What Are the Various Options for Receiving Annuity Income?

April 1, 2020

Once a person is ready to retire, annuities offer a number of retirement income options. The contract owner can choose to receive all the assets from the annuity at once, opt for a series of withdrawals until all the assets are exhausted, or decide to exercise the annuitization features of the contract.

The following information pertains to non-qualified annuities that are purchased with after-tax dollars. While the payout options available are the same for annuities purchased as part of qualified retirement plans the tax consequences are different.

Lump-Sum Option

When a contract owner elects a lump-sum distribution, the annuity is surrendered and all assets are withdrawn from the contract. Taxes will be due on earnings in the year the money is received and tax penalties may apply to withdrawals before age 59½. With this option, individuals are still faced with the need to generate a guaranteed stream of income.

Systematic Withdrawal Plan

With a systematic withdrawal plan, the assets are left in the annuity and the contract owner receives distributions at regular intervals until the assets have been exhausted or the contract owner elects to suspend the operation of the plan. All earnings on the investment are considered to be distributed before any return of principal and are taxable at ordinary income tax rates. Assets remaining in the annuity continue to grow tax deferred until withdrawn.

The principal advantages of a systematic withdrawal plan are the flexibility provided to the contract owner and the ability to maintain full ownership of the assets. The principal disadvantage is that the contract owner retains the risks associated with both uncertain longevity and investment fluctuations, particularly the exposure to adverse market performance during the early stages of retirement.

If a specified dollar amount is withdrawn each period, whether adjusted for inflation or not, the contract owner assumes the full risk of market cycles. The very principles that recommend dollar cost averaging as a successful strategy for entering the market work against the contract owner in a liquidation strategy. Withdrawal of a fixed dollar amount means that a higher percentage of assets will be liquidated in a down market than in an up market. This can be a very dangerous strategy, even if long-term investment performance meets anticipated targets, since the withdrawal of assets in earlier years can prevent the overall portfolio from achieving the projected return.

The withdrawal of a specified percentage of assets rather than a specified dollar amount may help reduce this risk. Many people plan their retirement income based on an average rate of return on their investments (such as 8 percent). If they happen to retire during a time of far lower (or even negative) returns, however, the specified percentage of assets they withdraw may not provide sufficient income to maintain their desired lifestyle. To help reduce the impact of market fluctuations on retirement income, it is important for retirees to have a variety of diversified investments in their portfolios, including annuities, which can help create a guaranteed source of income that will last as long as they live.

Guaranteed Withdrawals

Contract owners electing a guaranteed minimum withdrawal benefit (GMWB) rider can choose to receive the value of their investment through annual withdrawals (up to a set percentage) at least until the entire amount invested is completely recovered. Contract owners electing a guaranteed lifetime withdrawal benefit (GLWB) can choose to withdraw a percentage of their contract value each year for as long as they live, even if the account value is exhausted. All earnings on the investment are considered to be distributed before any return of principal and are taxable at ordinary income tax rates, as are any payments made by the insurance company should the account value be reduced to zero.

Contract owners electing these benefit riders have greater control over their assets, but may receive less on a monthly basis than if they annuitized. While some GLWBs are beginning to tailor the percentage withdrawal to the age of the contract owner, it is only through annuitization that an investor can take advantage of the increased income that comes with risk pooling.

Annuitization

Annuitization involves turning the contract owner’s accumulated assets into a stream of income based on the amount of the contract, the annuitant’s age, payout choices, etc. The insurance company guarantees that it will provide payments for the life of the annuitant(s). With a deferred annuity, money is saved and invested during the accumulation period, and then annuity payments are received during retirement. With an immediate annuity, payments begin immediately or within one year after the annuity is purchased. Payments can be either fixed or variable and guaranteed for one person’s life, for the lives of two people, and/or for a specified period of time. Payments can also be structured with a cash refund feature, which provides for a payment to beneficiaries of an amount equal to the difference between the annuitized amount and the total payments made prior to the annuitant’s death, should death occur before payments at least equal the amount annuitized.

Deferred Income Annuities

With a deferred income annuity (sometimes called Longevity Insurance), a retiree can purchase a contract at one point in time, for example, at age 65, but defer payments until a later time, for example, at age 85. Individuals not living until the commencement age will not receive benefits; and individuals who do live to the required age and beyond, will receive income payments. Because these products usually have no death or living benefits, and not all contract owners will live long enough to collect income, insurance companies can maximize insurance leveraging (risk pooling) and thus make larger income payments to retirees still living. Recent innovations include optional death benefit and joint and survivor payments, but the trade-off is a higher premium or smaller monthly payments.

If you are considering an annuity purchase, be sure to fill out our quote form to research suitable options available.