What a lifetime income annuity can do
- Hedge against market swings
- Provide guaranteed income for life
- Help diversify your income sources
The face of retirement in America has changed radically in recent decades. People are living longer. Pensions are increasingly rare. Add in market volatility, as well as questions surrounding the long-term financial health of Social Security, and it's no wonder many people feel anxious about funding their retirement.
If you were a newly hired employee at a Fortune 500 company in 1998, you likely had access to a defined benefit (DB) plan. But, by 2015, only 20% of employees did. Over that same 17-year stretch, 23% of Fortune 500 employers froze their primary DB plan and 15% closed DB plans to new hires.1 Today, the responsibility of financing your retirement is likely to fall squarely on your shoulders.
But there is a way to create a plan that can give you a regular "retirement paycheck"—through a lifetime income annuity. Resembling a traditional pension plan,2 this investment vehicle can provide a guaranteed3 stream of income that lasts a lifetime and is not vulnerable to the inevitable ups and downs of the market.4
An added benefit is that by locking in some guaranteed income, you will have more freedom to invest the remainder of your retirement assets for growth potential as part of a diversified income plan. Investors might want to consider an income annuity to cover the portion of their essential expenses not covered by other guaranteed income sources like Social Security or a pension.
"When you know that your essential expenses, your day-to-day needs, are covered for the rest of your life by a guaranteed source of income, you gain the peace of mind and financial confidence to pursue those things you want to do in retirement," says Roy Benjamin, vice president of product development and an actuary at Fidelity.
A lifetime income annuity represents a contract with an insurance company whose purpose is to convert a portion of your retirement savings (an amount you choose) into a predictable lifetime income stream. In return for a lump-sum investment, the insurance company guarantees to pay you (or you and your spouse) a set amount of income for life. You also have the option of starting your income either immediately or at a date you select in the future.
Because an annuity's guarantees are only as strong as the insurance company providing them, you should consider the strength of the company you select and its ability to meet its future income obligations.
Having the backing of an insurance company can help mitigate 3 key retirement risks that, generally, can be very challenging to manage by yourself:
- Market risk – Regardless of whether the market goes up or down, the insurance company is obligated to provide you with income payments every year.
- Longevity risk – Rather than trying to figure out how much of your savings you can spend each year before running out of money, the insurance company assumes the responsibility for paying you as long as you live.
- Inflation risk – By including an annual increase option, where available, you can reduce the risk that inflation will diminish your investments' purchasing power over time.
But not all lifetime income annuities are alike—some might provide higher levels of income with little or no flexibility in accessing assets, while others may provide lower levels of income with greater flexibility.
So you'll want to take the time to understand the differences among them and figure out which features might best meet your particular needs.
Let's take a closer look at 2 categories of lifetime income annuities, namely, a fixed lifetime income annuity and a fixed annuity with guaranteed lifetime withdrawal benefits.
What is a fixed lifetime income annuity?
As part of a diversified income plan, a fixed lifetime income annuity can provide you with guaranteed income for the rest of your life with payments starting immediately or at a future date that you select when you purchase the annuity.
These annuities offer:
- Lifetime Income – Avoid outliving your assets by ensuring you will receive a guaranteed stream of income beginning on a date you choose, up to 40 years from your time of purchase. You will also have the security of steady payments regardless of market fluctuations and downturns.
- Personalization – You may choose to receive guaranteed income for your lifetime (or for the lives of you and another person for joint accounts). In addition, you have the choice to purchase optional features to include protection for your beneficiaries or add an annual payment increase feature to help your payment keep pace with inflation.
The trade-off with an income annuity is that you typically must give up control of the portion of the savings you use to purchase one. In exchange, you don't have to manage your account to generate income, and you can secure a predictable income that lasts the rest of your life. What's more, fixed lifetime income annuities are often able to provide higher income payments than other products, such as bonds, CDs, or money market funds, due to the "longevity bonus" they can provide (see the chart below).
While the payments from traditional income solutions are limited to return of principal and interest from an investment, fixed lifetime income annuities also make available the ability to share in the longevity benefits of a "mortality pool." Effectively, assets from annuitants with a shorter life span remain in the mortality pool to support the payouts collected by those with a longer life span. Put simply, the longer you live, the more money you will receive.
What are the payment options and features?
Fixed lifetime income annuities offer various options that pay different amounts of income, based on the types of guarantees they provide. The 3 most common payment options are:
- Life with a cash refund – With this option, the priority is ensuring that you never get back less in payments than your original investment. As with many income annuities, you get a lifetime income payment (but typically lower than a life-only option). If you pass away before receiving payments that total your original investment, the remaining value will be paid to your beneficiaries. This means, for example, that if you are paid only $10,000 of a $100,000 policy during your lifetime, the remaining $90,000 is paid to your heirs.
- Life with a guarantee period – You'll receive income payments for the rest of your life. However, if you pass away before the guarantee period ends, any remaining income payments will continue to your beneficiaries until the end of the guarantee period. Here, you get a somewhat lower payment than life only, because the insurance company is guaranteeing to make payments for a minimum number of years.
- Life only – You'll receive income payments over either your lifetime alone or the joint lifetimes of you and your spouse (which would decrease the amount of the payment because it would be based on 2 lifetimes). The life-only option offers the highest possible income payment because it's only for as long as you or you and your spouse live; no money goes to your heirs. This option typically works well for those in good health and who anticipate a long life.
In addition to different payment options, annuities can include different features. One example is an annual increase option. This feature provides for annual increases in the payment amount beginning on the anniversary following your initial payment. The annual increase can be based on a fixed percentage or linked to changes in the Consumer Price Index (CPI), referred to as "inflation." Note that the initial payment amount for an annuity with this option may be lower than an identical annuity without the option.
Let's take a look at how these payment options might differ, using Fidelity's Guaranteed Income Estimator tool. Shown below are the results for a hypothetical 65-year-old man who invests $100,000 in a lifetime income annuity starting today. We assume that he was born on August 1, 1952, and started receiving income on October 1, 2017.
What's right for you? Choosing a payment option means focusing on the specific features of a fixed lifetime income annuity and your personal goals. "Before making a decision, you should ask yourself some key questions," says Benjamin. "What is most important to you? Would you rather receive the highest possible guaranteed cash flow, or would you be comfortable with a somewhat lower income payment in order to provide potential protection to your beneficiaries?"
What is a fixed annuity with a guaranteed lifetime withdrawal benefit?
As part of a diversified income plan, a fixed deferred annuity with a guaranteed lifetime withdrawal benefit (GLWB) can provide guaranteed income for the rest of your life, starting on a date you select when you’re ready to start receiving income.
These annuities offer:
- Lifetime Income – Avoid outliving your assets by guaranteeing a lifetime withdrawal benefit amount, beginning on a date you select.
- Flexibility – You choose when you would like to start receiving income, but if your situation changes and you need some or all of your money sooner, you have access to any Accumulation Value in your contract. 5
From the time of purchase, your future income amount is typically guaranteed to increase on each contract anniversary for the first 10 years or until your first lifetime withdrawal, whichever comes first. You will know how much income you (or you and your spouse for joint contracts) will receive each year at any age you decide to start lifetime withdrawals.2 Most importantly, you will have the security of a guaranteed cash flow, regardless of market fluctuations and downturns. Finally, in the event of your death, your beneficiaries will receive any remaining accumulation value in the policy.
How do lifetime income annuities fit into a retirement portfolio?
A lifetime income annuity can help diversify your retirement income portfolio so a portion of your income is shielded from market volatility. Generally, Fidelity believes that assets allocated to the purchase of fixed income annuities should represent not more than 50% of your liquid net assets. Why? Well, even though these products provide guaranteed income for life, they also require that you give up liquidity and access to that part of your portfolio.
Ultimately, it will come down to your individual situation and personal preferences whether you choose one or a combination of lifetime income annuities. Each can play an important role in strengthening your overall portfolio. "Spreading your sources of retirement income across different types of investment products can help you balance your risks and maintain some liquidity and opportunity for potential growth over the long term," suggests Benjamin.