Annuitization

What Is Annuitization?

Annuitization is the point at which an annuity owner chooses to turn the contract's accumulated value into a series of scheduled payments. Instead of holding a balance that can be withdrawn at will, the owner gives up access to that lump sum in exchange for a predictable income stream, often lasting for the rest of their life. Once payments begin, the decision is generally irreversible.

How It Works

Most annuities have two phases. During the accumulation phase, the contract grows through contributions and credited returns, and growth may be tax-deferred, as with a deferred annuity. When the owner annuitizes, the insurer converts the balance into payments using an actuarial calculation. The payment amount depends on the account value, the age of the annuitant, the payout option selected, and the interest rate assumptions built into the contract.

The insurer uses mortality tables to estimate how long payments will be needed. This is how a payout can be guaranteed for life, since the insurer pools risk across many contract holders. Because payments depend on life expectancy, a person who lives longer than expected may receive more total income than they paid in, while someone who dies early may receive less, unless a guaranteed period or beneficiary feature applies.

Common Payout Options

• Life only: payments continue for the annuitant's lifetime and stop at death.
• Life with period certain: payments last for life but are guaranteed for a minimum number of years.
• Joint and survivor: payments continue while either of two named people is alive.
• Fixed period: payments run for a set number of years regardless of lifespan.

Choosing among these options affects the size of each payment. Options that offer more protection generally produce smaller regular payments.

Advantages and Disadvantages

Annuitization can address longevity risk, the danger of outliving savings, by providing income that does not depend on investment withdrawals. It can also make budgeting more predictable. However, the lump sum is generally no longer available, and the payout is set by the contract terms. Unless an inflation adjustment is included, the payment may lose purchasing power over time, which is a form of inflation risk.

For tax purposes in many countries, including the United States, a portion of each payment from a nonqualified annuity may be treated as a return of the owner's original investment and excluded from tax. This share is described by the exclusion ratio. The remainder is taxed as ordinary income. Details depend on the contract and local rules, and a qualified tax professional can explain how they apply to a specific situation.