How Annuitization Works

When using big term such as, “annuitization,” it’s best to provide a literal definition and then explain what it means in terms that we can all understand. Literally speaking, annuitization is the process of converting a lump sum of capital into a series of periodic payments for specific period of time, or an individual’s lifetime. Used in the context of annuity products, it is a method by which a life insurance company, in exchange for a lump sum of capital, guarantees a stream of income for a set time period or for the life of an individual based on such factors as the amount of capital, the number of payment periods and interest rate assumption.

Annuities Explained

How it Works

When annuitization is to occur for the lifetime of an individual, the number of periods used to determine the income payment is based on the number of periods that occur between the individual’s current age and his or her life expectancy.  The “life insurance” component of income annuities, which is their most prominent feature, is the guarantee that, should the individual live beyond his or her life expectancy, the life insurer will continue to make the payments until the person dies.

Annuitization can take several forms, the most common of which is a lifetime option, in which payments are guaranteed for the life of the annuitant (the person receiving the payments).  Under this arrangement the payments cease and the remaining annuity balance is retained by the life insurer. Other forms include joint life, which guarantees an income on the joint lives of two spouses so that it will continue for the surviving spouse; and a period certain in which payments are made for a stated number of years. With all of these forms, there is also an option to provide the beneficiary with a refund of unused principal in the event the annuitant dies before the end of their annuity period. These refund options are typically selected with a term certain, meaning that, if the annuitant dies within a certain number of years after annuitization, the annuity value is refunded to the beneficiary.

Anytime extra guarantees, such as joint life or period certain with refund are added, it increases the cost of the annuity.  These added costs are recovered by the insurer by means of reducing the income payment by a certain percentage.  A lifetime annuity on a single life with no refund will receive a full payout, while a joint life arrangement will result in a reduced payout as would an annuity option that involves a refund.

Products for Annuitization

Annuitization can occur within two different types of annuities – a deferred annuity or an immediate annuity. With a deferred annuity, funds are accumulated over a period of time during the “accumulation stage” of the annuity. At the time of the annuity contract owner’s choosing, the deferred annuity can be annuitized at which time the annuity account value is committed to the life insurer so that it can establish a rate of payment.  This is called the “distribution stage” of the annuity. The other type, which is used strictly for annuitization, is an immediate annuity. With an immediate annuity, an individual deposits a lump sum of capital with a life insurer which then immediately (immediate could mean within 30 days or within a year), converts it to a stream of income payments.  In both cases, once the funds are annuitized they are irrevocably committed to the insurer (unless a refund option is selected by the annuity owner).

Income Maximization

Because income payments are calculated by dividing the total capital available (plus project interest) by the number of periods, higher income payments can be achieved by shortening the number of periods. For instance, annuitization that occurs over a person’s life expectancy of say, twenty years, would produce a lower monthly payout than one that is set up as a period certain for 10 years.  If one were concerned about maximizing their monthly income they could choose a shorter period certain option, but they would risk outliving their income.

Alternatively, they could delay annuitization as long as possible. Rather than commence lifetime income payments at age 65, which would generate a payout rate based on 17 years of payments, they could instead wait until age 70 which would shorten the number of payment periods resulting in a higher payout rate.  Another strategy is to combine deferred annuities with a series of shorter, period certain annuities which enable the annuitant to receive maximum income from the shorter termed annuities while allowing the remaining capital to continue grow. When the period certain annuity is depleted, another one is annuitized in its place.

Summary

Annuitization, in spite of its big, technical name, is actually a fairly straight forward process. It’s an exchange of capital for income.  Yes, there are a number of actuarial assumptions involved to calculate the income, but it’s not much more complicated than dividing the capital amount, including the interest to be paid over the term of the annuity, by the number of payments a person wants to receive. What set’s annuity products apart from any other type of income strategy or investment product, is that the payments, whether for a period certain, or for a lifetime, are guaranteed. In light of recent troubles in the financial markets and the uncertainty of the economy, a growing number of people find that aspect appealing. At the very least, an annuitization strategy using an annuity can be combined with other, more aggressive income strategies to create the income safety net everyone needs.