Annuitization Rate

Let’s start with the word "annuity." In this form of investment, you pay a lump sum now for the promise of annual payments down the road. So you might give a check to an insurance company for $200,000. For this money, the company agrees to pay you $1,000 a month starting 20 years from now. They will pay this money no matter how long you live (or, sometimes, even longer than you live...See: Annuity Certain).

In making this deal, you give up some potential upside (you aren't going to be able to invest...or spend...that $200,000), but you get security (you know you'll get the $1,000 a month no matter what).

You might guess that the word "annuitization" comes from "annuity." You'd be right! The annuitization rate is just a way of measuring the payout of an annuity. You might think of the annuity payment in terms of the amount you are receiving each month. But remember: an annuity is an investment. You need some way of comparing the amount of money you invest with the benefit you are receiving.

In the example we discussed before, you paid $200,000 and were receiving $1,000 a month. Doing a little math, $1,000 a month equates to $12,000 a year. Divide the $12,000 annual payout by the $200,000 you contributed, and the annuitization rate is 6%.