Create income that can last a lifetime
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 feasibility 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 plan. But, by 2015, only 20% did. Over that same seventeen year stretch, 23% of Fortune 500 employers froze their primary DB plan and 15% closed DB plans to new hires.1Today, 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 fixed lifetime income annuity. Resembling a traditional pension plan,2this investment vehicle can provide a guaranteed3stream of income that lasts a lifetime and is not vulnerable to the inevitable ups and downs of the market.
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 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.
But not all income annuities are alike — some might have high embedded fees or be issued by a company whose financial rating is low. 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.
What is a fixed lifetime income annuity?
A fixed 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 investment, the insurance company guarantees to pay you (or you and your spouse) a set rate of income for life. Recently expanded, this annuity category also gives you the option of starting your income either immediately or some time 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 three 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, you can reduce the risk that inflation will diminish your investments’ purchasing power over time.
The trade-off with an income annuity is that you 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 and the date you plan to begin receiving income. The three most common payment options are:
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 because 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.
2. 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 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 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 beneficiary(ies). 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.
In addition to different payment options, annuities can include different features. One of the more popular features 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 March 1, 1951, and started receiving income on April 21, 2016, with a 2% annual increase.
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?”
How do fixed lifetime income annuities fit into a retirement portfolio?
A fixed 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.
“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.
2. Unlike pensions, annuities must be purchased, and they differ with respect to complexity, fees, taxes, and suitability.
3. Guarantees are subject to the claims-paying ability of the issuing insurance company.
4. Any assets allocated to income annuities may have limited liquidity.
Guidance provided by Fidelity through the Planning & Guidance Center is educational in nature, is not individualized, and is not intended to serve as the primary basis for your investment or tax-planning decisions.
IMPORTANT: The projections or other information generated by Fidelity’s Planning & Guidance Center Retirement Analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary with each use and over time.
Fixed annuities available at Fidelity are issued by third-party insurance companies, which are not affiliated with any Fidelity Investments company. These products are distributed by Fidelity Insurance Agency, Inc. A contract’s financial guarantees are solely the responsibility of, and are subject to the claims-paying ability of, the issuing insurance company.
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Originally published at www.fidelity.com on July 27, 2016.