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An annuity can be a helpful source of guaranteed income in retirement. But to accomplish that, it must generally go through the process of annuitization. And while the concept itself is simple enough, some of the details and processes behind it can be complex.
And those details can also have a bearing on how the annuity ultimately benefits the owner. So, it’s important to have a handle on what’s involved in the annuitization process.
Annuity definition
Obviously, it starts with an annuity. That is a contract where, in exchange for a payment or a series of payments, an insurance company will provide a guaranteed stream of payments to someone (the contract owner). Depending on the type of annuity, this income stream can come either immediately or — after a period of potential growth — at some point in the future. This makes annuities a powerful tool for retirement.
“People with guaranteed income in their retirement tend to sleep better at night,” said Mark R. McManus, a senior vice president with Baystate Financial in Southborough, Massachusetts. “People relying on assets for income in their retirement tend to be nervous, because asset value can fluctuate. Annuities essentially allow someone to use assets to create their own kind of pension. So those who were nervous can get some peace of mind.”
Beyond their basic structure, annuities can differ in how they provide growth and tax benefits over time and when they can be annuitized. (Related: Different types of annuities explained)
What is annuitization?
Simply put, annuitization is the point at which the annuity investment is converted into the stream of guaranteed income payments. And, proverbially, it is the point of no return.
For some types of annuities — such as single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) — there isn’t really a conversion subsequent to investment, as the guaranteed income streams are established at purchase.
For other types of annuities — ones that allow for growth over time — at annuitization, the contract enters what’s called the annuity phase. This period begins on the annuitization date and ends with the last annuity payment. Once the contract enters the annuity phase, most annuities become illiquid, meaning there is no longer contract value in which to take withdrawals in addition to the guaranteed annuity payments.
The duration, size, and frequency of the payments resulting from annuitization can vary, depending on the carrier, type of annuity contract, its terms, and choices made at annuitization. Here’s a closer look at each of those areas.
Duration
How long will annuity payments come? Here are typical options.
- Single life: Annuity payments are made for the duration of the annuitant’s life.
- Joint and survivor life: Annuity payments go to a couple and typically end once the second partner passes.
- Period certain: This is where annuity payments are made for a fixed amount of time, usually from 10 to 30 years. After the period expires, payments cease.
There can be other options as well. For instance, many annuities allow for withdrawals under certain conditions, which some annuitants opt for instead of annuitization, or, depending on the annuity, in conjunction with annuitization.
Annuity payment amount
The amount of the annuity payments will depend on a number of factors.
- The duration of the annuity payments will affect the amount of the payment; for example, the longer the payment period, in conjunction with the annuity option selected, the smaller the periodic payments are likely to be. Joint-life payments will likely be smaller than life payments for a single annuitant, because they are covering the longevity of two people. And period-certain payments will likely be larger than either, since the payments are for a defined period of time that is typically shorter than a lifetime.
- Your gender and age at the time of annuitization are also critical factors because insurance companies use life expectancy in their payout calculations.
And beyond those factors related to you is what’s going on in the financial world at large.
“One major factor in calculating payout rates in addition to age, gender, and payout option is interest rates,” said Philip Michalowski, head of annuity products for MassMutual. “Interest rates are a big driver of the payout amount.”
And there are more elements affecting the annuity payment amount.
One is the type of annuity involved.
- Immediate income annuities usually start payments immediately upon the contract’s issuance at a fixed payment based on terms originally set in the contract.
- Deferred income annuities are designed to provide a future stream of pension-like income that may start typically after a year or be deferred longer and in amounts based on the terms set in the contract.
- Deferred fixed annuities guarantee payments start at a future date selected by the owner. Your investment grows based on a guaranteed rate of interest which — when you annuitize — will be used to calculate your payment amount. The longer you defer starting your guaranteed annuity payments, the higher — typically — the payments will be due to the investment growth based on a guaranteed rate of interest.
- Variable annuities also guarantee payments starting at a future date selected by the owner. Because these annuities are deferred, the longer you wait to annuitize, the greater growth potential there is for your investment. Those potential gains will be used to determine your annuity payment amount upon annuitizing. But remember, these types of annuities are subject to market risk and potential loss in value.
- Fixed index annuities also guarantee payments starting on a future date selected by the owner. Because these annuities are also deferred, the longer you wait to annuitize your investment, the greater growth potential. Your investment is benchmarked to the performance of an external market index up to a cap rate set by the insurance company. Growth is not guaranteed, but typically your investment is protected from market losses. Your income payments will be based on your contract value at the time you decide to annuitize and start receiving income.
For a side-by-side comparison of these different annuity types, go here.
“With the environment we’re in today, SPIAs and DIAs can be quite attractive,” noted McManus. “I advise clients entering their early- to mid-70s to take a look at them. Because of life expectancy at that point, they’re likely to get larger payments and get more leverage out of the mortality aspect of the products while enjoying the security of guaranteed income through the term of the contract.” (Related: Different types of annuities explained)
Also, riders —living benefits that can be added to the annuity contract at an additional cost — can affect payouts.
Additional calculations
When it’s time to make a decision about annuitization, many companies will illustrate the contract to determine what your income payments will be. Some companies will compare the annuitized income available under your existing contract to that of their immediate annuity and if that income is higher, they will provide you with the higher income payment amount. This is known as a “betterment of rates” comparison.
Conclusion
In the end, whether to annuitize and when to do it will depend on an individual’s situation and needs. Great care should be taken to analyze and consider the outcomes of annuitization — like the size and duration of payments — and whether those outcomes will satisfy the needs of the annuitant. A financial professional can help with that analysis.
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