Not all annuities are created equal. In fact, there are so many annuities on the market, and so many iterations, that it requires a full-time commitment to stay on top of the ever-changing market.
If you find yourself with an old annuity, considering the purchase of an annuity, or forced into an annuity decision through your employer’s lump sum or annuity option, you should know your options for annuitization (your options for income). While annuitization is not always mandatory, nor always the best option, it is an option. If you find yourself owning an annuity, you owe it to yourself to understand exactly what annuitization is.
Annuities often give you many income options to choose from. Specifically, you should know your options in terms of how much income you have the right to, and how long this income may last.
What is Annuitization?
Annuitization is the process of trading a lump sum of money for a systematic income payment.
The amount of income you receive is dependent on a number of factors, including your age, your gender, and how much money give the insurance company for said income stream.
Generally, you can assume these few facts, all else being equal:
- The older you are, the higher the income (because you will receive the income for a fewer number of years)
- Females receive less than males (as females tend to live longer)
- The more lump sum money you give the insurance company, the more income you may receive
- Insurance companies typically offer many income options that serve a number of needs
It’s important to understand that once you elect to annuitize an annuity, there is no going back. You no longer have access to your lump sum of money.
How to Get the Highest Possible Lifetime Income?
Wouldn’t it make sense to try and receive the highest income possible? Of course, but the highest income possible may come at the expense of other things.
The annuitization option that gives you the highest monthly payment for the remainder of your life is known as a single life annuity.
A single life annuity will pay you for as long as you live. Once you die, the income stops and your beneficiaries receive nothing.
If you choose to annuitize a contract and unfortunately die early, you may not receive as much back as you gave the insurance company. In essence, you lost! And in turn, the insurance company won! Your internal rate of return (a geeky term that investment nerds like myself use to mean measuring the profitability of possible investments) is potentially terrible.
However, none of us knows when we are going to die. When choosing to buy a single life immediate annuity, you may not be concerned about dying early. You’re operating under the assumption that you are going to live for a long time.
If this is true, and you live until 90, 100, 110 or beyond, then the insurance company will continue to pay you until you die. This means that the insurance company will pay you potentially more than you gave them. In this case, you win! –(theoretically you beat the insurance company!)
Should you Consider a Joint Annuity?
Single life annuities may be the best option for a single person. However, for those who are married or for those whom others depend on financially, choosing a single life annuity may not be the best choice.
The risk is that if the annuitant (the person whose life the payment is tied to) dies, then the income dies too.
Insurance companies recognize this concern and offer several options. The first option is a Joint Survivor Annuity.
With a single life annuity, the income stops upon the death of the annuitant. With a joint survivor annuity, however, the income is tied to two lives. Upon the death of the first spouse, the income continues for the second partner as long as they are alive. When the second spouse dies, the income stops.
When purchasing a joint annuity, the amount you receive each month will be less than what you would receive if you selected a single life annuity – the reason being, you are now insuring two lives, and often a married couple. It is more likely that payments will be paid for a longer time.
Joint annuities come in several options. Some of these include 100% survivorship, 75% survivorship, 50% survivorship, etc. With a 100% survivorship benefit, 100% of the benefit continues to the surviving spouse upon the death of the first spouse (for example, if $2,000 per month was being received when both were alive, then $2,000 per month would continue after the death of the first spouse).
With a 50% survivorship annuity, the surviving spouse will receive a reduction in the benefit. For example, if $2,000 was being received, then following the death of the first spouse, the second spouse would receive $1,000.
The higher the survivorship benefit, the greater the likelihood that the insurance company will need to pay more income, which explains the greater reduction in monthly income being paid out.
Joint annuities may be a good solution for those who are worried about income for more than one person.
What Other Things Should I Know?
Other options exist when selecting an annuitization option. Some insurance companies may allow payments over a guaranteed number of years instead of over your lifetime.
For example, you may select a “years certain” benefit. With a “years certain” benefit, you (or your beneficiaries) are guaranteed a payment for the stated numbers of years (often 10 or 20 years). After that time expires, your payments stop.
Because the payment is only set for a stated period (not for a lifetime), you should expect to receive a higher income payment during that time. However, when that “years certain” time ends, your income goes away.
Insurance companies may also offer cost of living adjustments. Often, when purchasing an annuity, the payment you receive is fixed. For example, if you receive $2,000 per month now, you will receive $2,000 per month in 5 years, and 10 years, and 20 years. As we all know, the value of $2,000 decreases over time.
A cost of living adjustment increases your benefit each year (subject to specific insurance company rules) to keep up with inflation. Using the same example, your $2,000 per month benefit may increase by 3% in the second year, giving you $2,060 per month.
When purchasing an immediate annuity with a cost of living adjustment, it’s important to know that this may come at a cost. The amount you receive in Year 1 may be less than what you would have received had you not selected this option.
This Seems Like a Lot of Options
It is, and there are plenty more, but if you are considering annuitization, you should consider all the options that your annuity offers.
You may find yourself asking these questions for any number of reasons. You may have a lump sum or an annuity option from your employer. You may have a pension benefit from working a certain number of years.
You may have this option because you purchased a fixed or variable annuity.
Or perhaps you have this option because you want to trade some of your hard-earned savings into an income stream.
Whatever the reason may be, you should be sure that you fully understand your income options, know what/who you are trying to protect, shop around various insurance companies, and ask a lot of questions. Not all annuitization is created equal, and you want to be confident that you’re making the right decision!
Variable annuities are designed to be long-term investments and early withdrawals may be subject to tax penalties and charges. Actual investment return and principal value may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. In reference to general account obligations and guarantees, such as is present with fixed annuities, the ability for the insurance company to meet these obligations to policyholders are subject to sufficient capital, liquidity, cash flow and other resources of the insurance company.
For fixed annuities, the ability for the insurance company to meet these obligations to policyholders is subject to the claims-paying ability of the insurance company.