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Written by: Tamiko Toland
It's Annuity Awareness Month, which means it's a great time to get into the weeds on an obscure fact about annuities. It also explains some of the misconceptions about the products in general (I wrap up with a rant about how confusing the word "deferred" is). I myself have explained the name "annuity" this way many times: all annuities can be annuitized.
Few are, and most are done through a 1035 exchange. Overall, annuitization is limited to about 3-5% of total annuity sales (per LIMRA), with that number fluctuating primarily with interest rates. Though this represents only "new" contract sales of single premium immediate annuities (SPIAs), we can reasonably assume that annuitization of existing deferred contracts doesn't budge the needle on this figure.
Why is that? In fact, a number of years ago, New York State was worried about consumers losing out on income if they rolled over an annuity contract into a new SPIA that had a lower rate than they could have gotten from their existing contract. This is certainly possible, even though it's the extremely rare exception.
Yes, All Annuities Can Be Annuitized
Getting back to the point at the top, ANY annuity can be annuitized. At purchase, the contract has a specific mortality table and other assumptions attached to it--even deferred contracts. That means that somebody could purchase a fixed or variable annuity for accumulation, hold it for many years, and then annuitize, potentially taking advantage of a very outdated mortality table = beaucoup extra income bucks.
Given improvements in the average American longevity, this seems like a loophole that people who want guaranteed income could really exploit. And it seems like a hidden benefit that a financial professional could miss when doing a 1035 exchange into a newer contract.
In fact, back in the early 2000s, a bunch of us nerds were worried this was going to become a huge compliance headache, but time and product design changes have proven us wrong.
Nerdz Were Wrong
To be fair, this is still a loophole for the rare policyholder that has a very old contract. If you happen to know somebody who's been holding onto a contract for decades, it's worth looking at that legacy annuitization rate.
If you happen to know somebody who's been holding onto a contract for decades, it's worth looking at that legacy annuitization rate.
But in the intervening decades, actuaries have astutely built in defenses against this (and against the compliance risk that some of us quaintly fretted about). To compensate for a mortality table becoming more stale, the contract uses other assumptions embedded with every contract, including the interest rate applied and the assumed age of the annuitant. What this boils down to is either a interest rate assumption (however that manifests) or adding years to the annuitant's actual life (i.e. real age + 10 years), also known as an age set back.
A Fun Diversion into Variable Annuity History
I mention these factors specifically because this stuff is hard to determine on a typical contract--I don't even know where to look it up--but it was a very visible element of the MetLife GMIB (guaranteed minimum income benefit) design that it used after the Great Financial Crisis, the same design that caused it to shatter sales records in 2011 and ultimately back out of that business. MetLife (too) gently applied the brakes by incrementally reducing the interest rate factor and increasing the age set back on the annuitization factors applied to the GMIB.
Example of the plain English description of the adjustment to the GMIB--how in the world was it not more obvious to registered reps how this might affect the lifetime income guarantee that the client would ultimately receive?
Unsurprisingly, distribution paid no mind to cryptic adjustments to the product, even though they reduced the richness of the benefit. It was certainly easy to ignore.
Back to the Point
As much as I appreciate New York State's drive to make sure annuitizers (take that, spellcheck) get the best rate possible, contemporary contracts are designed to cut off that loophole. And, given the frequency with which people actually annuitize, this is really best for consumers--current rates reflect current pricing information. Any time the insurance company has to account for the possibility of future guarantees, it costs consumers. That cost might be nominal or otherwise, but most people today don't rely on annuitization to receive lifetime income from annuities, period.
And one last important observation: the fact that any annuity is technically annuitizable (I'm really making spellcheck cranky now) doesn't mean it's easy. Insurers don't typically enable annuitization of deferred contracts. There's no online portal to easily check rates or button to click.
The guaranteed lifetime withdrawal benefit (GLWB) has become the mainstay of income generation. I'm still a fan of annuitization for various reasons, but I recognize and appreciate the value of overcoming behavioral biases that come with surrendering money in exchange for a thin stream of future income.
The fun fact that the [annuity] can provide a guarantee of lifetime income without annuitization creates a befuddling mismatch in nomenclature.
As I mentioned up top, the annuity's very name comes from its ability to be annuitized. But the fun fact that the same product can provide a guarantee of lifetime income without annuitization creates a befuddling mismatch in nomenclature.
The Promised Rant on the "Deferred Annuity"
The "deferral" in deferred annuities is deferral of annuitization, not (a) deferral of lifetime income or (b) irrevocable surrender of payment for lifetime income. Because you can defer a contract that is fully liquid (and take income) and you can defer receipt of annuity payments that is fully illiquid (deferred income annuity).
The gradual evolution of the annuity into the large and diverse family of products "it" has become means that the technical terminology serves us poorly when we try to explain what these blasted things do. And the fact that they can all be annuitized only makes matters worse. But the demand for certainty in retirement underscores the importance of better communication on products that do what no others can.
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