I have found that the majority of people think when you own an annuity for lifetime income, the annuity company keeps any money left in the account when you die. I can guarantee that too many people who needed a lifetime income stream from an annuity didn’t make that purchase because of this common incorrect assumption. That annuity payment structure that people are referring to is called “Life Only,” but is only one of over 35 different ways to contractually set up the income stream.
You can structure the annuity policy so that the carrier is on the hook to pay regardless of how long you live, but with any unused money going to the listed beneficiaries on the policy. In other words, the evil annuity company does not keep a penny.
I call this “backstopping” the policy. Because annuities are customizable, you can design that backstop exactly the way you want it to contractually work. Let’s look at the most popular ways to set up and "backstop" that annuity contract.
Annuities were first introduced in the Roman times as a lifetime income pension reward to the dutiful Roman soldiers and their families. The Latin word “annua” means payment, and is the origin of today’s word “annuity.” That first Roman annuity is very similar to today’s Single Premium Immediate Annuity (SPIA).
Today’s annuities, regardless of type, are issued by life insurance companies. Most annuity products are fixed annuities, regulated at the state level, and designed to provide a guaranteed lifetime income. With over 10,000 baby boomers reaching retirement age every single day, the fear of outliving your assets is a real concern.
Annuities are the only financial product that provides an income stream you can never outlive. Annuities have a monopoly on lifetime income. You transfer the risk to the annuity company to pay for the rest of your life. It contractually solves for “longevity risk,” which is the fear of running out of money.
The only other strategies that provide a lifetime income stream are your Social Security benefits and a pension (if you are so fortunate). By the way, both of those are annuity structures. Lifetime income payments are a combination of return of principal plus interest, with your life expectancy at the time the payments start playing the primary pricing role. Interest rates are a secondary pricing factor.
Annuity companies figured out early in the income solutions game that people wanted a lifetime income...but also wanted to make sure that their hard earned money wouldn’t go to the annuity company if they died before their projected life expectancy. Annuity companies listened to the consumer and created numerous ways to backstop that initial annuity lump sum. Of course, carriers price that additional "backstop" guarantee in by lowering the initial payment when compared to annuity payments without a backstop.
Never forget that annuity companies have the big buildings for a reason. They don’t give anything away.
Installment Refund Backstop
The most popular “backstop” that my clients use is “Installment Refund.” Single Life with Installment Refund or Joint Life with Installment Refund means that the annuity company is on the hook to pay for life. But when you die, any unused money goes in payment form to the listed beneficiaries until the money is exhausted. Joint Life with Installment Refund would pay for two lives, and when the second person dies...any used money would go to the beneficiaries until the money is gone.
Installment Refund provides the highest contractual lifetime income payout while making sure that the annuity company doesn’t keep a penny under any circumstance.
Cash Refund Backstop
Structuring your backstop with “Cash Refund” is very similar to “Installment Refund.” The only difference is that when you die, whatever money is left in your annuity account goes lump sum to the listed beneficiaries on the policy. You can structure the lifetime income stream Single Life with Cash Refund or Joint Life with Cash Refund. Single Life will provide a higher payment because the carrier is only guaranteeing a lifetime income for one life instead of two
A Cash Refund “backstop” provides a lower guaranteed payout than Installment Refund because the carrier has to come up with a lump sum at the time of your death. With Installment Refund, they get to keep your money longer. It’s common sense if you think about it from the carrier’s standpoint.
Period Certain Backstop
The other way you can “customize your backstop” is with a Period Certain. Life with a 10 Year Period Certain or Joint Life with a 20 Year Period Certain are examples of this type of structuring. It’s your choice at the time of application. You can choose any year time period as a backstop.
The shorter the "backstop time period" the higher the payment. For example, Life with a 10 Year Period Certain would pay higher than Life with a 15 Year Period Certain. Here’s an example of how this backstop works. If you set up the lifetime income “Life with a 10 Year Period Certain,” the annuity company would be on the hook to pay you for life. However, if you lived 5 years and died...then there would be 5 more years of payments to the listed beneficiaries. If you died at year 7, there would be 3 more years of payments to the beneficiaries. If you died at year 12, there would be no payment to the beneficiaries. Got it?
Backstop Commodity Customization
Lifetime income annuity products are customizable and should be shopped with all carriers to find the highest contractual guarantee for your specific situation and retirement plan goals. Always remember that the annuity company doesn’t have to keep a penny of your money even though they are on the hook to pay for the rest of your life.
If they do keep a penny, then that’s your decision on how you want to structure the policy at the time of application.