With employer pensions increasingly becoming a thing of the past, most Americans now need to build their own retirement income plan that may need to 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 annuities2 may be able to help. Also known as "personal pensions," these products are issued by insurance companies and deliver cash flow that you can rely on for either a predetermined period of time, or for the rest of your life. Specifically, deferred income annuities (DIAs) let you lock in a stream of guaranteed income years before retirement.
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 Stefne Lynch, vice president, Fidelity Insurance Agency.
When you invest in a DIA, you shift key retirement risks—longevity and market risk—off your shoulders and onto the issuing insurance company. The risk of outliving your income is passed 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 payment.
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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 will have limited access to the assets you dedicate to this solution and will give up the opportunity for potential market growth.
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 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 you should cover your essential expenses in retirement (e.g., food, utilities, health care, and other needs) with reliable sources of lifetime income such as Social Security, pensions, and certain types of annuities.
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.
"One of the strongest reasons to buy a DIA is the foundation it provides for your retirement income plan," says Tom Ewanich, vice president and actuary, Fidelity Insurance Agency. "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."
Investing in a DIA over time
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 is subject to the interest rates available at the time of purchase—so you can increase your retirement cash flow (incrementally) over time. Similar to bond laddering, building your income plan in increments allows you to stagger your investments with a range of interest rates.
Use the tool below to estimate potential income from a DIA. (Begin by clicking on the sliders at the left in the tool.)
Does a DIA make sense for you?
DIAs 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 income 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 annuity, the price you pay depends on the interest rates 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 foundation into place.
RMDs and annuities
The SECURE Act 2.0 that went into effect in January 2023 allows IRA income annuity owners the choice to aggregate their qualified income annuity with their other IRAs for the purposes of determining their required minimum distributions. distributions (Learn more in Viewpoints: A little-known way to satisfy RMDs). If you are 73 and older3, annuity payments in excess of the RMD for the qualified annuity can be used to potentially offset RMD obligations from IRAs, allowing assets within these other accounts to remain invested and grow tax-deferred. Annuities with a guaranteed lifetime withdrawal benefit (GLWB) work similarly. Please note this applies to newly purchased income annuities, and those with a GLWB, as well as those established before January 1, 2023. There are several factors to consider and we recommend speaking to your tax advisor regarding the tax implications and how this strategy fits into your overall plan.
Remember, though, that DIAs, like any investment product, aren't right for everyone. There is an element of trading investment portfolio access and growth potential for a guaranteed lifetime income stream when you need it. Since part of the trade-off is giving up some flexibility (access), it’s better to allocate a portion, rather than all, of your savings to a DIA. "The amount you commit to a DIA will have limited flexibility," notes Lynch, "but the trade-off is being confident that your income will be there when you need it."