What Is an Annuity?
An annuity is a financial product. It’s one possible way people can invest money.
Technically, an annuity represents a contract made between the insurance company and the person who bought the annuity. When you purchase an annuity, you can make a one-time payment for it. In exchange, the insurance company promises to provide some sort of benefit. Usually, that’s some type of income, long-term care, or growth of assets.
Annuities Are (Usually) a Ripoff
The definition of an annuity can make annuities sound great. But they’re usually something you want to avoid at all costs. Annuities are typically full of high fees that can make them a total rip-off.
Fees eat away at your investment return in annuities. The less you pay in fees, the more money you get to invest.
Consider two hypothetical investments: a low-cost index fund with a nominal fee, and an annuity with a 2% annual fee. Assuming a 7% rate of investment return, you’ll lose nearly half of what you could have had without the 2% fee.
Of course, there are some exceptions when annuities can make sense. For example, one type of annuity is the single premium immediate annuity (SPIA). The SPIA usually has low fees and can be a good way to guarantee future income.
Annuities may also make sense for individuals in very high tax brackets that have already maxed out their tax-advantaged savings for the year. In this case, the high fees on the annuities can be offset by the tax advantages offered by these high-fee products.
But, for the most part, annuities are expensive financial products not worth considering.
Annuities are usually sold by insurance salespeople who are paid on commission — which means when you buy the product, the salesperson gets paid for the sale. That creates an inherent conflict of interest, and it may be difficult to get the best advice since selling the product means a direct profit for the insurance salesperson.
What Is Annuitization?
Annuitization is the process of converting a large amount of money (such as $100,000) into an income stream (such as $8,000 a year for the rest of your life).
This isn’t the same thing as an annuity — remember, that’s a financial product sold by commission-based insurance salespeople.
Here’s one easy way to understand the difference: an annuity is a thing. It’s a noun. Annualization is a process. It’s a verb.
You can actually annuitize an annuity. That is, you can turn the value of your pot of money into a stream of payments. (But you don’t have to do this!)
You can annuitize other things too. You can also annuitize your pension benefit, lottery winnings, or money won from a lawsuit.
The Advantages of Annuitization
You could use annuitization as forced budgeting. Let’s say you have $100,000. You’re fearful that you lack the self-control required to manage that money over time, and you want to avoid any temptation to spend the $100,000 all at once.
With annuitization, you only get access to a small slice of your money each year. This prevents you from blowing all your money in one fell swoop.
Ease the Burden and Stress of Investing
Annuitization also relieves you of the burden of managing the investment of a large amount of money. Even if you do have the discipline to only spend $8,000 a year of your $100,000, what will you do with the rest of the $92,000?
Will you invest it? If so, how so? When you create your investment portfolio, what percent of your money will you put into stocks and what percent will you put into bonds? Are you going to rebalance it annually, quarterly, or never?
Annuitization makes these decisions more manageable and less overwhelming. And annuitization can offer a competitive guaranteed rate of return relative to investing a pot of money yourself.
Working with previous clients, I’ve seen annuitization schedules that offered a 6% rate of return (The investment return is calculated by considering how many payments you’ll get over time compared to the big pot of money not received). 6% is really competitive. Rarely in investing can you earn a steady 6% return on your investment.
Give Yourself a Tax Break
Finally, annuitization can also be used as a tax strategy. Receiving a one-time pot of money can trigger some adverse tax consequences. Opting for annuitization can decrease that tax burden.
Again, say you have $100,000 — but you choose to use annuitization to distribute $8,000 per year to yourself over 24 years. The relatively smaller distribution of $8,000 a year prevents you from being pushed up into a higher tax bracket.
What to Watch Out For
Of course, annuitization has risks as well. This includes company risk, market risk, and illiquidity risk.
If you annuitize, you put all your financial eggs in the basket of the company offering the annuity. If that’s your previous employer, it may not hurt to research your employer’s pension. Figure out how much money they have on the books. Is the pension underfunded? That’s likely the case with many pensions today.
Stock Market Risk
If you decide to take a one-time payment, you’ll be investing the money yourself. And, as with any investment, that carries risk.
Historically, the stock market has done well on very long timelines but has done relatively poorly on short timelines. When you don’t annuitize and instead take a larger one-time payment, you’re trading the risk the pension goes insolvent (i.e. goes under because it runs out of money) for the risk of the stock market. Both are risks.
And when you annuitize, you’re forced to settle for whatever annual payment you’re given. If you need cash in an unforeseen event, that’s too bad. You can’t invade the original pot of money when you annuitize.
Annuitization is Not an Annuity
Remember, an annuity is usually a very expensive investment product that should be avoided. An annuity is a thing. It’s a noun.
Annuitization is different: it’s a payment option you can take when dealing with a large pot of money. It’s a process – a verb.
That could apply to your pension benefit or to your lottery winnings. Either way, annuitization can offer many benefits over taking a large amount of money all at once and may make more sense in the context of your overall financial plan.