The fundamental concept behind a variable annuity is that the account value can grow and shrink based on the performance of the underlying sub-accounts. However, the basic insurance component of a variable annuity allows the holder of an “underwater” variable annuity (an annuity with an account value less than the initial investment) to annuitize – this means to convert the annuity to a series of guaranteed monthly or quarterly payments. Let’s take a closer look at annuitization, when one might opt for it, and how the payments are calculated.
When Should You Annuitize?
Annuitization is very rare and rarely recommended. Over 90% of all annuities are never annuitized. Generally, your variable annuity will continue to grow over time, but annuitization can be an attractive option if something terrible happens to the underlying sub-accounts to which the value of your annuity is linked. However, more common scenarios may also warrant consideration of annuitization.
All annuities after 1982 are taxed on a LIFO basis. Although when you annuitize you apply an exclusion ration. When the exclusion ratio is applied you receive part principle and part interest making the stream very tax efficient.
Let’s look at a hypothetical: imagine in 2005 you bought an annuity contract with a principal investment of $100,000 and a GMIB living benefit. By 2015, let’s say the value of that annuity has risen to $150,000 but the living benefit has grown to $179,084. Now, the stock market crashes and all of a sudden, the value of your annuity is cut in half on the account value side. What are your options? Well, if you annuitize your variable annuity living benefit, you will be able to receive a consistent stream of monthly payments for the rest of your life based on the $179,084 the amount of your living benefit rider.
There are two ways to annuitize a variable annuity. You can either opt for a fixed monthly income or a variable one. Virtually every annuity owner who chooses to annuitize goes for the fixed option – receiving a consistent stream of monthly payments at a fixed amount, which will never change. If you choose to variably annuitize if it is an option as most living benefit do not offer this, your monthly income will vary based on the performance of the sub-accounts to which the annuity is linked. Though very few people choose to variably annuitize, it might be a good way for people to capitalize on the tax-advantages of annuitization and also fix their annuity to the stock market. However, due to the high-risk nature of variably annuitizing, it’s almost never done. Thus, when we talk about annuitizing a variable annuity, we will discuss doing so to opt for a fixed monthly income.
Annuitization might also be an attractive option if you don’t have any beneficiaries or heirs. By annuitizing your variable annuity, you might be able to maximize your income during your retirement. Choosing to annuitize for your lifetime with no further benefits paid to anyone else gives you the highest monthly income amount. The earlier your annuitize and the more beneficiaries that an annuity contract will pay to, the lower the guaranteed periodic amount paid out will be.
How Are the Payments Calculated?
Your annuity payouts are calculated using actuarial tables. These tabulations examine your life – the life of the annuitant – looking at your life expectancy and interest earned in order to determine the timing and amount of your payments; thus, your life is the “measuring life.” The tables are gender based because women generally live longer than men.
If you seek to annuitize and elect for joint (with a spouse) or survivor (with an heir/heirs) options, the table will contain both your age and the designated survivor’s age. Both of these factors must be considered in order to calculate the amount of your payments. Let’s take a look at an example:
Imagine you bought an annuity, the value of which has now accumulated to $50,000. Imagine that you are also 65 years old and decide that it’s time to begin receiving payments under a life-only settlement option (i.e. you want payouts to continue for the duration of your lifetime, without any designated heirs/survivors). Using the actuarial tables, you would receive a monthly payment in the amount of $334.
Now, let’s imagine that you are 75 years old and decide to begin receiving payments under the same plan for the same amount. Using actuarial tables, you would be entitled to a monthly payment of $471. Typically, the later in life you choose to annuitize, the greater your monthly payments will be. In addition, the more beneficiaries you add to your contract, the lower the payments will be.
There are several online resources you can use to estimate the value of your payouts should you choose to annuitize your principal investment. Contact Annuity FYI at 866-223-2121 to determine if annuitization is in your best interest, and get an estimate of how much you will receive if you decide to convert your annuity into a steady stream of payments.
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