and say, ‘You know what, can I just get all my money back?’ No. You’re on a pension. You get paid every month. That’s what you get.”
Lifetime Benefits Rider Explained
An annuity with a lifetime income benefit rider will provide a smaller stream of annual income, Summers said, estimating about $8,000 for the same $200,000 annuity. But the purchase price and any earnings will be in a cash account to which the annuity owner has access.
Any unscheduled withdrawals from the account will reduce the income stream. By the same token, systematic withdrawals that form the income stream will reduce the amount of money in the account. But the remaining funds are still available.
The money in this account will also continue to grow, according to the investment strategy in the annuity contract. If it’s a variable annuity, the account could lose money. If the annuity owner dies, the remaining funds would go to a beneficiary. In this sense, this kind of annuity is more like an investment than a traditional income annuity, which is an insurance product.
The income rider may also include a guaranteed level of growth. But Summers said consumers should understand those guarantees relate to the dollar value of income payments and do not apply to the amount of growth of the underlying cash account.
Once the income stream depletes the contents of the account, the payments will continue. At this point, this kind of annuity will be considered annuitized, as there is no access to a cash account.
In deciding whether to purchase a traditional income annuity or an annuity with a living benefits rider, the main consideration is whether the lower income payments are worth the other benefits.
As Summers put it, “Would you take a little less of the income for growth potential and flexibility, or do you just want the max economic output, which is the annuitization option? … You want everything, but you’ve got to make the decision of what’s most important.”
Annuity Payout Options
By law, all annuities must allow for an annuitization option. People who don’t annuitize have several other options, according to the provisions of their annuity contracts.
Lump Sum Payment
At the end of a designated surrender period, during which access to the funds is restricted — typically five, seven or 10 years — the annuity owner can cash out the annuity and take the funds in the account, along with any earnings as long as the annuity holder is at least 59 ½ years old.
Roll the Money Over
Some annuities give the owner a window of time after the annuity matures to decide whether to take the money out. If the money is left in the annuity, it may create a new contract, restarting the surrender period.
Factors to Consider
Whether to annuitize is a decision that is personal to each person. You should decide whether annuitization works better than other payout options or an annuity lifetime benefit rider for you.
- Financial Objectives: Do you need guaranteed income for life, or is access to your underlying funds more important?
- Total Value of Your Assets: If you have enough savings to keep some funds liquid, it may make sense to annuitize a portion of your assets.
- Tax Treatment: Annuities grow tax deferred, meaning the untaxed funds are taxed as income when they are withdrawn. If you withdraw the funds all at once, there will be a larger tax payment due.
- Flexibility: Annuitization eliminates flexibility.
Other factors to consider include how long you expect to live. If you are in poor health and have a shorter life expectancy, annuitization may not make sense. On the other hand, if your life expectancy is short because of actuarial estimates, your annuity payments will be smaller.
In addition, you might not think gender plays a role in this decision, but it’s relevant. Because women have, on average, longer life expectancies than men, annuitization is more expensive for women. An exception is annuities purchased inside 401(k) retirement plans, where the law requires equal treatment.
6 Cited Research Articles
- Cussen, M.P. (2019, June 12). Is Annuitization Your Best Strategy? Retrieved from https://www.investopedia.com/articles/personal-finance/052714/annuitization-your-best-strategy.asp
- Decker, F. (n.d.). If an Annuity Is Paying Out, Is It Irrevocably Annuitized? Retrieved from https://budgeting.thenest.com/annuity-paying-out-irrevocably-annuitized-20582.html
- Giesing, T. (2019, October 25). Telephone interview with Annuity.org.
- Plaehn, T. (2019, April 25). What Happens Once a Variable Annuity is Annuitized? Retrieved from https://finance.zacks.com/happens-once-variable-annuity-annuitized-8255.html
- Pritchard, J. (2019, January 21). What Does It Mean to Annuitize? Retrieved from https://www.thebalance.com/annuitize-what-it-means-to-annuitize-315087
- Summers, J. (2019, November 13). Interview with Annuity.org.