Annuity Rollovers Overview

In financial parlance, a rollover has two common meanings, one general and the other specific. It can refer to the reinvestment of funds upon the maturity of an asset, such as a CD or a bond. More specifically, it can refer to reinvestment of funds that have been removed from a qualified plan, such as a 401(k). Using either definition, one possible destination for the rolled-over funds is an annuity, a contract in which individuals pay insurance companies in exchange for the promise of lifelong income.

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Annuity Rollover Mechanics

One important aspect of an annuity rollover is its mechanics. Funds previously devoted to one investment must now be extracted and redirected to a different investment. In some cases, the investor may suffer loss of income if the rollover is mishandled.

A bank CD, or certificate of deposit, has a fixed term, ranging from three months to ten years. As the maturity date approaches, the bank will contact the CD’s owner for instructions on what to do with the proceeds. (The bank is required to do this and in any case is anxious to have the money reinvested in another CD.) The investor can instruct the bank to transfer the funds to the insurance company that issues the annuity. Alternatively, the investor can allow the insurance company’s representative to handle the transaction, as many investors do. The overriding consideration is that the transfer be handled by the respective financial institutions, without the investor taking “constructive receipt” of the funds.

Why Mechanics Matter

The significance of this transfer emerges when the money is coming out of a qualified plan, such as an IRA or 401(k). Although technically the investor has 60 days within which to receive the funds and roll them over into a similar qualified plan, the safest way to insure that the government deadline is met is to keep the money out of the investor’s hands completely with a business-to-business transfer. Failure to avoid taking constructive receipt of the funds will subject the investor to financial penalties. By design and definition, qualified plans involve the grant of privilege by government in exchange for the fulfillment of a socially-desirable purpose. In this case, that purpose is the creation of wealth for future enjoyment. If the investor takes possession of the money outside the confines of the plan, the government cannot be sure that the investor is not enjoying benefits from the money now, rather than in retirement. Businesses have a fiduciary responsibility to abide by the guidelines of the qualified plans (and laws making annuities less attractive for pre-retirement consumption purposes), so the government knows that the investor cannot violate its rules with impunity as long as the investment funds are in possession of financial institutions.

So much for the mechanics of the rollover. What dictates the redirection of funds between investment vehicles?

Annuity Rollover Logic

People change investments because their circumstances, age, and goals change. Of course, one possible reason for a rollover is error. A young couple puts money in a CD, only to discover that they need the funds in liquid form as a precaution against illness, income loss or the vicissitudes of child-rearing. Alternatively, they find that their rate of return doesn’t satisfy their desire for growth. But there is no reason to assume that anybody has made a mistake.

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Annuity Rollover Examples: Pension to Annuity

A man spends decades working for one company and becomes vested in its pension plan. At retirement, he may wish to roll over a lump sum into a qualified annuity rather than take his pension under company auspices, provided the pension plan guidelines allow it. The most likely reason for this is safety. As recent events have demonstrated, pension plans may become casualties of faulty planning or economic misfortune. Annuities themselves are not invulnerable; their guarantees are only as good as the financial strength of the issuing insurance company. The existence of insurance rating-agencies makes it easier to gauge the strength of insurance companies than of ordinary businesses. Moreover, insurance companies diversify their investments; putting all your retirement eggs in one single company basket is much riskier.

A retiree has lost his or her source of income. A pension provides income, so the exchange of pension-for-annuity would suggest the selection of an immediate annuity. The lump sum payout by the company would comprise the single premium used to purchase the annuity. Among the options are a life annuity with a high periodic payout and a joint and survivor annuity that will continue paying to a surviving spouse. Whatever the specific distribution plan, the retiree has exchanged one form of annuity – a pension – for another one that has less risk.

Annuity Rollover Examples: Mutual Funds to Annuity

Retirement need not be the occasion for a rollover. Middle age is the time for investors to begin changing the composition of their portfolios, allocating more money to conservative, fixed-income investments and less to risky, growth-oriented vehicles. A rollover from mutual funds to annuities would further this goal, particularly if the investor’s eventual intention is to annuitize the investment and enjoy lifelong income. This may well occur inside a qualified plan, in which case strict attention should be paid to the mechanics outlined above – under no circumstances should the investor be caught holding the bag by taking constructive receipt of funds during the transfer process. (Asset reallocation will occur both inside and outside of qualified plans, but the terminology may differ. For example, a mutual fund has no maturity date, so a reallocation outside of a qualified plan is not usually termed a rollover.)

Such a life-cycle reallocation will likely favor deferred annuities so as to time the distribution to coincide with retirement. Whether the annuities chosen will be fixed, variable or indexed will depend on such factors as the investor’s risk tolerance, net worth and need for income in retirement. The higher are all of the foregoing, the more the choice will swing toward variable annuities, particularly the newest products that feature guaranteed minimum income and withdrawals. Fixed annuities are the most conservative but have the least potential for growth. Indexed annuities occupy the middle ground - an opportunity to participate in market gains while feeling the security of a floor under the credited interest rate and income.

Follow the rules and the logic of investments and your annuity rollover can put you in a comfortable position.

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