Is Annuitization Your Best Strategy?

Several decades ago, life insurance carriers began offering packaged annuity products to retirement savers as a form of insurance against superannuation—the technical term for outliving one’s income. One of the key benefits annuities offer is their 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. But before you choose this option, be sure you understand the mechanics of this process, as well as its long-term consequences.

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. (See also: Selecting the Payout on Your Annuity.)

Here are some key considerations:

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 60-80% 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 will vary from one state and insurance carrier to another. See Investopedia's guide to Medicaid planning for details.)

Annuitization offers different options, allowing you to figure in your estimated lifespan and whether the annuity needs to provide for your heirs. Needless to say, the financial consequences of substantially under- or overprojecting 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. If you opt for that straight life payout, you will forfeit the unpaid portion of your contract back to the carrier if there was any principal left when you died. (Had you chosen a contract with a "period certain" clause, that option guarantees 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 expectancies may outlive their savings.

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 as your family’s medical history and your own current health and lifestyle.

About half of annuity owners underestimate their longevity by at least five years, and women are more prone to overestimate their longevity than men. Today, the odds of living to age 100 for a 65-year-old are more than 9% for men and above 14% for women. 

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.

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.  

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. If they choose to use an income-benefit rider for protection, then they will receive $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. The best quote that they get for a joint-life payout with a 20-year period certain that requires annuitization is $5,746 per year, which will guarantee total payments of at least $114,920 ($5,746 x 20 years).

Obviously, the annuitized joint-life contract will pay them the highest monthly amount. However, this payout will be 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 tradeoff 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 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. For more information on annuitization and payout options, consult your life insurance agent or financial advisor.