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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. The success of your individual retirement income plan will rely on 2 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 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. "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 is that you don't have to wait until the moment you retire to know what your investment will deliver in income. You can gain peace of mind and some flexibility with your other assets."
For some, using a portion of retirement assets to lock in guaranteed income for the first several years of retirement is an attractive option; knowing the income is secure, some investors may have the confidence to invest part of their retirement assets more aggressively during those early years. While DIAs are an efficient way to generate income, keep in mind 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
Income annuities are different from other investment options because they offer 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 an individual investor to replicate this income stream.
DIAs are able to leverage the mortality credits and 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 the planning process ahead of your retirement age. In return for investing early, you are potentially securing a higher income amount than if you waited and invested in an immediate income annuity.
There are planning strategies that you may want to consider, including using a DIA as a portion of a diversified 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
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:
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 income 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) (50% stock/40% bonds/10% short term), 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 Consumer Price Index (CPI) 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 $248 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 $361 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—each additional investment subject to the interest rates available at the time of purchase—so you can increase your retirement income stream. By building your income plan in increments, you can stagger your investments with a range of interest rates and possibly take advantage of higher 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:
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 tradeoff is being confident that your income will be there when you need it."
Next steps to consider
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