Retirement Planning

Chapter 15 – Annuity Payout Phase

  Annuities are commonly purchased for use in retirement and they work well in this capacity. The annuity payout phase is probably the most important aspect of a deferred annuity. Of course, how much the annuitant or policyowner receives will depend upon how much was deposited and how much accumulation time was allowed to take place.

  The word "Annuity" means "a payment of money."  The insurance industry designed them to do just that. Although the deferred annuity was originally designed with income features in mind, today they are looked at more for their ability to accumulate and less so for their ability to distribute income at a later date.

The word "Annuity" means a payment of money.

  When the payout phase is reached, the policyowner can elect to take payments or withdraw the funds as a lump sum. If the lump sum withdrawal is selected, the policyowner is then free to reinvest elsewhere, spend the money or give it to others. Monthly annuity payments are usually higher than the income that could be earned by reinvesting.

  If the policyowner chooses to annuitize, an irrevocable bargain with the insurance company is initiated. Exactly how the policyowner receives the money will depend upon the option he or she decided upon. Once annuitization takes place, the policyowner may no longer withdraw funds or do as he or she pleases with the money.  However, there can be great security in knowing that the annuity will provide at least partial financial security. If a lifetime payout option is taken, the policyowner will have an income that he or she can never outlive. Certainly, this offers emotional security in often uncertain times.

  Some investors choose to withdraw their annuity accumulation as a lump sum from one company and simply re-deposit the funds with another insurance company into another annuity (typically an immediate annuity). In both cases the insurance actuaries compute the size of the monthly payments by applying a settlement-option rate, which is expressed as dollars of monthly income per thousand dollars of accumulated value. Settlement-option rates depend on how long the actuary believes the insurance company will be making these payments to the policyowner and on how well the company believes they can invest the policyowner’s money during that payout period. Of course, the money is not invested individually for each depositor. All policyholders' money is pooled, which allows the company to invest more profitably than an individual would be able to. 

  There are two factors used by an actuary when figuring out the settlement option rates. One is called the guaranteed settlement-option rate. This one is written into the annuity contract and represents a minimum payout. The other one is called the current settlement-option rate. It is not written into the contract, because it would be impossible at the time of purchase to know what the rate would be. However, the current settlement-option rate is the one that applies at the time of annuitization if it is higher than the guaranteed rate that is written into the annuity contract.

  While interest rates vary from year to year with highs and lows that can be very different, usually the current settlement-option rate is higher than the guaranteed settlement-option rate. In fact, in some years, the difference has been substantial. Because settlement rates can vary widely from company to company, it is always wise to shop around. Insurance companies may offer better settlement options to the policyholders that have been with their company for a period of time, as opposed to those who might be interested in an immediate annuity with money they have saved elsewhere. Some professionals feel this is an effort on the part of insurance companies to discourage shopping around. Even so, it is still a good idea to do some shopping around since there are insurance companies who specialize in immediate annuities and offer very good rates.

Unisex rates mean the annuity settlement options

are the same for both men and women.

  Some companies have unisex rates. That means that settlement options are the same for men and women. Many companies, however, do have different rates for men and women. This is not an example of sex discrimination. These rates are based on factual life span statistics. Qualified annuities must use unisex rates, but non-qualified annuities may use sex-distinct rates.

Payout Options

  For those who chose to annuitize their annuities, there are different options available to them.

Single Life Annuity

  Single Life Annuities are also commonly referred to as life annuities. Under this option, for as long as the annuitant or contract owner lives, he or she will receive a check each month for a "set" amount of money. It is called a "life" annuity because the policyowner receives a check throughout his or her lifetime. Thus, the saying, "an income that cannot be outlived." Of all the settlement options, a life annuity provides the receiver with the most monthly income.

It is important to note that the income stops when the policyholder dies. This means that there will be no income for any beneficiary, including a spouse. This may work out very well if the policyowner lives a long, long life. On the other hand, if he or she happens to die early, the insurance company comes out the winner. In a way, the policyholder and the insurance company are entering into a "gambling" contract. The policyholder is betting that he or she will live a long time (hopefully longer than average) and the insurance company is betting that the policyholder will not, allowing the company to keep any leftover funds that were not paid out. If the policyholder wins, he or she collects more than was paid in; if the insurance company wins, they pay out less than was paid in. Again, no leftover funds will be distributed to any beneficiary of the policyholder; the issuing insurer becomes the beneficiary.

Life-and-Period-Certain Annuity

  This annuity payout option may also be called a Life-and-Installments-Certain annuity. The vital difference between this option and the Life Annuity has to do with any leftover funds after the annuitant or policyowner dies. This option agrees to pay out a specific amount of money to somebody: to either the policyowner or to his or her beneficiaries. Therefore, one key word in this type of payout option is "certain." Somebody is going to get the money, even if the policyowner dies prematurely. Besides the promise to pay out a specific amount of money, the insurance company promises to pay an income to the policyowner for his or her lifetime. Therefore, a second key word in this type of payout option is "life."

  The Period-Certain will vary from contract to contract. 

For example:

  If Mary Martin selects a Life Annuity with a 10-year period-certain, she will receive a designated (set) amount of money for her lifetime, regardless of how long she lives. If, however, she happens to die before she receives ten years worth of payments, then her designated heirs would receive the balance of that 10-year period-certain. If Mary Martin only received five years worth of payments, then her heirs would receive the remaining five years of income. If Mary Martin received nine years worth of payments, her heirs would only receive the remaining one-year. Keep in mind that Mary Martin could live to be very old. If so, she could collect the set payments for as long as she lives, even if that happened to be twenty or twenty-five years (or even longer).

  We used the example of a 10-year period-certain. It does not have to be a 10-year contract. It could be five years or some other amount of time. Of course, a five-year period-certain would yield a higher monthly income than would a ten-year period-certain, because the insurance company is taking on less risk.

Joint-and-Survivor Annuity

  A joint-and-survivor annuity payout option is most often utilized by husbands and wives. However, it can be written on any two lives. Under this option, the insurance company will make monthly payments for as long as either of two named people survive. When the first named person dies, the insurance company will reduce the amount of the monthly payments to the survivor by as much as one-third to one-half. The exact amount depends upon the option that was chosen. Even though payments are reduced, the insurance company will continue to make a monthly payment to the second person until he or she dies. Then payments stop.

  It is possible to select a 100 percent joint-and-survivor annuity. This type is different from the ones available from an individual's pension, where payment is made to the survivor only when the retiree dies. Often, this is an excellent option to select, because the monthly payment amount may only be slightly lower than the monthly payment made under the single life annuity (which only covers one person). Of course, this is not always the case; payments can be dramatically lower depending upon the ages and sexes of the two annuitants involved. On this type of option, one of the annuitants is the primary annuitant. The level of the monthly payment is then dependent upon the secondary annuitant's age and gender. If the secondary annuitant is older than the primary or fairly close to the same age, the initial payment may not be much different from payments under a life annuity on the primary annuitant alone (a single life annuity option). If, on the other hand, the secondary annuitant is much younger, the monthly payments will be much lower. That is because, the insurance company has a greater degree of risk when the secondary annuitant is likely to live much longer than the primary and continue to collect monthly payments.

  Obviously, there are both advantages and disadvantages to this payout option. The primary annuitant receives less money while he or she is alive, but the secondary annuitant (often a spouse) will continue to have a guaranteed income for the remainder of his or her life. The larger the payment to the secondary annuitant, which depends upon the option chosen, the lower the payments will be initially to the couple jointly.

Other Methods of Collecting Income

  Not everyone desires to annuitize his or her annuities. Some people never annuitize them. Rather, they choose to simply draw the interest off on a monthly or yearly basis. Of course, the amount the policyowner receives is less this way, because the principal is never collected.

Many investors never annuitize their annuities.

Instead, they draw off the earned interest.

  There are also other ways to get money out of an annuity besides simply drawing off the interest periodically.

Systematic Withdrawals

  A systematic withdrawal plan is based on the policyowner’s life expectancy. This is calculated by the insurance company based on gender and other factors. Using life expectancy, gender, and the amount of money that has been paid in, the insurance company calculates a monthly payment amount. Therefore, the policyowner withdraws all the accumulated value, including principal, without ever actually annuitizing the account. Many insurance companies will waive the surrender fees when systematic withdrawal plans are used. The money in the account continues to earn tax-free interest during the withdrawal period at whatever rate the insurance company is posting.

  There are several advantages to systematic withdrawal plans. Because the annual income from the annuity is less than it would have been under some of the other payout options, the annuity owner saves income taxes. Part of the accumulation is taxable as it is withdrawn, of course. The interest earnings are only sheltered from taxes while they are in the account. Once withdrawn, taxation does occur. Additionally, many people need a monthly income, but they desire to leave any unused balances to their beneficiaries. Under a systematic withdrawal plan, they will be able to accomplish this. Even if the policyowner decides part way into the systematic withdrawal plan that he or she would like to annuitize the remainder of their funds, most insurance companies will allow them to do so.

  Another point to consider is the flexibility of systematic withdrawal plans. Under a single-life option or a joint-and-survivor annuity option, the monthly payment is fixed until death. With this type of non-annuitized withdrawal, annual payments can be increased or decreased, depending on how the account grows and on Internal Revenue Service rules. The IRS will require that the policyowner withdraw a minimum amount each year based on their life expectancy. Additionally, since the size of the account will change as interest rates change and as withdrawals occur, the payments may go up or down each year. While this may not initially sound like an advantage, it may well be.

For example:

  Sam decides to retire at the age of 60 even though he is too young to receive Social Security payments (age 62 is the earliest age he can draw Social Security). Since his retirement from the lumber mill is not enough to live on, Sam decides to begin a systematic withdrawal plan on his annuity. Because he needs more money now, but will need less money later (when Social Security kicks in), he elects larger payments to begin with. In a few years, he decreases his monthly income from the annuity. By this time, the account is less, due to his monthly withdrawals, so decreasing his payments will also insure that the money lasts longer. Eventually, Sam will probably draw all of the money out of his annuity, but if he does not, the remainder will go to his beneficiaries because he never did annuitize the account.

Lump-Sum Payments

  When the accumulation phase of the annuity ends, many people elect to simply draw all the funds out in a lump sum. Although this is not always a good idea, it is an option available to the policyholder. Many people take a lump sum withdrawal because they have become unhappy with the rate of interest paid on their annuity and they feel they can invest it better elsewhere. In some cases, this may be true. However, late in life is never a good time to enter into a risky investment. The ability to recoup losses is gone when employment ends. Often people take their annuity as a lump sum simply because they do not understand their annuity options. If they understood them fully, they would probably either leave the funds in their current annuity or re-deposit them in an immediate annuity that they feel more comfortable with. It is not uncommon for an individual to withdraw the funds in a lump sum and then simply deposit them into a Certificate of Deposit that pays a substantially lower rate of interest. Obviously, this is not a wise choice. The reason often given is "availability of funds." An insurance company often seems very far away, whereas their bank seems close and accessible. Perhaps it is this logic that has aided banks in recent years in their own annuity sales. Even though the funds are still in an insurance company that is "far away," the bank itself seems close and accessible. Perhaps there is a lesson in this for all insurance agents. How accessible do you seem to your clients?

A person is not wise to invest in risky vehicles

during or just prior to retirement.

Split-Funding Techniques

  Although this may seem like a new withdrawal method, it has actually been used for some time. Under this method of withdrawal, an individual takes a sum of money and divides it into two separate annuity funds: an immediate annuity which provides an immediate flow of income and a deferred annuity that continues to grow at the designated rate of interest. Many people, like Sam, who take an early retirement find this method especially beneficial.

Annuity Taxation

  Even though annuity funds grow tax-deferred, taxation does eventually occur. The definition of deferred is "Defer: to delay or postpone." Webster's Dictionary, College Edition

  This definition is exactly how annuity taxation occurs: on a delayed or postponed basis. Taxation is a complicated thing and annuitants should consult a tax expert. We are not tax experts and this text is not attempting to provide tax information or advice. What is stated here are generalities, and should not be considered as personal advice.

  When individuals annuitize a qualified annuity, the monthly payments are fully taxable, because the contributions themselves were not originally taxed. That fact is exactly why annuities are "qualified."

  Withdrawals of earnings from a nonqualified annuity are fully taxable at ordinary income tax rates. Unless the annuity was purchased before August 14, 1982, the earnings are considered withdrawn first and are therefore subject to taxation.

  At one time, an annuitant could claim that only principal was being withdrawn initially, but that has not been available for a long time (1982). Now the Internal Revenue Service considers initial withdrawals to come from the earnings, so taxable. Once all the earnings have been withdrawn, then principal is withdrawn. It is not necessary for the individual withdrawing the funds to try to determine how much is interest and how much is principal; the insurance company does that and sends a statement to the policyowner.

  Taxation considers the type of annuity. A nonqualified variable annuity grows tax-deferred, for example, until withdrawals begin, or the annuity is annuitized. Since nonqualified annuities do not provide a step-up basis at death, the deferred earnings are taxable once withdrawn, so the annuity income will be taxed as ordinary income.

  It is possible to entirely withdraw the principal at some point and end up drawing entirely interest earnings if the annuitant lives long enough to deplete their principal. When this happens, the entire amount of the monthly payment would be taxable.

  If a spouse will be the beneficiary of an annuity, or will become the new owner upon the policyholder's death, the IRS will tax the proceeds the same way. There will be no tax savings.

  If the beneficiary of an annuity is a child or some other person, the IRS will require that he or she take the proceeds from the annuity account within five years of the death of the policyowner. If the funds are left in the account past this five-year period, a penalty could be levied.

  At the time of death, the annuity value is normally included in the value of the estate.  Therefore, the annuity is also subject to federal and state estate taxes, if they are applicable. Placing money into an annuity will not save taxes. At some point, taxes will be paid.

Withdrawal Penalties

  As we stated earlier, annuities are designed for long-term investing. Primarily used for retirement funds, there are penalties imposed by the IRS for early withdrawal. This is true even if the insurance company does not have any. When an individual withdraws funds from his or her annuity before the age of 59½, the IRS imposes a 10 percent penalty tax on the amount by which the value of the annuity exceeds the premium that was paid in. This IRS rule assumes that the annuity is non-qualified. For qualified annuities, the entire amount withdrawn would be taxed because taxes were not paid on the principal prior to deposit.

  Many people assume that the IRS taxes the entire amount withdrawn on both qualified and non-qualified annuities, so it is important to stress this difference to clients. If the insurance company has surrender charges in their contract, those charges will be in addition to those levied by the IRS.

If the insurance company has surrender charges, those charges

will be in addition to any levied by the Internal Revenue Service.

  As with so many things, there are exceptions for both qualified and non-qualified annuities. If the policyowner chooses a systematic withdrawal plan and meets certain conditions, then he or she may be able to avoid IRS penalties. For example, once payments begin, they must continue for at least five years AND until the policyholder turns age 59½. This exception applies only to qualified plans.

  If early withdrawal is desired, since taxation rules change periodically, it is always wise to consult both the insurance company's legal department and one's own personal tax accountant. Bear in mind that tax accountants do not always have annuity knowledge.  Therefore, if the insurance company's legal department’s advice differs with the advice offered by a tax accountant, a third opinion should be obtained. Usually, however, the insurance company makes a point of keeping up on current taxation rules. Even so, many insurers will not allow their personnel to give tax advice, in which case they will not help an individual make a tax determination. This is not really too surprising. Liability would certainly exist any time tax suggestions are given. In fact, any time an individual is dealing with tax consequences, it is vital to make sure that any information obtained is current. We recommend that only those who are familiar with retirement plans and retirement taxation be consulted. Again, this text is not offering tax advice and makes no guarantee that taxation information provided here is either current or correct. Consult your own tax experts.

End of Chapter 15