16 Jun Annuitizing
What Does Annuatizing Mean?
With each passing year, the annuity becomes a more and more popular form of retirement investment. Thanks to its tax-deferred status and lack of annual contribution limits, an annuity is an excellent way for retirees of all income levels to supplement their traditional retirement plans. Certain types of annuities even provide guaranteed regular retirement income payments for the rest of your life!
As you reach your retirement years, you have the option to “annuitize” your annuity. This is a process that allows you to transfer your annuity’s funds into a series of regular withdrawals, usually on either an annual or monthly basis. While this can be a great option for some retirees, annuitization does have its downsides, especially if you don’t have access too many liquid funds.
There are quite a few factors to consider when deciding whether to an annuity. Let’s dig into the details to find out if annuitization is the right call for your retirement funds, or if you would be better served by another distribution strategy, such as an income benefit rider or a liquidation.
Why Are Annuities So Popular?
Annuities have become increasingly commonplace, as investors look for ways to ensure their income lasts throughout their retirement years. In a rather startling statistic, only about 25% of Americans save sufficient money for retirement, partially due to the low contribution limits of individual retirement accounts (IRA) and 401(k) plans.
With a 401(k), you can only contribute $19,500 per year until you turn 50, at which point you can increase your annual contributions to $26,000. IRAs are considerably more restrictive, as you are only allowed to invest up to $6,000 per year until your 50th birthday, after which you can contribute an additional $1,000 annually. Depending on the standard of living you’ve enjoyed throughout your working years, these limits can fall very short of providing the nest egg you need to continue thriving after retirement.
With an annuity, you can fill in any remaining gaps in your retirement portfolio with guaranteed regular income. If you choose a life annuity, you will receive annual payments from the annuity from retirement until your death. This provides a tremendous amount of peace of mind, as retirees can rest assured knowing they won’t outlive their savings. But how does annuitization play into this situation?
What Does Annuitizing Mean?
Before we get too deep into the specifics, it’s important to point out that most variable annuities never go through the annuitization process. In fact, less than 10% of all variable annuities issued today will not be annuitized at any point in their life cycles. For the most part, annuitizing is much more common with fixed and fixed indexed annuities than it is with variable annuities. However, this process can present some significant benefits for the right circumstance, so it’s certainly still worth discussing, even if you do have a variable annuity.
Annuitization converts your annuity into a series of payments in a systematic payment plan. For the most part, you cannot change your mind once you decide to annuitize your annuity. The process is usually irreversible — even if you can reverse the annuitization process, it’s usually highly complicated and loaded with financial disincentives.
Annuitization takes place in between your accumulation phase (the pre-retirement years when your annuity earns money) and your withdrawal phase (the years when you start accepting payments). Annuitization can produce regular income payments for the rest of your life, or for a set number of years. One important factor of annuitization to keep in mind is that you often need to wait a few years after annuitizing to begin taking withdrawals from your account.
How Do You Determine if Annuitization Is the Right Choice for You?
There are quite a few variables to consider when deciding whether to annuitize your annuity or not. The first aspect is how the annuity fits into your overall retirement investment picture. In general, annuitization is a good idea if you have plenty of money saved in other accounts. Because you have access to other funds in case of an emergency, you won’t have to worry about dipping into your annuity for extra money, which is not an option if you annuitize.
The less money you have saved elsewhere, the worse of an idea annuitization tends to become. While there are obviously extenuating circumstances for each individual’s financial situation, it is typically not advisable to transfer the majority of your retirement savings into regular payments. After all, if you encounter an unexpected financial burden, your annuitized payments will not change. In other words, there’s no option to take an extra payment early and pay it back later. With this in mind, it makes sense that most financial advisers don’t recommend annuitization if the annuity represents more than roughly two-thirds of your assets.
Life expectancy is another variable that plays into the annuitization picture. As an example, let’s assume that you have a life annuity rather than a period-certain annuity (which pays a certain amount for a set number of years). If you annuitize that life annuity into a stream of regular payouts for the rest of your life, any remaining funds are usually returned to your annuity carrier when you pass away. If you opt for a period-certain payout when purchasing your annuity, your loved ones can typically inherit the remaining money.
This is obviously an important decision, and one that requires careful consideration of your wants and needs in retirement. To illustrate the other side of the coin, people who choose to forgo annuitization may end up regretting it if they live to reach old age. In this circumstance, a retiree may live too long for their annuity, and they can very easily run out of money well before they pass away.
Understanding your life expectancy is a crucial factor in the annuitization process. Rather than simply referencing general life expectancy figures, you should examine longevity data for your specific geographic region, as well as for previous generations of your family. If your ancestors regularly lived into their 90s or 100s, annuitizing your annuity with a straight life payout provides you with the financial safety net you’ll need if you significantly outlive your annuity’s payout schedule.
How Does the Annuitization Process Work?
To better illustrate this process, let’s quickly outline an example in which a husband and wife are trying to decide whether they want to annuitize their annuity or not. Both of them are over 65, and they are both recently retired. They decide to buy a fixed indexed annuity in the amount of $200,000, with an immediate payout structure. What does the decision-making process look like for this hypothetical couple?
In one scenario, the couple decides to annuitize the contract. They choose a joint payout structure with a 15-year annuitized withdrawal system. Upon annuitization, the account will pay the couple roughly $15,000 per year for 15 years, resulting in a total payout of $225,000. Even if the husband or wife dies before the annuity withdrawals are complete, the surviving member of the couple would continue receiving those same annual payments until the annuitized payout structure is fulfilled.
On the other hand, the couple could instead choose a lifetime income benefit rider, one of the most popular non-annuitized options. A lifetime income benefit rider provides a set amount of money each year until the accountholders pass away. This steady stream of income is unaffected by any potential performance issues in the annuity’s subaccounts. Additionally, you don’t need to annuitize your annuity or sacrifice access to your principal to enjoy a lifetime income benefit rider.
How much would the couple receive as withdrawals in the lifetime income benefit rider scenario? In most cases, they would receive around 5% of the original $200,000 each year. In other words, their payouts would be $10,000 per year. As long as one-half of the couple is still alive, the annuity carrier will provide them with this same $10,000 payment, even if the total amount of withdrawals has already exceeded the contract’s original value.
If you look at these two different options, it certainly seems like the annuitized option is the better bet. After all, that payout structure ends up providing $225,000 over the course of 15 years, while the lifetime income benefit rider option would take 23 years to exceed that amount. However, depending on your goals and the specifics of your other retirement savings accounts, the loss of liquidity associated with annuitizing might make that option less palatable.
In the scenario outlined above, the annuitized payout is typically a better choice for people with plenty of other money that they can use for emergencies, medical bills, and other unexpected financial situations. Meanwhile, the lifetime income benefit rider maintains the couple’s ability to access their original principal payment. Therefore, if they don’t have access to much money outside of the annuity, they will likely not want to risk annuitizing it.
What Are the Alternatives to Annuitization?
We already discussed the option of an income benefit rider, which is probably the most common annuitization alternative. The income benefit rider’s popularity is based on the fact that they supply their owners with guaranteed payments, and those payments can sometimes outgrow the annuity’s actual value. Furthermore, the owners retain their rights to access the principal, albeit with some surrender charges and tax penalties.
The other common option is to liquidate the annuity. If the contract holder is at least 59 ½ years old and the annuity has passed its surrender period, they can simply choose to receive the account’s entire value in a lump-sum payment. However, liquidating the annuity before it matures involves some steep financial penalties, so this is only an advisable option after the accumulation process of the annuity is completed.
In fact, if you withdraw any funds from your annuity before you reach 59 ½ years of age, you will be subject to a 10% tax penalty from the Internal Revenue Service, and you may need to pay standard income taxes on the withdrawal as well, regardless of whether the annuity is qualified or non-qualified.
The decision of whether or not to annuitize your annuity is a complicated one, and there’s no obvious cut-and-dried answer regarding what you should do with your annuity once it matures. However, for the most part, it comes down to each annuity owner’s risk threshold. If you have enough money in other accounts to have a higher risk tolerance for your annuity, it often makes sense to annuitize. This is because you likely won’t have the temptation to dip into your annuity’s principal to pay for an emergency.
On the other hand, if you fear that an unexpected expense would require you to access the funds in your annuity before it matures, annuitizing is almost always a bad idea. After all, this isn’t even an option after you annuitize — and it’s rarely advisable in any circumstance due to the significant financial penalties involved. Unfortunately, emergencies happen sometimes, and we can’t always foresee the effect they’ll have on our finances.
Do you still have some questions about how the annuitization process works? Perhaps you’re wondering how annuitizing would affect the payouts from your specific annuity? For more information, speak with your independent insurance agent or a financial advisor. These experts can help you determine the best course of action for your retirement future.
If you just want to get a quick, rough idea of how annuitizing your annuity would work, you can use an annuity estimator, like this one from Charles Schwab. You can choose from single life, joint life, and period-certain annuity structures, base your estimate on your original principal or your monthly income needs, select an immediate or deferred payout, and more. These tools only provide an estimate instead of an exact figure, but they can be an excellent way to figure out what your next steps should be.