Settlement options often present the potential annuitant with a hard series of decisions.
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Ever more people who are approaching retirement are beginning to appreciate the advantages of using annuities for all or part of their retirement funding. Most insurers offer a wide variety of potential settlement options, many of which are not included in the standard policy forms, particularly not in deferred annuities that are to be converted to payout mode. Fortunately, few insurers seek to have their annuity owners annuitize with the settlement option originally selected at the time the annuity was purchased. Since this election may have occurred decades before the time for retirement annuity benefits to commence, it is hardly likely that the option elected will still be appropriate.
Prior to the time annuity payments are to commence for any annuitant, most insurers will contact the retiree to provide information about potential settlement options and to try to educate the annuitant about the ramifications of the various settlement options available. This usually presents the potential annuitant with a hard decision or series of decisions. As we have stated before, if we all knew when we were going to die, there would be no need for life contingency annuities. Since the actual date of death is unknown to most of us, we must make compromises about the annuity options we will select.
A straight life annuity--one where annuity payments cease with the last payment prior to the death of the annuitant--provides the greatest amount of annuity payment. It is the annuity equivalent of term life insurance. Since the annuitant forfeits any remaining contract value at the time of death, the insurer generally makes larger annuity payments than for any other settlement option. This straight life annuity can often be available on joint lives so that a couple can be sure that annuity payments will continue so long as one of the joint annuitants lives. This settlement option usually appeals to people who want to maximize their retirement income and who are not concerned with leaving any legacy from the annuity to the natural objects of their bounty.
Few annuitants actually select a straight life annuity, at least not if the value of the annuity represents the bulk of their assets. If other assets will be passed to loved ones upon the death of the last remaining annuitant, then a straight life annuity may be appropriate. However, most people seem unwilling to risk the forfeiture of any remaining annuity value, particularly if they fear premature death--i.e., prior to the normal mortality assumed in the annuity tables contained in the annuity contract. Therefore, most annuitants select an annuity settlement option that permits them to hedge against premature death and the forfeiture of annuity values that such an event will trigger.
Most annuity contracts provide the standard "term and certain" annuity settlement option that provides that payments will continue for the life of the last surviving annuitant and will then continue to the beneficiary for a period of time that is selected by the annuity owner. The standard in the life insurance industry has long been a "10 year certain and life" option. The annuitant or annuitants are protected against living too long by the contractual provision that annuity payments will be made for life. However, if annuity payments are made for less than 10 years, the insurer will continue to make payments for the remaining years of the 10-year period. Most insurers will permit time periods other than 10 years. It is a fairly simple mathematical calculation for the insurer's actuaries to compute the actuarial equivalents for almost any period certain.
Other, more sophisticated options may also be available. These usually take some form of a "refund" annuity where different mathematical formulas are available to enable annuitants to hedge against forfeiture of annuity values in the event of premature death. These options may make particularly good sense if all or some portion of annuity payments are to be under a variable annuity.
One of these options that has long been used with variable annuities is the "installment refund option." This option takes the variable annuity value at the time annuity payments commence and calculates the amount of the first periodic annuity payment to be made. This dollar amount is then converted to annuity units at the then annuity unit value. Thereafter, each variable annuity payment will be the value of the annuity unit value at the time the payment is calculated and the amount of each such payment is deducted from the remaining annuity value. If the last surviving annuitant dies while any there is any remaining annuity value, such remainder is paid to the beneficiary. If the last surviving annuitant is alive after the annuity value has reached zero, annuity payments will continue for the remainder of life. The amount of the periodic annuity payments will equal the number of annuity units originally calculated when payments began multiplied against the annuity unit value at the time the calculation is made. The advantage of this "installment refund option" is that it allows annuitants and beneficiaries to benefit from favorable performance of the assets underlying the variable annuity.
Most annuity contracts will permit beneficiaries to "commute" the value of any annuity payments owing under a refund annuity and receive a lump sum payment of the present value of the future payments. This commutation value is generally calculated at a rate of interest that is roughly equivalent to the minimum rate paid by the insurer on fixed annuities.
Regardless of the settlement options elected by an annuitant or contract owner, we believe that a life contingency should be incorporated into the option chosen. There are many reasons why the lifetime protections afforded by a life annuity contingency are necessary since no one knows when they are going to die. In essence, a life contingency annuity is insurance against living too long.
In this context, we also believe that it is smart planning for retirees to hedge against inflation by having some portion of their annuities in a variable payout mode. After all, the variable annuity was originally invented to permit a hedge against inflation as afforded by a long-term investment in the American stock market. This hedge still exists and is as appropriate today as it was when the original variable annuity was first developed in the early 1950s.
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