The days when retirement might have meant a gold watch and a pension for life may be long gone for most Americans. Add in heightened market volatility, as well as questions surrounding the long-term feasibility of Social Security, and it’s no wonder many people feel anxious about funding their retirement.
In 1985, if you were hired by one of the 100 largest employers in the U.S., 89 out of a hundred offered you a traditional defined benefit pension.1 By the year 2012, it was down to 11. This is a huge shift in the financing of retirement.
But there is a way to create your own plan that can give you a regular “retirement paycheck” via a lifetime income annuity. Resembling a traditional pension plan,2 this investment vehicle can provide a guaranteed3 stream of income that lasts a lifetime. It can also help you diversify your income sources and act as a hedge against market fluctuations, which may help put your mind more at ease.
Investors might want to consider an annuity to cover their essential expenses in retirement. "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.
But not all income annuities are alike—some might have high embedded fees or are issued by a company whose financial rating is low. So, you’ll want to take the time to understand the differences between them and figure out which features might best meet your particular needs.
What is a lifetime income annuity?
A lifetime income annuity represents a contract with an insurance company whose purpose is to convert part of your retirement savings (an amount you choose) into a predictable lifetime income stream. In return for a lump sum payment, the insurance company guarantees to pay you (or you and your spouse) a set rate of income for life.
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 allows you to transfer two key retirement risks that can generally 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.
The trade-off with an income annuity is that you must give up control over the portion of the savings that you use to purchase it. In return, you can enjoy the freedom of not having to manage your account to generate income and can secure a predictable income that lasts the rest of your life.
What’s more, 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 chart below). While the payments from traditional income solutions are limited to just return of principal and interest from an investment, lifetime income annuities also make available the ability to share in the longevity benefits of a “mortality pool.”
Effectively, those annuitants who don't live as long subsidize those annuitants who live longer. The process is similar to homeowner's insurance, whereby some people are able to collect more money from the insurance pool than others do. Some people are able to collect more because others in the pool die sooner than the actuarial tables predicted. Therefore, the remaining money left in the annuity pool is shared with less people, potentially boosting the remaining investor’s payouts.
"Simply stated, no other financial product can match the long-term guaranteed income provided by mortality credits," says Benjamin.
How do they work?
Lifetime income annuities offer various payment options that pay different amounts of income, based on the types of guarantees that they provide. The three most common payment options include:
1. 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 since it would be based on two 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 expectancy.
2. Life with a Guaranteed Period. You’ll receive income payments for the rest of your life that are guaranteed for a minimum number of years. If you pass away before the guarantee period ends, any remaining income payments will continue to your beneficiary(ies) 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.
3. 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 somewhat lower than the two options above). If you pass away before being repaid, the remaining value of your original investment will be paid to your beneficiary(ies). This means, for example, if you are paid only $10,000 of a $100,000 policy during your lifetime, the remaining $90,000 can be paid immediately to your heirs.
Here’s a hypothetical example of how these payments might differ, calculated by Fidelity’s Guaranteed Income Estimator tool. Assume, starting today, that a 70-year-old man invests $500,000 in a lifetime income annuity. His monthly payments under each of the three payment options described above could be:
|Payment Option*||Life Only||Life with a 10-year Guarantee Period||Life with a Cash Refund|
|*Assumes owner is a single Connecticut male resident using qualified money. For illustrative purposes only. Based on the best rates available as of 04/30/13 for fixed income annuities available through Fidelity. Rates can change daily. Payments quoted do not reflect income taxes that will be due. For more information on the tool methodology, please consult the Guaranteed Income Estimator.|
Choosing a payment option means focusing on the specific features of a lifetime income annuity and your personal goals.
“At this point, you should ask yourself a couple questions before making a decision,” 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 payments to your beneficiaries?”
How do they 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 lifetime income annuities should be no 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.
"Spreading your sources of retirement income across different types of investment products can help you balance your risks and maintain some liquidity over the long term," suggests Benjamin.
Also, given their fixed income payments, lifetime income annuities offer less protection against inflation, so you may want to invest at least some of your retirement portfolio into more growth-oriented products to reduce inflation risk.