When to annuitize an annuity is a question that many retirees and people saving for retirement face. After many years of saving and waiting to start reaping the benefits, you finally reach retirement age and wonder: should I annuitize now? In one year? In ten years? Does it make a difference? The answer is yes. Choosing the right time can be the difference between getting the most out of your annuity and leaving money on the table.
In light of this, let’s dive into what factors to consider when deciding to annuitize, the pros and cons of annuitizing, and how to do it smartly to enjoy a nice, worry-free retirement.
What is annuitization?
To understand when to annuitize, we must first understand what it means. Annuitization is the process of turning a lump sum of money into a guaranteed stream of income payments for life. When you annuitize an annuity, you essentially convert your account balance into an income stream. This income stream can be for a set period, such as 10 or 20 years, or the rest of your life.
There are two main types of annuities: immediate and deferred. An immediate annuity pays out income right away, while a deferred annuity allows you to grow your account balance over time before receiving income payments. In other words, with a deferred annuity, you are deferring the income payments until a later date.
This may make you think: “Ok, so, that means that I can only annuitize deferred annuities because immediate annuities are “immediately” annuitized, right?”
While that makes total sense and is true for a “vanilla” immediate annuity contract, i.e., one without contract riders, the fact is that, even with immediate annuities, you can choose whether or not to annuitize. In the case of deferred annuities, you have to choose what that date will be when you sign your contract because you’re deferring payments to a later date.
Do you have to annuitize?
Based on what we just discussed about immediate annuities, it should be evident that, when it comes to deciding what to do with your savings, even if they are invested in an annuity, annuitization is just one of several options. This means that you don’t have to annuitize if you don’t want to, and the fact of the matter is that most Americans choose not to. Only about 5% of annuity contract holders end up annuitizing their savings.
This begs the important question of why that is. If, in theory, an annuity is an instrument specifically designed to guarantee income for the rest of your life, why don’t people use it for its intended purpose? There are several reasons behind this, but let’s start with why 5% of retirees end up annuitizing their savings.
The benefits of annuitizing
There are several reasons why someone would choose to annuitize their savings. The most obvious reason is to guarantee income for life. As we said before, when you annuitize, you are essentially converting your account balance into an income stream that will last for as long as you live or for a set number of years. This can be especially helpful for those worried about outliving their savings.
The thing is, you can achieve the same goal with an annuity without actually annuitizing. How? by modifying the annuity contract with a lifetime income rider. Just as a normal annuitized annuity, this rider will guarantee that you will receive income payments for the rest of your life regardless of how long you live or how the markets perform.
The only problem with income riders (and any other type of rider, for that matter) is that they usually carry a fee to set up, and they always lead to a lower income stream than what you would get by annuitizing instead. The reason behind this is simple.
Insurance companies can only guarantee income even if you outlive the original balance in your account by compensating with the leftover balance from annuitants who die before expected. In other words, when you annuitize, your nest egg is pooled with everyone else’s in one single account, therefore spreading the risk that the insurance company will lose money. Less risk means lower premiums, which, in turn, means more money for you.
But, if annuitizing means more income, then why do so many people choose not to do it?
The risks associated with annuitizing
There are several reasons why annuitizing can be a risky proposition, even if it does offer certain guarantees.
The value of your nest egg is locked in.
The first reason is that once you annuitize, you are locked in. This means that even if the markets perform well and your account balance grows, you will not be able to access that money. You will only receive the originally agreed-upon income, leaving the opportunity for growth on the table.
No protection against inflation.
Also related to the above, annuitizing can be risky because it does not offer any protection against inflation. This means that, even though your payments will remain the same, their purchasing power will decrease over time. In other words, what you can buy with your payments today will not be the same as what you’ll be able to buy 20 or 30 years from now.
You lose control and access to your principal.
Thirdly, annuitizing means you lose access to your principal mainly because it’s pooled with the other annuitants’ savings. This means you effectively lose your savings’ cash value, and the only way to get at least some of it back is to sell the future income payments to someone else at a discount. If you do, you’re obviously losing money.
Annuity payments usually end upon the annuitant’s death.
Although joint annuities can continue making payments to a spouse or legal partner, single-life annuities end when you die, and any remaining balance in your account is lost (unless you added a contract rider that says otherwise).
As you can see, deciding whether or not to annuitize is by no means an easy choice. It’s an important decision that compares to choosing between different investment options when preparing for retirement.
However, while you could rely on sane investing advice from investment newsletters like Motley Fool, Seeking Alpha, and Capitalist Exploits, you don’t have a similar option to help you choose between annuitizing and other options.
Annuitization vs. income riders ON your annuity.
Now that we’ve seen the pros and cons of annuitizing let’s compare it to adding an income rider on your annuity instead. Riders are designed to help investors overcome most or all of the drawbacks that normal vanilla annuities bring.
Are you worried about inflation? Add a rider that indexes your payments to the CPI, so they grow over time and never lose purchasing power.
Are you worried you may die sooner than expected and want to leave the unpaid balance to a loved one? No problem. Just add a death benefit rider, and you’re set.
Also, if you want to receive income for the rest of your life without annuitizing, you can add an income rider. You’ll receive steady payments, but your account won’t be locked in. You can still access your account balance and make withdrawals if needed, and you have the potential to grow your nest egg.
On the other hand, while this all sounds great, you must remember that this implies paying a fee for every rider you add. The more complex the contract, the more expensive it’ll be and the less income you can expect to receive every month.
When to annuitize an annuity
There is no easy answer as to when you should annuitize your annuity. It all depends on your specific circumstances and needs. It all starts with knowing or deciding how much income you want to get from your annuity. As a general rule of thumb, the more income you want to get, the more you’ll have to wait to annuitize. This is for two reasons:
- The longer you wait, the more time your investment will grow through compounding interest.
- The older you are by the time you annuitize your savings, the less the insurance company thinks you’re likely to live, so they’ll spread your money across fewer payments, making each payment larger.
You can learn to estimate how much income you’ll get from an annuity by reading this post. You can also use different online tools and calculators to do the same. You can find your life expectancy in the Social Security Actuarial Life Table and use that as input to determine how much income you stand to gain if you were to annuitize today.
You can also test a lower number of years to find the right year to start receiving payments for your desired income level.
If you still haven’t bought an annuity and are wondering whether or not it makes sense to buy one, you can also refer to this post, where we cover the best age to purchase an annuity.
Other options besides riders and annuitization
If you’re wondering whether the 95% of people who don’t annuitize opt for an income rider instead, the answer is no. The most popular way to access the money in an annuity is to withdraw as needed.
As long as you start making withdrawals after turning 59 and 1/2 to avoid the IRS’s 10% early withdrawal penalty, and you also make sure to avoid any surrender charges included in the contract, this is one of the safest ways to use an annuity.
Withdrawals come with their own rules, though, such as required minimum distributions (RMD) and others that apply to traditional retirement accounts like 401(k)s and IRAs. If you’re not familiar with these, we recommend reading this post.
The bottom line
There’s no easy answer as to whether or not you should annuitize your annuity nor when it’s best to do so if you decide to go for it. It all depends on your specific circumstances and needs.
If you have a clear budget for retirement and know how much income you’ll need to get by, you can run the numbers yourself and see how long you would have to wait to receive the amount you’re hoping for. That will depend on how much you have saved for retirement, your age, and your general state of health.
If you’re still unsure, we recommend talking to a financial advisor who will study your case and give you their professional opinion.