Annuity Guarantees

U.S. households lost trillions of dollars in the first few quarters of the economic and financial crisis of 2007, 2008, and 2009. Total wealth relative to after-tax income had fallen to its lowest level since March 1995 by the end of 2008.

This sharp drop likely had a severe effect on the retirement income security of millions of U.S. households.

 Retirement savings have become increasingly individualized, meaning that retirees have had to manage several economic risks increasingly on their own.

 ·         First, there is longevity risk, or the chance that a retiree will outlive his or her savings.

·         Next, there is market risk, or the probability of an underperforming market and thus less-than-anticipated retirement income.

·         Third, there is idiosyncratic risk, or the chance of unwise or unlucky investment and savings decisions, which can further reduce expected retirement income.

·         Fourth, there is labor market risk, or the possibility of earnings losses alongside financial market declines. All of these risks may have increased over time.

Greater risk exposure has two policy implications. First, risks are an economic cost, and workers should save more than in the past to handle the new costs of greater risk.

Additionally, individuals’ psychological makeup stands in the way of optimal wealth creation. Savers do not regularly rebalance their portfolios; they buy high and sell low, and invest large amounts of their portfolio in employer stock, among other steps that can inadvertently reduce their savings.

What Does Annuitization Method Mean?
A type of annuity distribution structure that gives the annuitant periodic income payments for the rest of his or her life, or a specified period of time. This is different than the systematic withdrawal method, with which the annuitant chooses the amount he or she would like to receive each month, which he or she receives until the amount in the account runs out.

Annuitization Method
Upon annuitization of his or her account, the annuitant effectively converts the entire savings in the account into an income stream. If he or she choses the life option, the income stream is guaranteed by the insurance company to last the rest of the annuitant’s life, even if he or she should live much longer than originally expected.

Of course, the risk in chosing the life option is that, should the annuitant die sooner than expected, he or she will not receive all of value of the annuity account – the insurance company gets to keep the remainder of the account upon the annuitant’s death.

Most annuities, however, offer period-certain options or spousal coverage, which can reduce the risk of the annuitant’s funds not being sufficiently paid out because of an earlier-than-expected death. For some investors, an annuity can be an appropriate part of a sound financial plan. However, one feature of annuities that is commonly misunderstood is payout options. Here we define these options, how they are calculated and how they are taxed.

Phases of an Annuity
The two phases in the life of an annuity are the accumulation phase and the annuitization phase (or payout phase). During the accumulation phase, you can add funds to your annuity contract by depositing cash, converting life insurance cash values or doing a 1035 exchange from another annuity (to name a few ways of contributing). If you follow the annuity rules, your annuity will accumulate earnings on a tax-deferred basis until you make withdrawals.

Once you reach age 59.5, you can begin to withdraw funds from the annuity without penalty charges.

Annuity Payout Options
There are a few different methods for taking annuity payouts. Generally speaking, the two most common methods to receive cash payouts are the annuitization method and the systematic withdrawal schedule. The other is taking a lump-sum payment. The annuitization method gives you some guarantee of monthly income for a determined period. Under the systematic withdrawal schedule, you have complete control over the timing of distributions but no protection against outliving annuity assets.

Annuitization Methods
Let’s look at some different options you have with the annuitization method.

• Life Option
  The life option typically provides the highest payout because the monthly payment is calculated only on the life of the annuitant. This option provides an income stream for life, which is an effective hedge against outliving your retirement income.
• Joint-Life Option
  This common option allows you to continue the retirement income to your spouse upon your death. The monthly payment is lower than that of the life option because the calculation is based on the life expectancy of both the husband and wife.
• Period Certain 
  With this option the value of your annuity is paid out over a defined period of time of your choosing, such as 10, 15 or 20 years. Should you elect a 15-year period certain and die within the first 10 years, the contract is guaranteed to pay your beneficiary for the remaining five years.
• Life with Guaranteed Term
  Many people like the idea of income for life (which they get with the life option), but they are afraid to choose that option in case they die in the near future. The life-with-guaranteed-term option gives you an income stream for life (like the life option), so it pays you for as long as you live. But with this option, you can select a guaranteed period, such as a 10-year guaranteed term, for which your annuity is obligated to pay to your estate or beneficiaries even if you die before that guaranteed period is over.

Systematic Withdrawal Schedule
Under this method, you can select the amount of payment that you wish to receive each month and how many you want to receive. However, the insurance company will not guarantee that you will not outlive your income payments. How much you receive and how many months you receive payments depends on how much you have in the account. The burden of life-expectancy risk is on your shoulders.

Lump-Sum Payment
Taking out the assets in your annuity in one lump sum is usually not recommended because, in the year you take the lump sum, ordinary income taxes will be due on the entire investment-gain portion of your annuity. Clearly, this is a very inefficient payout option from a tax minimization perspective.

Electing Not to Take Payments
Some individuals have no need for income from the funds that have accumulated in their annuity. If the same is true for you, be sure to check your beneficiary designation is correct since the annuity can be transferred to your beneficiary at your death.

How Does the Insurance Company Compute your Monthly Payment?
There are several factors that insurance companies use to compute your monthly payment amount; two of the most common are gender and age - both of which affect your life expectancy. Since women have longer life expectancies than men, women won’t receive as high of a payment as their male counterparts. And, of course, the older you are, the lower your life expectancy. A 75-year-old man with the life option will receive a higher monthly payout than a 65-year-old man because the older man’s life expectancy is shorter.

Another major factor that affects the size of your monthly payout is the payout option that you select - which affects how long the payments will last. For example, if you select the joint-life option, your monthly payout most likely will be lower as the payment continues to your spouse after your death.

Finally, the size of your monthly payout depends also on the insurance company that you use, and its expected investment returns on your money. If the company can make a 5% instead of a 3% return with your money, your payment will be higher. However, the increase in your payment when returns are higher depends on whether you select a fixed monthly payout or a variable monthly payout from your annuity. If you select the fixed amount, your payout will not change, and the insurance company assumes all investment risk. Under the variable payout, the size of the monthly payout fluctuates based on market conditions, so you assume the market risk.

Tax Treatment of Annuity Payouts
Once your contract is annuitized, part of each payment (from a fixed annuity) is considered a partial return of the basis (your contribution) and part is taxable income using an exclusion ratio. Once you select your payout method with your insurance company, you should ask for your exclusion ratio, which tells you how much is excluded from being taxed. If your exclusion ratio is 80% on a $1,000 monthly payout, then $800 is excluded from income tax and $200 is subject to ordinary income tax.

Premature distributions (those occurring before you reach age 59.5) are subject to a 10% penalty, and for annuities purchased before Aug 14, 1982, the FIFO (first-in, first-out) method is used for withdrawals. For annuities purchased after Aug 13, 1982, the withdrawal rule is LIFO (last-in, first-out), meaning that earnings will come out first. You have to pay not only a 10% penalty on the withdrawal, but also income tax on any portion of the withdrawal attributable as investment gain. It is not a wise decision to pull funds prior to age 59.5, so try to avoid it at all costs.

Credit Quality Concerns
A final factor to consider is the credit quality of the insurance company. Remember that just because you have accumulated your annuity at one insurance company over the past 20 years, you don’t necessarily need to start your payouts with them. If another insurer with a high rating has offered you a higher monthly payout, it might be worth your time to look into doing a tax-free 1035 exchange to the new insurer, but make sure to check the surrender charges on your current contract before you initiate any transfer!

The insurance companies have employees in specialized departments that will provide you with an estimated payout for each option. – Have multiple quality insurance companies give you a quote on the current value of your annuity with multiple payout options.

Conclusion
Deciding on the best annuitization payout method to choose for your annuity is not an easy decision. Consider your priorities, the amount you need each month and how long you think you will need these payments.