Annuitization

What is Annuitization?

Annuitization is the process by which the holder/owner of an annuity receives the payouts from it. The income from an annuity can either be paid out all at once, in a lump sum, or through regular distributed income payouts, in installments.

An annuity is a type of insurance contract that is designed to provide its holder with a stream of fixed income. Commonly used as a source of funding for individuals once they reach retirement, annuities can either be purchased at once with one large sum of money or they can be purchased over a period of time, with a series of payments. In such a way, the options for paying for an annuity mirror the options for receiving the annuity’s payouts.

Annuitization Payouts

Annuitization enables annuitants to receive periodic income payments, either over a specified period of time or throughout the rest of the annuitant’s life.

The process of annuitization not only provides periodic income payments to annuitants; it can also be utilized to provide income for an annuitant’s surviving spouse or another specified beneficiary.

In order for it to occur, an annuitant must set up a joint life arrangement annuity, which specifies an additional individual who may receive the annuity’s income once the original annuitant’s passed away.

Phases of an Annuity

There are two phases of an annuity:

1. Accumulation

The first of the two phases is the accumulation phase. During the accumulation period – as the name suggests – an annuitant makes financial contributions to his or her annuity, similar to the ways that an individual would make contributions to any other investment.

The length of the accumulation phase is generally specified at the time that an annuity contract is purchased. In many cases, the length of time that an individual may make contributions to his or her annuity is determined by the type of annuity held by the individual and by the institution (insurance company) or agent providing the annuity.

2. Annuitization

The second phase, then, is the annuitization period. As discussed above, the process of annuitization is the means through which an annuity is converted from and investment into periodic income payments. The annuitization phase, then, is the period of time during which the periodic payments are made.

As previously noted, such a period of time may not be a “period” at all, but instead one payment. Alternatively, the annuitization period may be a specified period of time, which includes the remainder of the annuitant’s life.

Types of Annuities

There are several types of annuities available. It’s important for an investor to know what type of returns or benefits he’s looking for in order to pick which kind of annuity will work best for him or her.

Among the different types of annuities, three of the most popular are the following:

1. Deferred annuities

Deferred annuities are popular because they beneficial in the long term. An annuitant who chooses a deferred annuity is able to invest a particular sum of money (or make several investments over a period of time) and then defer income payments received from the annuity until a specified date in the future. Deferred annuities are beneficial because it allows the invested money to accrue interest over the intervening time period between buying the annuity and the later period of annuitization.

Essentially, the annuitant earns “free money” that they can then receive in later payouts. It is the tax structure of deferred annuities that makes them an attractive option, along with the flexibility they offer. A deferred annuity receives pre-tax contributions. The income derived from the annuity is only taxed upon withdrawal. It enables the annuitant to defer paying taxes on the earnings from the annuity almost indefinitely.

Deferred annuities offer the annuitant several options for receiving distributions. You can elect to take a series of lump-sum withdrawals, essentially accessing your annuity’s fund “as needed.” Alternatively, you can choose to cash out the annuity all at once or convert it from an annuity into another investment vehicle. You can also opt to take the most commonly chosen path for annuity distributions – receiving a steady stream of income payments.

The tax liabilities associated with a deferred annuity can get rather complex, so you should certainly consult your financial advisor before purchasing an annuity and also prior to taking income distributions from it. Make sure you fully understand your options.

2. Fixed annuities

Fixed annuities are another popular form of annuity because, as the name implies, they offer earnings in the form of a fixed rate of interest on all funds invested in the annuity. In such a way, fixed annuities are like certificates of deposit (CDs), although they typically offer a higher interest rate than CDs do.

Fixed annuities can be either immediate (meaning they provide fixed payouts, determined by annuity size and annuitant’s age, almost immediately following the accumulation phase) – or deferred (which means they continue to collect interest at a set rate and payouts are made later). Fixed-rate annuities are popular among individuals who are risk-averse. They prefer the security of a fixed rate over potentially higher income that might be received by investing in a variable annuity.

3. Variable annuities

Variable annuities involve more risk than fixed annuities, but also offer the potential for greater reward. With a variable annuity, annuitants are able to invest in a diverse portfolio of accounts or investment funds. The risk, though, is that the annuity’s value (and thus, the amount the annuitant is capable of drawing income from) is dependent upon how successful the annuitant’s investments are.

The ability to invest in a broad basket of subaccounts means the annuitant can diversify or hedge their investments significantly. Still, there is a potential for considerable loss if the multiple accounts don’t perform well.

Related Readings

To keep learning and advancing your career, the following resources will be helpful:

• Annuity Due
• Income Annuity
• Indexed Annuity
• Pension Fund
• Variable Universal Life (VUL) Insurance
• See all wealth management resources