Annuitization

Article byAbhilash Ramachandran
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What is Annuitization?

Annuitization is a method by which ‘annuity’ investments are converted into systematic income payments at regular intervals. In other words, it is a systematic income plan wherein the holder of the annuity (a contract made between the insurance company and the holder of the insurance who makes a lump sum payment or a series of payments to start receiving a fixed income at regular intervals) triggers the income payments.

Key Takeaways

  • Annuitization is the process of converting a lump sum of money, such as retirement savings, into a series of regular income payments by purchasing an annuity. It serves as a tool to manage longevity risk and ensures a reliable source of income during retirement.
  • It allows individuals to receive a steady income stream over a specified period.
  • Decisions regarding annuitization involve various considerations, including an individual’s financial goals, risk tolerance, expected longevity, current market conditions, and the terms and features of different annuity products. Evaluating these factors helps individuals make informed choices about annuitization.

How does Annuitization Work?

  • While entering into an annuity contract, the insurer gets the capital amount that is invested by the insured, also known as the annuitant. The insurer calculates the payments for the annuity based on the current age of the annuitant and the life expectancy.
  • The payments are based on the future interest rate based on the invested amount. The annuity payment amount is calculated in a way that the fees cover the total amount of the annuity, including the interest payments, which are projected and which is returned by the end of the payment period.
  • The payment period can either be the life expectancy of the annuitant or can be a specified fixed period. Some annuities have the option of lifetime payments. The significant difference between a fixed payment period and a lifetime payment period is that in a lifetime payment period option.
  • The insurer has to continue to make payments even if the annuitant lives beyond the life expectancy period. The extended longevity of the annuitant is a risk that the insurer takes in case of a lifetime payment period annuity.
Annuitization

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Types of Annuitization

#1 – Lifetime Payment Annuitization

This is a one with a lifetime payment. As explained above, the price for the annuity will be paid until the annuitant lives. The life expectancy of the annuitant is considered to be the maturity of the annuity; however, if the annuitant lives above this age, the insurer is required to make payments as per the contract. If the annuitant dies soon after entering the annuity, there is no guarantee for the expense of the principal or the amount invested in the grant.

This is a win-win situation for both the annuitant and the insurer since it all depends on the time for which the annuitant lives. If the annuitant lives longer than the expected years, he/she enjoys the period payments until their death, whereas if the annuitant dies soon after investing in the annuity, the insurer gains by not having to make any further payments.

#2 – Joint Annuitization

As the name suggests, the joint annuitization refers to the annuity in which two annuitants usually include the spouse. This benefits the annuitant to secure his / her family with future payments in the unlikely event of the death of the annuitant. Since this type of annuity ensures two people, the charges are low compared to a standard annuity; the chances of one partner living more than the other partner are high, which increases the chances of making payments for a higher period for the insurance company.

#3 – Life with Fixed Period Annuitization

A Life with fixed period annuitization has a specified period of payment until the annuitant’s life. Suppose the period is set to 15 years. This means the annuity payments will be made for 15 years or for the time the annuitant lives for, whichever is longer. Since this plan mitigates the risk of early death, the payments on this type of annuity are lower than a lifetime payment annuitization.

#4 – Fixed Period Annuitization

A fixed period annuitization is often used as an investment plan since it is higher for a shorter payment plan. It helps in generating a guaranteed fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more for a specific period. The insurer pays for the specified time based on the calculations made when entering the annuity.

Advantages

  • It helps annuitants to secure guaranteed periodic payments in the future for an amount invested today, which includes interest payments as well.
  • Insurers can benefit from annuitization if the annuitant dies shortly after entering into an annuity in which the insurer is not required to make payments in case the annuitant dies before a specific period.
  • If the annuitant lives above the predicted life expectancy, the annuitant receives payments until their death.
  • The annuitant has the option to choose the type of annuitization that best suits his/her needs.

Disadvantages

  • It depends on the life expectancy of the annuitant and can result in a loss for the insurer in case the annuitant lives above the life expectancy age.
  • Although the insurer receives a lump sum amount initially, the insurer needs to make regular payments to the annuitant after a specific time if the annuitant lives above the life expectancy age.
  • The income from an annuity is taxable, and hence the annuitant is required to pay taxes on the income that is generated from the payments from the annuity. Even though the annuity acts as a hedge to income tax, the revenues generated from the annuity are taxable.
  • Annuities are tax-free until they are annuitized, and they are taxed.

Conclusion

  • This is the conversion of an annuity to bear payments at regular intervals. It ensures secure income for the annuitant for a fixed time, depending on the terms agreed upon when entering the contract.
  • Annuitization benefits both the insurer and the annuitant based on the amount received as a lump sum by the insurer and the fixed payments at regular intervals.
  • Investing in annuities help the annuitant to escape tax until the investment starts paying back. The payments received from the annuities after annuitization attract taxes and hence results in reduced returns.

Frequently Asked Questions (FAQs)

1. What is the difference between amortization and annuitization?

Amortization refers to the gradual repayment of a loan or debt over a specified period through regular payments that include both principal and interest. Each payment reduces the outstanding balance until the debt is fully paid off. On the other hand, annuitization involves converting a lump sum of money or an investment into a series of regular payments, often in the form of an annuity. 

2. What is the risk associated with the annuitization method?

The annuitization method is associated with certain risks. One key risk is longevity risk, which arises when the annuitant lives longer than anticipated, potentially leading to a higher total payout from the annuity than originally expected. Inflation risk is another concern, as fixed annuity payments may lose purchasing power over time if they do not keep pace with inflation. Additionally, once the annuitization process is initiated, the annuitant loses access to the lump sum used for annuitization, limiting flexibility and liquidity.

3. Can annuitization be reversed?

In general, annuitization is not reversible once the process has been initiated. Once an individual convert their lump sum into an annuity and begins receiving regular payments, it is typically impossible to undo or reverse the annuitization process. 

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