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IN A RECENT ONLINE discussion, I compared the benefits of an immediate-fixed annuity with the 4% retirement-income rule. The 4% rule suggests that investors can withdraw 4% from a well-balanced investment portfolio in the first year of retirement, and then add annual inflation adjustments without fear of running out of money over a 30-year retirement.
Using the NewRetirement annuity calculator, I found that a 65-year-old man could purchase an immediate annuity for $1 million, with a 3% annual inflation adjustment, and receive initial income of $54,000 a year. This annuity would continue monthly payments to our 65-year-old’s heirs if he died before getting back the entire $1 million through annuity payments.
Compare that with the $40,000 initial payment he’d receive on the same $1 million using the 4% rule. While the 4% rule allows withdrawals to increase each year to offset inflation, it still offers less income and less certainty than the annuity. For many, I believe, the annuity’s guaranteed and growing income should be more attractive than accepting the risk that the 4% strategy won’t pan out.
But most people in the discussion group disagreed with me, and strongly so. The response—often repeated—was, “The insurance company may go bankrupt.” Yes, that could happen. But the fact is, only three to five annuity-issuing insurance companies have failed over the past 10 years. These were small companies you’ve likely never heard of. The exact number of failures is unclear because some of the insurers in question are still winding down their operations.
But while everday investors may worry that annuity insurers will fail, large corporations seem unconcerned. Several years ago, IBM bought $16 billion in annuities from Prudential Financial for its employees’ pensions. My former employer did the same this year for $2 billion. It’s fair to say that the chances of bankruptcy, if you stick with large insurers with a high rating for financial strength, are negligible.
The comments that really fascinated me were those who claimed that, by using the 4% rule, they’d never run out of money, even when retiring in their 50s. Some even claimed they would eventually have more money in their accounts than when they began withdrawals.
Dave Ramsey says you can withdraw 8% a year from a diversified portfolio with no problem. He bases this on his claim that the S&P 500’s long-term average annual return is 12% or so, which is a bit of a stretch for most historical periods. Then he subtracts 4% for inflation’s bite, giving him his 8%. Simple, right?
YouTube financial commentators jumped on Ramsey’s advice, calling out its flaws. It’s risky to assume you’ll get average returns when both inflation and stock market results vary each year, often significantly. Ramsey didn’t take into account what’s called sequence-of-return risk, the chance that consecutive losing years will put a big dent in a portfolio’s worth, even as your withdrawals continue unabated.
If an 8% withdrawal rate is a nonstarter, how about 4% instead? I recently spent a fun afternoon viewing YouTube videos about the 4% rule from a variety of “experts.” Youza. Many claimed the rule is no longer valid.
It should be 3%, or 5%, or 6%, these experts say. Just tweak your investment mix to achieve a higher return percentage, some claim, and then you can withdraw more. Meanwhile, a new Morningstar study says the 4% rule is viable once again. Interestingly, the IRS’s required minimum distribution rate also works out to about 4%. I guess that’s convenient at least.
It’s the unknowns that make projections of the right withdrawal rate about as accurate as the fortune teller in the carnival kiosk. The unknowns include your age at retirement, the market cycle during your retirement, the rate of inflation you experience and the results for your individual investment mix. There’s a reason they call these retirement success projections a Monte Carlo simulation: You spin the wheel and you take your chances.
How to cope with these unknowns? One person in the discussion group said he wouldn’t take withdrawals during a down market, but rather pull money from cash reserves. He said his cash assets are sufficient to pay for five years of his expenses. Sounds like a good plan, just not in the real world. While HumbleDollar readers may have five years’ worth of expenses stashed in money market funds and certificates of deposit, I doubt most retirees have that sort of cash sitting around.
One thing not mentioned by anyone is the discipline needed to follow the 4% rule or a similar approach. For instance, you aren’t meant to pull out a lump sum when, say, the old car irretrievably breaks down and you need to buy a new one.
Based on my experience working in retirement benefits, I tend to think in terms of average folk. These are the kind of people who at age 65 have $280,000 saved for retirement and no earthly idea what their Social Security benefit will be. Is this large segment of society equipped to manage a complicated withdrawal strategy? Do average folk understand the risks of having 100% of retirement investments in an S&P 500-index fund or—for that matter—100% in bonds?
If you’re going to bet your 30-plus-year retirement finances on averages and assumptions, I think more than one strategy is necessary. Here’s my suggested mix of approaches:
Richard Quinn blogs at QuinnsCommentary.net. Before retiring, Dick was a compensation and benefits executive. Follow him on X (Twitter) @QuinnsComments and check out his earlier articles.
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I do have an annuity. I bought it in my 20s. Too bad I didn’t have more money to invest back then! It was a charitable gift annuity and my wife still receives the payments.
As I read the article and numerous comments, it strikes me that buying an annuity has many things in common with hiring an investment advisor, with the exception that company providing the annuity is taking the risk (for guaranteed or fixed annuities.)
As Richard and others have reminded us, many people either hire an investment advisor, buy annuities, or both, and they have good reasons.
For me, surprise, surprise, annuities are like their cousins, insurance–something to buy only when I can’t manage the risk myself, since the broker/dealer/company has to make a profit to do it for me.
With that in mind, one disadvantage (okay, once in a while it’s an advantage) is that once purchased, annuities can’t (easily) be sold. They are lifetime contracts. My father, however, used this to our benefit (maybe accidentally?) by purchasing annuities when he was dying. Fortunately they guaranteed return of principal, so we got that back (and annuities are usually guaranteed issue, no health exam required.) Whether it was the cancer or the cancer meds, he was especially susceptible to sales pitches in those terrible years.
I could not disagree with this article in stronger terms. Annuities are sold, not bought.