With employer pensions increasingly a thing of the past, most Americans now need to build their own cash flow in 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 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 able to 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, reducing the effect of market volatility on your retirement income plan.
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 Investments Life Insurance Company.
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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 are giving up access to the assets you dedicate to this solution and 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 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
Fidelity believes it makes sense to 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, 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 begin—each additional investment subject to the interest rates available at the time of purchase—so you can increase your retirement cash flow (incrementally) over time. Similar to dollar-cost averaging, building your income plan in increments allows you to stagger your investments with a range of interest rates. Remember, periodic investment plans do not guarantee a profit or protect against a loss in a declining market.
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:
- 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.
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 invest in 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 payment.
Lastly, if you are age 73 or older required minimum distributions (RMD) can impact your overall portfolio. The SECURE Act 2.0 that went into effect January 1, 2023, has also provided a new tax treatment for DIAs. The cash flow generated can potentially offset your RMD obligation from other accounts. There are several factors to consider and we recommend speaking to your tax advisor regarding the tax implications. If you decide to use the income from the DIA to satisfy your RMD, you can potentially allow other parts of your portfolio to grow. Please note this applies to all DIAs including those established before January 1, 2023.
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 income annuity with their other IRAs for the purposes of determining their required minimum distributions. If you are 73 and older, cash flow generated from the income annuity can be used to potentially offset RMD obligations from other accounts, 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 growth potential for a guaranteed lifetime income stream when you need it. 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 Lynch, "but the trade-off is being confident that your income will be there when you need it."