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.
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 payments for the annuity are calculated by the insurer on the basis of the current age of the annuitant and the life expectancy.
- The payments are based on the future interest rate on the basis of the invested amount. The annuity payment amount is calculated in a way that the payments 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 an option of lifetime payments, the major 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.
Types of Annuitization
#1 – Lifetime Payment Annuitization
This is a one with lifetime payment. As explained above, the payment 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 payment of the principal or the amount invested in the annuity.
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 there are two annuitants who 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 secures two people the payments are low as 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 fixed 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 the risk of early death is mitigated by this plan, 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 the payment is higher for a shorter period paying plan. It helps in generating a guaranteed fixed income for a specific period. The insurer pays for the specified time on the basis of the calculations made at the time of entering the annuity.
- 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.
- 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 at the start, the insurer needs to make regular payments to the annuitant after a certain period of time in case 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 payments generated from the annuity are taxable.
- Annuities are tax-free until they are annuitized and they are taxed.
- This is the conversion of an annuity to bear payments at regular intervals. It ensures secure income for the annuitant for a fixed period of time depending on the terms agreed upon at the time of entering the contract.
- Annuitization benefits both the insurer and the annuitant on the basis of the amount received as a lump sum by the insurer and the fixed payments at regular intervals by the annuitant.
- 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.
This has been a guide to What is Annuitization & its Definition. Here we discuss the types of annuitization and how does it work along with advantages and disadvantages. You can learn more about from the following articles –