Annuitization is the process of converting a capital sum into a level, regular stream of payments. In practice, annuitization is normally synchronized with retirement, although this is not invariably true. By definition, retirement signals the end of earned income. The retiree will need to replace this income in order to support continued consumption. This is the time to convert accumulated assets into a dependable flow of income. That is exactly what annuitization does.
History and Format of Annuitization
The process derives its name from the annuity. Originally, this was a flow of regular, lifelong income. The first annuities were issued by insurance companies in exchange for a lump sum payment that formed the capital sum. The company guaranteed to pay the annuitant a lifelong stream of money. Meanwhile, it invested the proceeds conservatively enough to fund the payments over the annuitant’s expected life span.
Today, we refer to an annuity in which annuitization commences soon after purchase as an immediate annuity. It contrasts with more popular forms called deferred annuities, in which payouts are delayed until a specified future date, allowing time for accumulation of the capital sum. Investment during this accumulation period occurs under the auspices of the insurance company. Under various kinds of fixed annuities, the insurance company does the investing, paying the annuityholder’s accumulation account a fixed rate of return. With variable annuities, the annuityholder directs the investment process by choosing from investment alternatives provided by the company.
It is normal for all of these annuity products to offer the option of annuitization. Exceptions include time-limited annuities designed for specialized purposes. In actual practice, Americans seldom annuitize, preferring discretionary control over the capital sum. Some academic students of annuities explain this fact by noting that a great deal of retirement-oriented wealth is already “annuitized” via Social Security taxes and company pension plans. (Thus, it is possible to have “annuitization” even outside of an annuity.) Elsewhere in the world – particularly where government social insurance programs have been replaced or supplemented – annuities are much more popular.
The Rationale for Annuitization
The immutable problem addressed by annuitization is the uncertainty of the death date. This creates “longevity risk” – the possible of outliving one’s income sources. Annuities are the only product offering a guarantee of lifelong payment. This guarantee is only as good as its financial underpinnings. That is one reason why the major financial ratings agencies rate the financial strength of life insurance companies. These rating allow a would-be annuity purchaser to evaluate the likelihood of losing annuity income to insurance-company insolvency. Another back-up system is the state guaranty fund, which underwrites the assets of insolvent insurance companies.
Because individuals differ in their tolerance for risk and craving for security, annuitization will be more valuable to some people than others. The trend toward increased life expectancy tends to encourage annuitization. This is not only because of the increased risk posed by longevity but also because the rate of return on any annuity depends on the length of its term – the longer payments continue, the larger they are as a percentage of the annuity purchase price.
Other considerations favor annuitization. Tolerance for risk is greatly reduced in retirement, when there is little time left to recoup investment losses. While there are numerous alternative income sources open to retirees, most of them entail higher risk to the retiree’s principal than do annuities. Stock dividends are not guaranteed and may fluctuate erratically in size and frequency. Corporate bonds have a risk of default. Bond funds pose a risk to principal from rising interest rates, which reduce the value of bonds in the fund’s investment pool. Even U.S. government bonds – long deemed the proverbial “riskless asset” – now entail an element of risk, as witnessed in the threat by bond-rating agency Moody’s to downgrade the federal government’s credit rating.
There is also reason to prefer annuitization within an annuity rather than, say, a company pension. Because pension assets can be threatened by company insolvency, the lump-sum withdrawal and placement of those assets under an insurance company can reduce risk while retaining the benefits of annuitization. Insurance-company investments are much more diversified than the company’s, hence less subject to sharp decreases in value.
Don't Just Shop, Implement a Solid Retirement Strategy
Purchasing an annuity is a big decision. Online research is a good start, but prudent investors should discuss all their options and risks with an independent financial advisor. Request a free, no-obligation consultation today, along with a report of current rates on brand-name annuities.
(limited time offer)
Sources of Resistance to Annuitization
One reason for rejecting annuitization is the loss of control over funds, which are
administered by the insurance company. The annuitant may need a large chunk of money on short notice to pay for emergency medical care, finance a vacation, pay sudden automobile or home expenses, or assist family members. While annuities usually offer a limited scope for liquidity – often 10% of the annuity value annually – this may fall short of some retirees’ needs.
Original annuities specified the forfeiture of the capital sum to the company if the annuityholder died before collecting. Needless to say, this proved unpopular with customers. Today’s products offer both a death benefit to a named beneficiary and the option of assuming the annuity payments after the holder’s death.
Inflation is a traditional bugbear for fixed-income recipients like annuitants. “Real annuities” index their distributions to some measure of inflation, such as the Consumer Price Index. These have been offered for some time in Europe and have recently migrated to American shores.
Tax-related estate planning may militate against annuitization, at least within an annuity. Annuity distributions are taxable as ordinary income, which today carries a higher tax rate than do long-term capital gains from investments such as mutual funds. The higher the tax rate faced in retirement, the less favorable is annuitization compared to forms of wealth accumulation and distribution such as mutual funds.
How Does Increasing Life Expectancy Affect the Decision to Annuitize?
Average life expectancies increased steadily throughout the 20th century. In the last half of the century, life expectancy at age 65 increased markedly in response to improvements in medical diagnosis and treatment. These increases have important implications on the decision to annuitize retirement wealth.
A longer life expectancy increases longevity risk. This makes annuitization more valuable. The rate of return provided by annuitization depends on actual longevity. Longer life expectancy increases the average return, thus chalking up another gain to annuitization.
A potential negative factor is that longer life expectancies increase the exposure to inflation, which can seriously reduce the purchasing power of a fixed annuity payment. One way out of this dilemma is to purchase a real (inflation-indexed) annuity. Another strategy is to annuitize sufficient wealth to pay basic expenditures for food and shelter, while devoting part of the retirement portfolio to growth investments such as mutual funds.
Risk Aversion and Annuitization
Another important parameter in the annuitization decision is the emotional makeup of the investor. The more risk-averse is the investor, the greater the potential gains to annuitization. There is some evidence that recent financial-market setbacks have increased investor awareness of the dangers inherent in investment, thereby increasing overall risk aversion. This is yet another factor suggesting that annuitization of retirement wealth will become more frequent.
Annuitization is the act of distributing wealth in the form of regular, level payments. It was originally associated with what are now called immediate annuities – assets purchased with a capital sum sufficient to finance guaranteed, lifelong income payments. When deferred annuities supplanted immediate annuities in popularity, they usually offered annuitization as one option for distributing the money accumulated through investment.
Although time-limited annuities exist, annuitization is generally associated with retirement – the point at which earned income ends and investors want to secure a stream of income to support them until death. A life annuity is the only asset that is guaranteed to provide income for the remaining lifetime of the owner. This inherent linkage with retirement is reinforced by law and IRS rules. Annuities, which usually offer the option of annuitization, offer the privilege of tax deferral of investment gains, but are subject to taxation and IRS tax penalties of 10% when money is withdrawn prior to the owner’s attained age of 59 ½.
Annuitization can occur outside the context of an annuity. Most countries offer so-called social insurance, similar to Social Security old-age and security payments. These follow the basic model of annuitization. Corporate employee pensions are another form of annuitization outside the annuity framework. Academic studies suggest that the relative unpopularity of annuitization in the U.S. is due to the high percentage of American retirement wealth that is pre-annuitized by these two sources. Annuitization within an annuity will offer a better rate of return than government social insurance and less risk than a corporate pension.
Factors favoring annuitization include increasing life expectancy (which increases longevity risk and the rate of return to annuitization) and increasing risk aversion. While inflation poses a definite threat to the purchasing power of fixed-income annuity payments, it may be neutralized by inflation-indexed annuities and a mixed investment strategy pursuing both annuitization and growth.
To find the best annuity products request a free, comprehensive quote comparision. Secure your retirement today, Get Started Now .Source: www.freeannuityrates.com