While past generations 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 plan and create 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 a guaranteed1 retirement income stream typically had to wait until retirement to buy a single premium immediate annuity. Now, however, deferred income annuities (DIAs) let you lock in a stream of guaranteed income years before retirement.
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The advantage of a DIA is that it offers a degree of certainty. “DIAs 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 from the time you buy a DIA to when you retire, you still get guaranteed lifetime income.”
The disadvantage, however, is that you are giving up access to your assets and the opportunity for potential market performance with that portion of your portfolio.
How deferred income annuities work
These insurance products turn a portion of your savings into a stream of lifetime income payments, beginning in two to 40 years, for the rest of your life. Some annuities 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. Each additional investment increases your eventual income payments and is subject to the rates available at the time of your purchase.
Like other insurance products, DIAs 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. With many annuities, if other investors pass away before they start collecting income payments, their beneficiaries get the amount invested, but the earnings stay behind. This creates mortality credits, which increase the income paid out to everyone else in the pool.
Why buy a DIA years before retirement rather than waiting and buying a single premium immediate annuity when you need an income stream? In short, to get potentially higher income and greater certainty. Longer deferral periods also allow the insurer to invest in longer-term securities, which typically pay more than shorter-term securities. Adding to your DIA over time will also enable 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, in the same way you have 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
How does the purchase of a DIA compare with the alternative, which is to simply invest your money and convert to a single premium immediate annuity at retirement? Consider a hypothetical example of how a DIA might work under different market conditions.
Let’s say you have two 55-year-old couples, each with a hypothetical retirement portfolio of $500,000, who want to generate income starting at age 65. The Pringles decide to purchase a DIA for $125,000, which provides $6,632 per year of income starting at age 65. To address their inflation concerns, they also choose to have the income increased annually by 2% once payments begin. They leave the remaining $375,000 invested in a diversified investment portfolio.
The Johnsons invest the entire $500,000 solely in a diversified investment portfolio. At age 65, a portion of the balance ($177,333) is used to purchase a single premium immediate annuity whose income stream matches that of the DIA. 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, with the withdrawal amount adjusted for inflation thereafter.
As you can see, when the financial markets didn’t perform so well (generating 0% annualized return), the portfolio containing a DIA generated more income at retirement than the investment portfolio used to buy a single premium immediate annuity ($21,632 versus $19,539). That’s because even under less favorable market conditions, the DIA still pays the same guaranteed income.
But when the markets returned 8%, the portfolio that doesn’t contain the DIA produced more income at retirement ($42,717), compared with the combination DIA and diversified investment portfolio ($39,016).
“That’s the whole point of this product,” says Benjamin. “It gives your retirement income plan some downside protection in rough markets because the amount invested in a DIA is no longer subject to market risk.”
Additionally, the Pringles don’t have to worry about how much their guaranteed income will cost once their DIA has been purchased. And the income is guaranteed to not go down—and could go up with a cost-of-living rider. The Johnsons, on the other hand, wouldn’t know how much the same level of income the Pringles bought will cost them until they hit age 65. In our example, the Johnsons had to pay $177,333, but it’s quite possible that changes in interest rates would mean they have to pay significantly more or less.
Does a DIA make sense for you?
A DIA is “an option available to investors who are concerned about the market and want the peace of mind that comes with securing a guaranteed fixed stream of retirement income several years before they will need it ,” says Tim Gannon, vice president, Fidelity Investments Life Insurance Company.
These DIA products tend to be most beneficial for pre-retirees between the ages of 55–65 and who are planning to retire in five to 10 years. In addition to reducing market and longevity risk—an advantage of all fixed annuities—DIAs have the following advantages over immediate annuities:
- Potentially higher income. Because DIAs have a deferral period, the underlying investments have a longer duration and higher potential return (and higher risk) than annuities that start income payments immediately.
- 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 DIA 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 DIA 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 DIA puts that risk-reduction process in motion automatically. You might also avoid the need to sell equities at the wrong time—in a down market—to pay your expenses, because you’ve already put a DIA 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 DIA, 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 DIA; 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, that DIAs, like any investment product, aren’t right for everyone. They are designed for someone trading growth potential for a guaranteed future lifetime income stream. Part of that trade-off is giving up some flexibility (access), which is why it’s better to allocate a portion, rather than all, of your savings to a DIA. “Once you buy this product, you are permanently committing these savings to income generation,” notes Benjamin. But knowing that you’ll have lifetime income you can rely on may be well worth the trade-off.
- 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 income annuities available through Fidelity.
- Speak to a Fidelity Annuity Specialist at 866-450-3909.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917