- A deferred income annuity can help cover your essential expenses in retirement along with other sources of guaranteed income like Social Security, pensions, and other annuities.
- Combining income from multiple sources in retirement follows the same principle as diversifying investments during your saving years.
- You can use deferred income annuities several ways to help diversify your portfolio and secure an income stream in retirement.
Watch a video about DIAs:
With pensions increasingly a thing of the past, most Americans now need to build their own cash flow in retirement that could last decades. The success of your individual retirement income plan will rely on 2 key factors: Will you be able to create a cash flow that truly lasts your entire lifetime, and will you trust and stick to that plan even through periods of market volatility?
That's where guaranteed income annuities* may be able to help. These products are able to deliver cash flow that you can rely on for either a predetermined period of time, or for the rest of your life. And, specifically, deferred income annuities (DIAs) let you lock in a stream of guaranteed income years before retirement, while reducing the effect of market volatility on your retirement income plan.
The advantage of a DIA is that it offers a degree of certainty. "That’s because no matter what the market does between when you buy it and when you retire, you still get guaranteed lifetime income," says Tim Gannon, vice president, Fidelity Investments Life Insurance Company.
For some, using a portion of retirement assets to lock in guaranteed income is an attractive option; knowing the cash flow is secure, some investors may have greater confidence to invest their remaining retirement assets more aggressively. While DIAs are an efficient way to generate cash flow, keep in mind that you are giving up access to the assets you dedicate to this solution and the opportunity for potential market growth.
How deferred income annuities work
A significant reason income annuities are different from other income-producing investments is because they offer longevity risk pooling (referred to as mortality credits). The concept of mortality credits is that assets from annuitants with shorter life spans remain in the "mortality pool” to support the payouts collected by those annuitants with longer life spans. Put simply, the longer you live, the more money you will receive. This is why it is so challenging for an individual investor to replicate this income stream.
DIAs are able to turn a portion of your savings into a stream of income beginning anywhere between 2 and 40 years that will last over your lifetime. By investing in a DIA you are starting to put in place your future retirement income prior to your actual retirement date. In return for investing early, you are potentially securing a higher cash flow than if you waited and purchased an annuity to provide an immediate guaranteed income stream at retirement.
There are planning strategies that you may want to consider, including using a DIA as a portion of a diversified income plan or investing in a DIA incrementally with additional payments to build your own pension-like income. First, let’s explore how a DIA may work as part of a diversified income plan.
DIAs as an element of a diversified income plan
Fidelity believes it makes sense to cover at least your essential expenses in retirement (e.g., food, utilities, health care, and other needs) with guaranteed lifetime income from Social Security, pensions, and certain types of annuities. This way your essential expenses will be covered for life, regardless of how long you (or you and your spouse) may live, and your investment portfolio can help cover your discretionary spending (e.g., vacations, hobbies, and other "wants").
A guaranteed income annuity can help:
- Reduce the effects of market risk (PDF). Having a guaranteed income stream as part of your diversified income plan can help protect against the impact of market downturns on your retirement portfolio's ability to produce income.
- Reduce longevity risk (the risk of outliving your assets). Guaranteed income can help reduce the chance that you may draw down your savings too quickly and run out of money in retirement.
Consider a hypothetical example of how a DIA might work under different market conditions.
Imagine a 60-year-old couple with a hypothetical retirement portfolio of $500,000 who wants to generate a cash flow starting at age 65. The example below illustrates 2 different ways of creating income:
- Option 1:The couple decides to invest their $500,000 in a balanced target asset mix (TAM) of 50% stock, 40% bonds, and 10% short-term investments, then starts taking income at age 65. The plan is to use only a Systematic Withdrawal Plan (SWP) with an initial 4% annual withdrawal rate and payments increasing 2.5% on each payment anniversary thereafter.
- Option 2: The couple decides to diversify and splits the $500,000 as follows: (1) $250,000 is invested in a balanced TAM for 5 years; then, at age 65, income is taken using a SWP with an initial 4% annual withdrawal rate and payments increasing 2.5% on each payment anniversary thereafter; and (2) $250,000 is used to invest in a joint life deferred income annuity contract with a cash refund and 2.5% cost-of-living adjustment (COLA), with payments starting at age 65.1
As you can see, assuming average historical returns for the balanced TAM, the portfolio with the guaranteed income generated first-year monthly income that is $409 less than that generated from the portfolio without the guaranteed income. Because deferred income annuities are not exposed to market volatility, the income amount remains consistent regardless of a market downturn. Therefore, when historically low returns are assumed in the example, the portfolio with the guaranteed income outperformed the portfolio without the guaranteed income—generating first-year monthly income that is $206 higher.
"One of the strongest reasons to buy a DIA is the foundation it provides for your retirement income plan," says Tom Ewanich, vice president, Fidelity Investments Life Insurance Company. "You establish a guaranteed level of income no matter what happens over the next several years, and are one step removed from the anxiety of watching the markets move every day with your retirement in sight."
Another consideration with deferred income annuities is the ability to invest incrementally over time by making additional payments. While most income annuities only allow a single investment, DIAs allow you to make additional investments to the annuity before your income payments begin—each additional investment subject to the interest rates available at the time of purchase—so you can increase your retirement cash flow so you can (incrementally) increase your future retirement income over time. By building your income plan in increments, you can stagger your investments with a range of interest rates and possibly take advantage of higher future interest rates.
Does a DIA make sense for you?
These DIA products tend to be most beneficial for pre-retirees between the ages of 55 and 65 who are planning to retire in 5 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 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. Because you can add to your DIA before starting your income, 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 reason to stay the course. 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 reducing 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 can shift some key retirement risks—longevity and market risk—off your shoulders and onto the issuing insurance company.
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 either a predetermined period of time or the rest of your life. The insurer also assumes the interest and market risk associated with your DIA investment; 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. There is an element of 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. "The amount you commit to a DIA is irrevocable," notes Gannon, "but the trade-off is being confident that your income will be there when you need it."