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What is a life insurance annuity?

A life insurance annuity works like an income in that the death benefit is divided up over a number of years into equivalent amounts that the beneficiary receives each year.

If you have life insurance and you’ve been keeping up with your premiums, when you die the life insurance company will pay out a death benefit to your beneficiaries. The amount of the death benefit is called coverage, and the amount of coverage you need depends on your financial situation and the amount your beneficiaries need to survive without you.

How the death benefit gets disbursed is usually up to the beneficiaries. Most people choose a lump sum disbursement — they get the entire amount at once, tax-free, divided between the number of beneficiaries.

Another option is to receive the death benefit as an annuity. An annuity works like an income in that the death benefit is divided up over a number of years into equivalent amounts that the beneficiary receives each year. Read on to learn the differences and why you might want to receive one or the other.

What is an annuity?

As an investment product, an annuity is a financial instrument that pays out a sum of money to its owner over the course of a number of years. If you have an annuity, you’re guaranteed at least a certain amount of money every year until the annuity expires or you become deceased. This amount is a payment plus interest, which can accrue at different rates.

The interest rate you earn depends on the type of annuity you have. The most popular types are:

  • Fixed annuities, which earn interest at a fixed rate set at the time you purchase the annuity.
  • Variable annuities, which earn interest at a rate tied to market trends that may increase or decrease over the life of the annuity.

You can also choose between different types of annuities:

  • Fixed-period annuities, which only pay out for a certain number of years, usually between 10, 15, and 20. These are also called period-certain annuities. If you die before the end period, the remaining payments will go to a beneficiary you designate when you purchase the annuity.
  • Lifetime annuities, which keep paying you for the rest of your life, are a great choice if you’re young and/or plan to live forever.

You can buy an annuity by spending a lump sum up front, then after a certain amount of time you’ll receive a percentage of that money back each year, plus interest.

Annuities are a steady stream of income, but they often have lower returns than other investment tools. It’s possible to beat the guarantee, but not every annuity performs the same way. Still, annuities are useful as an investment tool if there’s a market downturn but you continue to receive the same interest rate.

The amount you pay to purchase an annuity is calculated by a “mortality table” developed by the annuity company. The table determines what it’ll cost the company to pay you over a period of time, or how much risk you pose to the company that you’ll live so long that the company will start to lose money on your investment.

Why people choose the lump sum death benefit

Coverage amounts for an individual life insurance policy usually range between $500,000 and $1 million. When calculating the amount of coverage you need, you should take into account all the expenses you help your loved ones pay for, such as a mortgage, college tuition, or medical care. Your coverage should be enough to continue paying for all those things, and more, when you’re gone. Find out how much coverage you need, then get a free estimated quote online from Policygenius.

Additionally, when you die, there are lots of costs associated with your funeral service and burial, which could set your family back as much as $10,000 (at least, usually more). And that’s not to mention immediate medical expenses that could have resulted from your death, especially if it was the result of a long illness or disability.

For these reasons, it makes sense for the beneficiary to claim the death benefit as soon as possible as a lump sum. He or she doesn’t want to fall behind on bills, and the large amount of money could be of some comfort to a grieving person. And the death benefit is tax-free, so someone wondering about what an extra $500,000 might do to their taxable income need not worry.

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Takeaway

Your beneficiary can choose to receive the death benefit as an annuity, which is like receiving an income every year.

Why you might want to consider a life insurance annuity

If your beneficiary chooses to receive the death benefit as an annuity, that means he or she wants to divide up the payments across a number of years of his or her choosing. Instead of receiving a lump sum of money, the beneficiary can choose to turn the death benefit into an annuity by using the lump sum to purchase the annuity, or what’s called annuitization.

Purchasing a life insurance annuity is less popular than simply accepting a lump sum, as there’s not a huge advantage to choosing such deferred payments when the lump sum is tax-free. (Annuity payments are also tax-free.) But you may want to choose to receive the death benefit as an annuity if you have fewer expenses, such as when you’re older and retired. A life insurance annuity may also be a good idea if you’re bad with money and need to restrain your spending.

The annuity is a guaranteed amount paid out by the life insurance company. If you elect to receive an annuity, the combined annuity payments may actually be worth more than the lump sum if the annuity owner lives a long time, essentially beating the mortality table’s predictions. Beneficiaries often elect to receive an annuity that pays out the rest of their life.

However, the intricacies of interest rates and market performance can be difficult for the average consumer to follow. If you’re the beneficiary of a life insurance policy, you should speak with a certified financial planner who should be able to help you determine whether you’d benefit from converting the life insurance death benefit into an annuity.

Life insurance annuities will be fixed-interest annuities, but as a beneficiary you can choose whether you want the benefit paid out throughout a fixed period or your lifetime.

The risks of annuities

Aside from the obvious value of receiving a large amount of cash as a lump sum, there are some risks with choosing an annuity to receive the death benefit. If the death benefit is worth $1 million, and you elect to receive an annuity that pays out 6% per year, you have to wait almost 17 years just to break even with what you’d get from a lump sum.

That means that, if you’re an older person, you may end up collecting less cash over time if you die before the entire amount is paid out. In other words, the annuity company wins its bet that you won’t outlive your money.

Most investments have a principal amount that you can withdraw if you need the cash. With an annuity, your principal is the amount you initially paid, but you won’t be able to withdraw any part of it outside of the annual disbursement without paying a steep early-withdrawal fee.

And while other investments let you cede some liquidity in return for a higher rate of return, with an annuity you’re essentially giving up that liquidity. Unless your financial planner thinks your life insurance annuity can perform better than the market, you’re almost certainly better off taking the lump sum.

You may also be stuck with fees that don’t exist in other investment vehicles. Such fees are already baked into the annuity payments, so you may get less of a return.

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Disclaimer: Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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