What is a life insurance annuity?

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 will 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.

What is an annuity?

As an investment product, an annuity is a financial instrument that pays out a sum of money to its owner or a beneficiary 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.

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.

Annuities are a steady stream of income, but they often have lower returns than other life insurance 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, allowing you to 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 in terms of whether or not the company will start to lose money on your investment.

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.

Annuity interest 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.

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Benefits of a life insurance annuity

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.

• It can act as a source of income: 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, so it can be used as a source or regular income.

• It can help manage spending: A life insurance annuity may also be a good idea if you’re bad with money and need to restrain your spending.

• It can become worth more than the lump sum: 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 would have been if the annuity owner lives a long time, essentially beating the mortality table’s predictions.

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 over the course of your lifetime. 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.

Risks of a life insurance annuity

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.

• It takes a while to get it all: 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.

• It’s expensive to withdraw the money if you need it: 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.

• You can lose liquidity: 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.

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.

Why people choose not to get a life insurance annuity

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.

Additionally, when you die, there are a lot 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.

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.