Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

Meaning of “annuitize”

The word “annuitize” does not appear in the dictionary. In the IRS lexicon, it means that all or part of an individual’s account in a defined contribution (DC; ¶ 10.1.05 ) plan is used to purchase an immediate annuity. For example, suppose a participant wants to use part of his IRA balance to purchase an immediate annuity from an insurance company, i.e., he wants to convert that money into a stream of periodic payments that the insurer guarantees will last for some specified period of time or for specified lives. In exchange for that promise the participant gives up his ownership of the money turned over to the insurance company. When an IRA owner gives up his ownership of and access to the money in his account, and transfers it to an insurance company, in exchange for the insurance company’s promise to pay a stream of payments for a term of years or a life or lives, and the investment risks and longevity risks associated with that fund and that promise “belong” to the insurance company, we say the participant has “annuitized” the account. Ernesto Example: Ernesto, age 62, has a $1 million IRA invested in mutual funds. On June 1, Year 1, he causes the IRA to use $300,000 of the $1 million to purchase, inside the IRA, a deferred annuity contract. The contract is invested in an assortment of mutual funds, but guarantees that the value will grow at least four percent per year. If on any “anniversary date” the value of the underlying funds has grown more than four percent, the contract’s “value” wi ll increase by such greater amount. If the underlying funds grow less than four percent or lose value, the contract’s “value” will nevertheless grow by four percent. “Value” is in quotes because the guaranteed value may not be something Ernesto can realize by cashing out the contract, especially in the early years of its existence; rather it may represent a value that can be converted into a true annuity someday and/or a minimum death benefit for his beneficiaries. Ernesto’s IRA at this stage owns an annuity contract, but it has not been “annuitized.” He can cash out the contract and take back his money and its earnings (albeit minus some possible surrender charges). At age 69, Ernesto converts the contract to a life annuity. He no longer has the right to cash out the contract and take his money back. His IRA has now been “annuitized.” In general, when this book refers to an annuity, a fixed annuity is intended—one in which the payments in the series are fixed in amount—for example, $1,000 per month. Such a fixed- amount annuity may or may not have an escalator (cost-of-living adjustment or fixed scheduled increases) built in, but the payment amount does not depend on the investment performance of any securities. However, there is another type of annuity: A variable annuity is similar to a “regular” annuity in that it represents an insurance company’s promise to make periodic payments to the annuitant for life or a term of years. Under a variable annuity, however, the periodic payments are not fixed; they fluctuate in tandem with the performance of an investment portfolio. When one does encounter a true (immediate) annuity inside an IRA, whether it is a deferred variable annuity that has been annuitized or whether it is an immediate annuity that was purchased as such, it will almost always be a fixed type of annuity, though it is possible for an immediate annuity to be of the variable type. Variable vs. fixed annuities