The Pros and Cons of Accepting the Lump Sum Payment of an Annuity Buyout Offer

I once had a client come into my office with something he’d received regarding an annuity he’d been collecting on for years. It was a notice from his insurance company wanting to buy him out. Needless to say, the client was confused. After all, annuity contracts are designed to be held for the long term for retirement income. But in this case, the insurance company that sold him the annuity wanted to cash the client out with a lump sum offer. All the client had to do was sign off on his right to receive income payments in exchange for a lump sum now.

This isn’t an unusual case. Many insurers have offered lump sum payouts to annuitants to remove the contracts from their books, or to end ongoing payment obligations, and they often have a good reason for this. Sometimes, it might be a good idea to take this lump sum payout, but unless you are well-informed about the process, it could cost you.

Why Do Insurance Companies Buy Out Annuities?

Insurers usually call these offers annuity buybacks. To understand why they do this, you need to understand how insurance companies manage their annuity business. The standard way it works is that the insurance company pools together the premiums it receives from its clients. They use the premiums to purchase investments, such as bonds, and they use the earnings from those investments to  make payments and pay benefits to clients. How well those investments perform help the company establish and manage the features of the products they issue, such as the guaranteed minimum values, credited interest rates, payout rates, and other contract elements. Sometimes the annuities being offered for a buyout are older annuities that have been in force for a number of years. When clients who have held annuities for an extended period of time live longer than the life expectancy that the company estimated when they set their payout rates, this can result in a higher risk level for the company because these annuitants are collecting income payments for longer than the company anticipated. When people buck the odds and live significantly past their life expectancy, the amount of their total annuity payments can go up exponentially.

If the market, particularly the bond market, performs poorly, insurance companies still must make those guaranteed payments, so they often increase their investment contribution. They’re also required to keep enough cash on hand to pay out all current annuitants, so having those funds tied up in payments means it can’t be invested.

When that happens, the insurance company may look to a number of alternatives to manage their cash flow, one of which may be the offer of a buyout option to annuitants. If you receive a buyout offer, here are some things you should know about the offer they’ll make.

When It Might Not Be a Good Idea

Generally, in an annuity buyout, the insurance company will offer you what your annuity is currently worth, plus a portion of future guaranteed payments paid in one lump sum payment. While the lump sum might look good on the surface, it may only represent a portion of what you have the potential to receive in income payments over the long term.

One way to evaluate the offer is to compare the lump sum offer to the calculated current value of the future guaranteed payment stream. Getting the present value will tell you how much those future annuity payments will add up to in today’s dollars. For example, say you’re expected to receive $6,000 a year from an annuity at a 4% interest rate for the next 10 years.  The present value of that annuity would be $48,665.37. This is calculated with the following formula:

Annual payment received/ (1+ (number of payments x interest rate)

or

$6,000/ (1+ (10 x.04) = $48,665.37

Once the present value is set, you might want to compare that present value to what it would cost to buy a new immediate annuity that would cover you for the same period of time, or how much you would have to earn in any other insurance or investment product each year to match this same amount. If your annuity is very old, that present value may not be able to create the same value or income stream in today’s market.

When you elect to take the buyout, this decision is irrevocable and you cannot change your mind at a later date. You also need to be ready and able to invest this lump sum on your own. With the annuity, the insurance company handled all of the investment decisions, which you will need to take on yourself. In addition, if your annuity offered a death benefit to your beneficiary or any other living benefits, these too will be lost when the annuity is canceled.

Finally, when it comes to the lump sum, you’ll have to pay taxes on the buyout for any portion you didn’t pay before. So if your annuity was bought post tax, you’ll have to pay taxes on anything above the principal. If it was purchased with pre-taxed dollars, you’ll be taxed on the full amount at your current income rate

That being said, there are times where it might actually be a good deal.

When It May Be Worth Considering the Buyout

One big question you should be asking when you get that buyout offer is how much time do you realistically have left on the annuity? If you are already taking income payments and it is for a fixed period of time, the decision may be an easier one. But remember you’re still hedging life expectancy.

One thing to consider is why did you purchase the annuity in the first place and has that need changed? Do you still need the steady stream of income, or do you think there’s a chance you might want to liquidate the annuity in the future? Do you have unexpected expenses coming up or new health problems that you didn’t have when you started receiving payments?

If you’re early into the annuity and think you might need to liquidate any of it for any reason, it may be a good idea to take the lump sum offer rather than wait because, if you wait, the offer may be off the table, and you may incur surrender penalties later if you surrender it. An annuity lump sum offer is often more beneficial when you’re closer to the end of the annuity payout period and you believe that it’s unlikely that you’ll be around to receive income payments later on.

If you have been offered a buyout from your annuity company, you should discuss your options with an insurance or financial advisor, like one in Retirement HQ’s network. An independent professional will be able to help you decide if it’s worth taking the lump sum offer or if you may be better off holding on to your annuity.