Understanding Annuities: What Annuitization Means

We often explain that annuities are longevity insurance—policies protecting you against outliving your money. A key to understanding them—and why we frequently counsel folks against these policies—is being familiar with annuitization: the process of swapping your nest egg for a payment stream. This is the critical point at which the annuity acts as insurance. But rather than eliminate risk, it is very possible for annuitization to introduce it. Here are a few key issues that may arise at annuitization, which we’ll cover in depth.

• Does annuitizing help you meet your retirement goals?
• Does it make sense, given your health?
• Is the insurance company backing the product financially sound?

A Brief Explanation

An annuity normally has two phases: accumulation and annuitization. During the accumulation phase, you deposit funds into an annuity account. Think of it as a savings period, where the money in the account builds but is still liquid.

When you’re ready to start receiving periodic payments, you annuitize your account. That is, you stop saving and switch to “withdrawal” or “income” mode for the annuity. Annuitization, as this conversion process is called, can occur upon purchase—an immediate annuity. Most often, however, annuitization occurs later, at a time of your choosing after the accumulation phase­—a deferred annuity. The payment period can also vary. If annuitization lasts for a specific amount of time, then it is period certain. Payment can also be for a lifetime, or for the longer of two lives if the annuity is held jointly. Additionally, there are hybrid annuities that combine lifetime payments with period-certain features.

Once an annuity is annuitized, there is typically no longer any cash value, and the money you saved is no longer yours. The annuity provider assumes ownership—irrevocably—and, in exchange, they provide a fixed payment stream (lasting for a certain period or a lifetime). In other words, the money you had invested is no longer accessible and you can’t withdraw it at will.

Annuitization Risks

Because annuitizing a contract is usually irrevocable, you should understand all the risks and ramifications before making the decision. First, is it needed? Unless you have ample liquid savings elsewhere, converting all or most of your funds into an inflexible and illiquid cash flow would be ill-advised. In the event of an emergency or sudden expense after your annuitization, your hands would be tied.

• Purchasing power eroded: Think about inflation. Because annuity payments are generally fixed, they do not consistently keep pace with inflation. Over time, as the cost of living rises and your annuity payment stream does not, your retirement lifestyle could suffer, potentially jeopardizing the very goal the annuity was meant to safeguard.
• Illiquid and nontransferable: If your goals aren’t exclusively aimed at income generation, annuitization can be very inefficient. The ability to transfer wealth can be limited or lost, and there is often no lump-sum death benefit option once you annuitize, unless you add it for a cost. This reduces the amount of income you receive—or that can be passed on to your heirs.
• Unnecessary complication: If your financial assets are already large enough to ensure a comfortable retirement, annuitization is probably unnecessary. Indeed, most contracts are never annuitized and instead kept liquid in reserve or in case of emergency. An annuity just needlessly complicates the financial planning process, in such cases.

Second, what is your estimated life expectancy? The key factors insurers use to calculate payments are the current age and life expectancy of the annuity holder(s), as well as the projected interest rate that will be credited to the annuity balance. Most people underestimate their life expectancy. Few retirees at age 65 fathom they could have 20, 30 or more years ahead of them. IRS tables show lifespans average 21 years after 65, but this has only lengthened over time. Among the fastest-growing demographics in the US are 100+ year olds (albeit from a low base).

Obviously, the longer you live, the greater the eventual payout from annuitization. But absent an inflation adjustment, guaranteed income will likely lose purchasing power over your lifetime—potentially significant purchasing power 15, 20 or 25 years down the road.

If your health is in decline, annuitization may be even more of a risk. This could jeopardize passing your wealth on to family members. Forfeiture risk is especially big for single-lifetime annuities. Absent a death benefit, any principal remaining stays with the insurance company. If period-certain, remaining payments can be passed to a beneficiary, but there is usually no lump-sum option.

Third, be aware of legal recourse to your state’s guarantee fund. If the insurer goes under—during either the accumulation or annuitization period of your contract— you’ll want to know your state’s coverage limits. Although insurance-company default rates have historically been low, that isn’t something you’d want to hang your retirement on. Spreading income annuities among insurers to keep payouts below state guarantee limits is an option, but again introduces costs and complications that likely outweigh the benefits.

A guaranteed income may help some individuals in a very specific niche, but we find these annuitization products are sold much more often than they are actually needed by the investing public. Whether you’re considering the purchase of an annuity or the annuitization of an existing one, make sure you fit that niche. The decision may be financially constraining—and irreversible.