Just as your life has likely been nothing like your parents’, your retirement probably won’t be either. It’s no longer as simple as signing up for Social Security, collecting your pension, and settling back. You will probably be more active, live and work longer, and need to rely more on what you’ve saved for income. And that means ensuring that this income has the potential to last for your lifetime and to weather rising health care expenses, inflation, and market ups and downs.
While this may sound overwhelming, it doesn’t have to be. First, take the time needed to make a smart choice around how and when to take Social Security, which is an important source of guaranteed income in retirement. (Read Viewpoints: How to get the most from Social Security). Then, turn your focus to creating a diversified income strategy that leverages three types of income-generating investments: fixed-income annuities, variable annuities, and an investment portfolio. Your mix can be made up of one, two, or all three types in various proportions, based on your preferences and income needs.
“Together, these components can work to help provide a stream of guaranteed income1, the potential for growth, some flexibility to refine your plan over time, and protection from market volatility,” explains Fidelity executive vice president John Sweeney.
Creating a plan that includes some guaranteed income is particularly important if you happen to retire when the markets are down or inflation is rising for a prolonged period. The chart below shows that if you had just started taking withdrawals from your retirement investments in 1972 (when the markets were down and inflation was rising), your investment portfolio would have been depleted early in your retirement. The earlier a market downturn happens in retirement, the greater the effect on your portfolio. That’s why it’s important to lock in some guaranteed income for retirement so you can cover essential expenses no matter what the markets do.
Components of a diversified income strategy
We believe it makes sense to use guaranteed income1 from fixed-income annuities and certain types of variable annuities,2 in addition to your Social Security or pension income, to help ensure that your essential expenses (food, utilities, health care, and other must-haves) are covered—even if a bear market hits in the early years. Then you can position your investment portfolio for growth, as well as use it for your discretionary spending (vacations, hobbies, and other nice-to-haves).
“By diversifying your income, you can create an efficient retirement strategy—one that uses the least amount of savings to generate the after-tax income you need,” notes Klara Iskoz, CFA®, vice president in Fidelity Strategic Advisers.
Let’s take a closer look at the three components that supplement Social Security.
1. Fixed-income annuities: guaranteed income
A fixed-income annuity is a contract with an insurance company that, in return for an up-front investment, guarantees to pay you (or you and another person) a set amount of income either for the rest of your life or for a set period of time. The income could start immediately or on a future date that you select.
Why do we suggest including a fixed-income annuity as part of a diversified income strategy? It’s straightforward: Fixed annuities, along with Social Security and/or pensions, provide guaranteed income to help meet essential expenses. The insurance company is obligated to make payments to you for a specific time frame you select, or if you choose a lifetime option, the payments will occur as long as you or your spouse lives. With either the defined period or lifetime option, payments will continue to occur regardless of what happens in the financial markets, subject to the claims paying ability of the insurer.
There are two things that a typical fixed-income annuity won’t provide: access to the money you invested and growth potential. Because you give up access to the savings you use to purchase this type of annuity, you will need to have other assets available to address unexpected expenses that might crop up. And because you also forgo any market growth potential for this money, we believe a fixed-income annuity should be only a portion of your overall strategy.
We generally suggest you consider a fixed-income annuity with a cost-of-living adjustment (COLA) to help protect your income payments from inflation. For example, if you use additional assets to purchase a 2% COLA for your annuity, your income payments will increase by 2% every year and can help address the impact of inflation.
2. Variable annuities2: guarantees and growth potential
Unlike fixed-income annuities, variable annuities have underlying investment options that provide potential for growth and that may help offset inflation. A variable income annuity guarantees payments for as long as you live. Depending on the specific guarantees of the annuity, these income payments may go up or down based on the performance of the underlying investments. You can pay extra for a deferred variable annuity with a guaranteed minimum withdrawal benefit (GMWB) to ensure that your payments won’t dip below a set amount, though they may rise due to market performance.
Why might you purchase a variable annuity rather than invest the money directly in the stock market? A variable annuity with a lifetime income payment option may help protect you against the risk of outliving your assets. This is much harder for an investment portfolio to do on a consistent basis.
As with a fixed-income annuity, however, you may have to give up access to savings you use to purchase certain variable annuities.
3. Withdrawals from an investment portfolio: growth potential and flexibility
An investment portfolio with a mix of equities, fixed income, and short-term investments that matches your time horizon and risk tolerance can be an essential part of a diversified income strategy. Why? It provides flexibility (you can generally access your money when you need it) and growth potential, which is as critical in retirement as it is when you are saving for it, because you may need these assets to last 30 years or more. Of course, there is market risk with an investment portfolio, which is why we suggest that it be used to cover discretionary expenses in retirement to the extent possible or necessary. If the market were to perform poorly, you could always cut back on some of your discretionary expenses to help compensate.
Creating and managing an investment portfolio in retirement can be challenging and it requires discipline. You need to choose an asset mix that reflects your time horizon and risk tolerance, select investments that match your goals, monitor them over time, rebalance when needed and, finally, look for opportunities to maximize your after-tax returns.
Once you’ve created your investment portfolio, the next question is how much you should withdraw each year. The answer depends on how long you want your money to last and how it’s invested. As a rule of thumb, though, our historical research suggests that an annual withdrawal amount of 4% of your starting balance, adjusted annually for inflation, may be sustainable throughout 27 years of retirement. (This assumes a balanced portfolio of 50% stocks, 40% bonds, and 10% short term investments for the duration of retirement.)
When determining your own potentially sustainable withdrawal rate, be sure to consider factors such as inflation, time horizon, market conditions, and your asset allocation. Fidelity Income Strategy Evaluator®3 can help you determine your rate.
So, let’s bring the concept of income diversification to life using the Fidelity Income Strategy Evaluator® tool. Consider a hypothetical couple, Marsha and Charles Wilson.4 They’re both 63 and retired, and have $600,000 in savings invested in a balanced portfolio of 50% stocks, 40% bonds, and 10% short-term investments. Their monthly expenses add up to $4,200, of which $3,000 is essential and $1,200 is discretionary. Their monthly income from Social Security and pensions, adjusted for taxes, is $2,635. So, they estimate they’ll need to generate $1,565 more a month from their savings, of which $365 is for essential expenses.
Discretionary expenses are important to the Wilsons, too. They want to travel and spend money on their children and grandchildren. There’s also a history of longevity in their family, so they’re planning for a 31-year time frame.
Let’s look at two different hypothetical income strategies.
Income strategy 1: withdrawals from an investment portfolio
Can the Wilsons rely on just regular withdrawals from their portfolio to fill their $1,565-a-month income gap? Using our analysis, they would need to invest approximately $533,629 of their $600,000 to potentially generate $1,565 a month based on a withdrawal rate of about 4% per year. Using average market conditions (what we call a 50% confidence level), their portfolio would continue to generate that amount (adjusted annually for inflation) and could grow to $2,327,3135 after 31 years. However, if they were to assume a 0% return market, not only would their portfolio run out of money early, but they would need to tap into their surplus assets, and, after 22 years, all their retirement savings would be depleted.
Although the average market scenario looks good on paper, no one can predict market performance and the Wilsons don’t want to take chances with all their hard-earned money. The impact of bad markets on a portfolio while you’re saving and investing during your working years may slow down your plans and delay your future retirement date. However, after you enter retirement, down markets can be devastating, because your ability to recover is limited because you are taking withdrawals. Because of these considerations, the Wilsons are concerned that this strategy might not be able to generate enough money in tough years.
Income strategy 2: withdrawals from an investment portfolio and annuities
The Wilsons don’t want to risk running out of money, and they’re willing to give up access to some of their savings and some growth potential in exchange for guaranteed income.
To achieve their objectives, they might consider investing $493,901 of their $600,000 retirement savings in a multiproduct strategy. To cover their gap in essential expenses, they could put $148,170 into a joint-life fixed-income annuity with a 2% COLA , and $98,780 into a joint-life variable income annuity. Both annuities would provide guaranteed lifetime income, but the payments would differ. The monthly payment from the fixed-income annuity would start at $450 and increase 2% each year thereafter. The initial monthly payment for the variable income annuity would be $357, with subsequent payments fluctuating based on the underlying investments’ market performance. The couple would leave $246,951 invested in a balanced portfolio. They would withdraw $758 a month for the first year and then increase the amount 2.5% each year thereafter to account for inflation (see pie chart, right, for details).
This strategy provides both upside potential and downside protection. In average market conditions, their income need is satisfied throughout their lifetime and their portfolio could grow to almost $1.8 million5—similar to the first strategy’s outcome under this market scenario. But what’s more important is that they now have the protection of lifetime income to ensure that their essential expenses are covered throughout retirement. Even in a 0% return market, although their investment portfolio (including reserves) runs out of money by year 22, their annuities continue to pay income for their lifetime. This results in an increase of $107,600 in cumulative lifetime income when compared with Strategy 1 ($655,100 versus $547,5005).
Which strategy covers all the bases?
Income strategy 2 delivers the desired mix of flexibility, growth potential, and guarantees to address the Wilsons’ income needs. We believe this approach will more effectively weather rising health care expenses, inflation, market changes, and longevity while providing guaranteed lifetime income (see the comparison below).
|How do income strategies stack up?|
|Investment portfolio only||Investment portfolio and guaranteed
income from annuities
|Retirement savings available||$600,000||$600,000|
|Assets needed for income strategy||$533,629
in balanced portfolio
|Estimated initial monthly income (after tax)||$1,565||$1,565
|0% return market5
|For illustrative purposes only. This hypothetical example was created using the Fidelity Income Strategy Evaluator. Results are calculated based on how the hypothetical portfolio might have performed in a certain percentage of simulated market scenarios. These percentages are called confidence levels. Average market results are based on a 50% confidence level. This means that in 50% of the market scenarios tested, the hypothetical portfolio performed at least as well as the results shown for the average market. Results are also calculated assuming that the hypothetical portfolio experienced a 0% return environment. The variable income annuity values reflect the deduction of the annual annuity charge. Fund fees will also apply and are not reflected. (See the disclosure section below for more information.) Planning age is 31 years from today. Guarantees apply to certain insurance and annuity products (not securities, variable, or investment advisory products) and are subject to product terms, exclusions, and limitations, and to the claims-paying ability and financial strength of the issuing insurance company.
All figures are estimated.
An investment portfolio plus annuities gives the Wilsons some guaranteed income to help cover their essential expenses as long as they live, and lets them invest for growth to help fight inflation, while utilizing the least amount of their savings. Of course, they need to be comfortable giving up access to the money used to purchase annuities in exchange for guaranteed income (see the pros and cons below).
Two income-generating strategies: a comparison
|Strategy||How it works||Potential
|Withdrawals from investment portfolio||Withdrawals of both earnings and principal from a diversified portfolio of investments, managed for total return||
|Combining withdrawals and guaranteed income from annuities1||Covers essentials with guaranteed income sources and uses withdrawals from a diversified portfolio to cover discretionary expenses||
These are just general examples of income strategies. The sustainability of a portfolio depends on the investor having the discipline to stick with his/her strategy, and will vary based on actual returns, withdrawals, and taxes.
Everyone’s situation is unique, so there’s no one diversified income strategy that will work for all investors. You’ll need to determine what’s more important to you in retirement—growth potential, guarantees, flexibility, or potential preservation—to help you pinpoint the strategy that is right for you. For instance, more growth potential can mean settling for less guaranteed income. With more guarantees, you get less growth potential and less flexibility. Consider, too, your family’s history regarding longevity and whether you plan to leave a legacy to your heirs.
The following questions can help you get started on your own personalized income strategy:
- Would you call yourself a sophisticated investor with many years of experience?
- Are you willing to accept ups and downs in asset value and/or income value in exchange for potential growth?
- Do you need income that is guaranteed to last for a lifetime?
- To get guaranteed income, would you be comfortable giving up access to a portion of your assets?
- How important is it to have your income protected from market downturns?
- Are you willing to pay a fee for help managing your retirement portfolio?
Retirement is a new and potentially long chapter of your life. Why not take the time to figure out how you want to live it? Then, develop a retirement income plan that helps you do that.
Indexes are unmanaged. It is not possible to invest directly in an index.