While generations past may have taken comfort in having pension income to rely on in retirement, to get the same sense of security today, you’ll probably have to buy your own lifetime income stream. That’s easy enough to do, with the proliferation of guaranteed income products, like annuities. But what type should you choose, and when should you buy it?
Until recently, people looking for guaranteed retirement income streams typically had to wait until retirement to buy immediate single premium annuities. Now, however, deferred fixed income annuities (DFIAs) let you lock in a stream of guaranteed income years before retirement.
The advantage of a DFIA is it offers a degree of certainty. "Deferred fixed income annuities can help you fill a gap in your retirement income and provide peace of mind," says Roy Benjamin, vice president and actuary, Fidelity Investments Life Insurance Company. "That’s because no matter what the market does between when you buy it and when you retire, you still get guaranteed lifetime income."
Watch a video about DFIAs:
The disadvantage, however, is that you are giving up access to your assets and limiting the potential market performance of that portion of your portfolio. To decide whether a deferred fixed income annuity makes sense for you, consider:
- how it works
- what role it plays in a well-rounded retirement income plan
- what the guarantees mean to your retirement security
How deferred fixed income annuities work
These insurance products turn a portion of your savings into a stream of lifetime income payments, beginning in 2 to 40 years, for the rest of your life. Some plans allow a one-time option to change your income start date. During the deferral period, which is the time between your first investment and first income payment, you can make subsequent investments into your annuity at any time in order to increase your eventual income payment.
Like other insurance products, DFIAs may also offer you additional income through "mortality credits." When you buy an annuity, you and many other investors pay premiums into a pool, which generates earnings by investing in fixed income securities. Under many plans, if other investors pass away before they start collecting income payments, their beneficiaries get the amount invested but the earnings stay behind. That creates mortality credits, which increase the income paid out to everyone else in the pool.
Why buy a DFIA years before retirement rather than wait and buy a single premium immediate annuity when you need an income stream? In short, to get potentially higher income and greater certainty. Longer deferral periods allow the insurer to invest in longer-term securities, which typically pay more than shorter-term securities. Adding to your deferred fixed income annuity over time will also allow you to “diversify” the rate of interest you earn. With a single premium immediate annuity, you’re subject to the interest rates at the time of your purchase—which could be high or low and will determine the level of income you receive.
Role in a diversified income plan
Fidelity believes that two key principles should guide the use of guaranteed income products—both deferred and immediate—in a diversified retirement income plan. First, we believe it makes sense to cover at least your essential expenses in retirement (e.g., food, utilities, health care and other "needs") with guaranteed income from Social Security, pensions, and certain types of annuities. This way, you’re free to use withdrawals from your investment portfolio to help cover your discretionary spending (e.g., vacations, hobbies, and other "wants").
Second, we believe it’s important to combine income from multiple sources to create a diversified income stream in retirement, much like you diversified your investments during your retirement savings years. While each component has its role, a guaranteed income annuity could help:
- Reduce the effects of market risk. Having a guaranteed income stream can help cushion the impact of market downturns on your income in retirement.
- Reduce longevity risk (the risk of living longer than anticipated). Guaranteed income can help reduce the chance that you may draw down your savings too quickly and run out of money in retirement.
But why opt for a deferred fixed income annuity rather than simply invest your money and convert to an immediate annuity at retirement? Consider a hypothetical example of how a DFIA might work under different market conditions.
Let’s say you have two couples, age 55, with hypothetical retirement portfolios of $500,000, who want to generate income starting at age 65. The Pringles decide to purchase a deferred fixed income annuity for $125,000. They also choose to have the DFIA include annual income increases of 3% to address their inflation concerns. They leave the remaining $375,000 invested in a diversified investment portfolio, allocated 60% to stocks, 35% to bonds, and 5% to money markets. The Johnsons invest the entire $500,000 solely in the diversified investment portfolio. At age 65, a portion of the balance ($205,855) is used to purchase a single premium immediate annuity whose income stream matches that of the deferred fixed income annuity. The remaining portfolio balance is used for systematic withdrawals. In both cases, 4% annual withdrawals from the diversified investment portfolio are assumed to begin at age 65.
As you can see, when the financial markets didn't perform so well (generating 0% and 4% net returns), the portfolio containing a deferred fixed income annuity generated more income at retirement than the investment portfolio used to buy an immediate annuity ($22,846 versus $19,615, and $30,053 versus $29,220, respectively). That’s because even under less favorable market conditions, the deferred annuity still pays the same guaranteed income.
But when the markets returned 8%, the portfolio that doesn't contain the DFIA produced more income at retirement ($42,793), compared to the combination deferred fixed income annuity and diversified investment portfolio ($40,233).
"That’s the whole point of this product," says Benjamin. "It gives your retirement income plan downside protection in rough markets, rather than take risks to pursue maximum returns."
Does a DFIA make sense for you?
A DFIA is "a solution for investors who don’t want to wait until their retirement date to secure a guaranteed fixed stream of retirement income," said Brett Wollam, senior vice president, Fidelity Investments Life Insurance Company.
These DFIA products tend to be most beneficial for pre-retirees age 55–65, who are planning to retire in five to 10 years. In addition to reducing market and longevity risk—an advantage of all fixed annuities—deferred fixed income annuities have the following advantages over immediate annuities:
- Potentially higher income. Because you typically buy a DFIA years before you retire, the underlying investments have a longer duration—for example, 18 years—and higher potential reward/risk than annuities that start income payments right away, which typically would have durations under 10 years.
- Chance to vary your interest rate exposure. With any fixed income product, the interest rates you receive depend on the rates being paid at the time of purchase. But because you can add to your DFIA before taking payments, you have the ability to adjust your interest rate exposure over time. If rates rise and you add new money, that could boost your guaranteed income stream at retirement.
- A more appropriate Target Asset Mix (TAM). Locking in some guaranteed income through a DFIA now may give you the confidence to maintain your target asset mix through market ups and downs, allowing you to establish, and maintain, an asset allocation more consistent with your investment time horizon, risk tolerance, and financial situation.
- A means of dialing down risk. Pre-retirees tend to shift to more conservative investments as retirement draws closer. Establishing guaranteed income well before retirement with a deferred income annuity puts that risk-reduction process in motion automatically. You might also avoid the need to sell equities at the wrong time—into a down market—to pay your expenses, because you've already put this income resource into place.
Why guarantee your income?
Guaranteed income products serve a very particular purpose. They shift some key retirement risks—longevity and market risk—off your shoulders and onto the issuing insurance company.
With respect to longevity risk, when you buy a deferred fixed income annuity, you shift the risk of outliving your income to the insurer, who promises to pay you a certain amount of income for the rest of your life. The insurer also assumes your interest and market risk when you buy a DFIA; even if the market and interest rates are down significantly during your deferral period, you still get the same guaranteed rate of income.
Remember, though, deferred fixed income annuities, like any investment product, aren't right for everyone. They are designed for someone trading maximum growth potential for a guaranteed future lifetime income stream. Part of that tradeoff is giving up some flexibility (access), which is why it’s better to allocate a portion, rather than all, of your savings to a deferred fixed income annuity. "Once you buy this product, you are permanently committing these savings to income generation," says Benjamin. But at a time when life offers few guarantees and personal finances may feel uncertain, knowing that you’ll have lifetime income you can rely on may be well worth the tradeoff.
- If you are looking for income now, see Fidelity Income Strategy Evaluator®2 (login required).
- Learn more about investing for income in the Fidelity Guide to Retirement Income Investing.
- Review and compare deferred fixed income annuities available through Fidelity.
- Speak to a Fidelity Annuity Specialist at 866-450-3909.