- 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.
Watch a video about DIAs:
With pensions increasingly a thing of the past, most Americans now need to build their own streams of income for a retirement that could last decades. Your individual retirement income plan’s success will rely on two key factors: Will you be able to create income that truly lasts your entire lifetime, and will you trust it 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 a stream of income that you can rely on no matter how long you live. 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. "You can secure a portion of your retirement income years before entering retirement," says Tim Gannon, vice president, Fidelity Investments Life Insurance Company. "The advantage being you don't have to wait until the moment you retire to know what your investment will deliver in lifetime income. You can gain peace of mind and some flexibility with your other assets."
While DIAs are an efficient way to generate income, the disadvantage is that you are giving up access to the assets you dedicate to this solution and the opportunity for potential market performance.
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.
What separates annuities from other investment options is the benefit of longevity risk pooling (referred to as mortality credits). Effectively, 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 any individual investor to replicate this income stream.
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.
DIAs as an element of a diversified income plan
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 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 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 simply investing your money and converting to a single premium immediate annuity at retirement? Consider a hypothetical example of how a DIA might work under different market conditions.
Imagine two 55-year-old couples, the Pringles and the Johnsons, 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 $11,936 per year of income starting at age 65. 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 ($227,376) 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, assuming the financial markets didn't perform 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 ($26,936 versus $22,841). That's because even under less favorable market conditions, the DIA still pays the same guaranteed income because you locked in the payout when you purchased the contract.
But when the markets returned 8%, the portfolio that doesn’t contain the DIA produced more income at retirement ($46,019), compared with the combination DIA and diversified investment portfolio ($44,320).
"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."
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 not to go down. 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 $227,376, 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?
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 (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 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 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 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 tradeoff is being confident that your income will be there when you need it, for your lifetime."
Next steps to consider
Provide you, or you and your spouse, with guaranteed* income for the rest of your life.
Choose from a mix of income-producing investments.
Make managing your finances easier and less expensive.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Fixed annuities available at Fidelity are issued by third-party insurance companies, which are not affiliated with any Fidelity Investments company. These products are distributed by Fidelity Insurance Agency, Inc., and, for certain products, by Fidelity Brokerage Services, Member NYSE, SIPC. A contract’s financial guarantees are solely the responsibility of and are subject to the claims-paying ability of the issuing insurance company.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917