Lesson 7: Annuitization

The “A” word strikes fear into the hearts and wallets of advisors throughout the financial services industry. Irreversibly handing over a lump sum of money — to an insurance company, no less — in exchange for a promise to slowly return this money over a very long period of time rightfully feels like financial suicide to many retirees.

Ironically, the loathed process of annuitization is at the core of defined-benefit (DB) pensions — a steady generator of retirement income, which is cherished by retired civil servants around the world — and helps mitigate longevity risk, something I discussed in last month’s lesson. In fact, the lifetime-income guarantee from Social Security is also based on the annuitization process. You can’t securitize, cash-in or monetize your income stream, although it definitely lasts for the rest of your life.

So which one is it then? Is voluntary annuitization to be shunned and avoided or is it the foundation of a well-balanced retirement income plan? In this month’s lesson I will provide a closer look at the pros, the cons and some of the fixes. Indeed, if you are going to accept annuitization as a partial solution for your client’s retirement income, then you should understand the mechanics of how and when it works. Likewise, if you plan to bypass this approach as a viable solution, it makes sense to talk intelligently about its shortcomings.

The Pros
Table No. 1 displays sample quotes for single premium immediate annuities ( SPIAs ) in mid-June 2007. Each column contains the top five quotes from five different insurance companies for a given purchase age and gender. These numbers are provided by an intermediary called CANNEX Financial Exchanges, which is attempting to provide the equivalent of a stock exchange quoting-system for retirement income products; more on that later.

Here is how to read these numbers: If your 65-year-old female client invests or deposits $100,000 in a SPIA, then the best insurance companies offer a range of $643 to $641 per month for life, pre-tax of course. Note that this income stream will completely cease upon death. Indeed, if she dies 10, five or even one year into the annuitization period, everything is lost.

Naturally, most if not all people select a guarantee period for their SPIA, for which they receive a slightly lower income stream. For example, as shown in the table, if your 65-year-old female client selects a 10-year payment certain (PC, as they are often called), the income is now lower; the top company range is $627 to $625 per month. A 65-year-old male gets slightly more. His numbers range from $670 to $663 if he selects a 10-year payment certain and $697 to $688 if he does not.