Annuitization
With a clear understanding of how variable annuities are purchased and valued, you're ready to tackle annuitization: the process of converting a lump-sum contract into a stream of income payments.
Types of Annuity Payout Elections
The contract owner chooses a payout option at annuitization. The choice determines how long payments last and whether a beneficiary receives anything after the annuitant's death.
| Payout Option | How It Works | Payment Amount | Risk to Annuitant |
|---|---|---|---|
| Life only (straight life) | Payments for the annuitant's lifetime only; nothing to beneficiaries after death | Highest per period | Early death = forfeited payments |
| Life with period certain | Payments for life, with a guaranteed minimum period (e.g., 10 or 20 years); if annuitant dies during the certain period, beneficiary receives remaining payments | Lower than life only | Protects against very early death |
| Joint and last survivor | Payments continue for the lifetimes of two annuitants; payments continue until the last survivor dies | Lowest per period | Protects both annuitants |
| Unit refund (cash refund) | Payments for life; if annuitant dies before total payments equal the contract value, beneficiary receives the difference | Similar to life with period certain | Measured in dollar amount, not time period |
Key rule: The more protection the payout option provides (against early death or for multiple people), the lower the periodic payment.
- Life only = highest payment (insurance company keeps everything at death)
- Joint and last survivor = lowest payment (insurance company must fund payments over two lifetimes)
Exam Tip: Gotchas
- Annuitization is irrevocable. Once the contract owner elects a payout option, the decision cannot be undone.
- Life only pays the most per period because the insurance company keeps any remaining value at death. Joint and last survivor pays the least because it must cover two lifetimes.
Variable Payout Mechanics
In a variable annuity payout, the dollar amount of each payment fluctuates based on separate account performance relative to the Assumed Interest Rate (AIR).
- The number of annuity units is fixed at annuitization and does not change
- Each payment = fixed number of annuity units x current annuity unit value
- Payments increase, decrease, or stay the same depending on whether the separate account performance exceeds, falls short of, or equals the AIR
The Assumed Interest Rate (AIR)
The AIR is a benchmark rate used to determine the initial annuity payment amount and to measure subsequent payment adjustments. It is NOT a guaranteed return.
How the AIR Is Set
- The AIR is set at the time of annuitization and does not change during the payout phase
- It represents the rate the separate account must earn to keep payments level
The AIR Tradeoff
| Higher AIR | Lower AIR |
|---|---|
| Higher initial payment | Lower initial payment |
| Harder for payments to increase (must beat a higher benchmark) | Easier for payments to increase (lower benchmark to beat) |
| More likely payments will decrease over time | More likely payments will increase over time |
AIR vs. Actual Return - The Critical Relationship
| Separate Account Return vs. AIR | Effect on Next Payment |
|---|---|
| Actual return exceeds AIR | Payment increases |
| Actual return equals AIR | Payment stays the same |
| Actual return falls below AIR | Payment decreases |
- If the separate account earns exactly the AIR every period, payments remain level (identical to the initial payment)
- The AIR is a benchmark for calculating adjustments, not a floor or guarantee
Exam Tip: Gotchas
- The AIR is NOT a minimum guaranteed return. It is a benchmark for calculating payment adjustments. If the separate account underperforms the AIR, payments decrease.
- Earning exactly the AIR = level payments (not increasing). A common trap: "If the separate account earns 4% and the AIR is 4%, what happens to the next payment?" Answer: It stays the same.