Annuities vs. the 4% Rule: Why guaranteed income wins

New research published in the Journal of Retirement found that full or partial annuitization leads to better retirement income outcomes than the 4% rule. The research also found that those with smaller nest eggs benefit from annuitizing more of their income.

Researchers found that for anyone retiring with $250,000 or more in savings, a strategy of systematic withdrawals from more liquid investments or cash savings combined with annuities outperforms other strategies. This remained true whether the retiree bought an immediate annuity or had a strategy that included a gradual, laddered annuitization process.

The popular 4% rule is problematic, the researchers found. Although the 4% rule offers flexibility, withdrawing 4% of initial wealth, subsequently indexed to inflation each year, has significant failure rates for retirees at older ages.

Those retiring with less than $250,000 benefit most by annuitizing higher portions of their savings, if not all their savings.

The research evaluated different retirement income strategies for various retirement savings levels (varying mixes of annuities and regular withdrawals according to the 4% rule), examined the distributions of their outcomes, and ranked the strategies within the research paper.

David Chavern, president and CEO of the American Council of Life Insurers, supported an earlier version of this research, and discussed its implications with InsuranceNewsNet.

“There has been so much focus on saving for retirement,” he said. “But now, how you spend those savings is as big an issue as how much you save. How do people take those retirement savings and spend them when a lot of things are uncertain? Your health is uncertain, the economy is uncertain and there has been this historical idea about the 4% rule.”

But the 4% rule wasn’t the be all and end all of retirement withdrawal, Chavern said.

“It was kind of a rough idea and you need to go a step lower in terms of the techniques people must use to create the best outcomes for them throughout retirement.”

Annuitizing some savings = Best retirement outcome

After looking at different modeling, researchers found that a combination of drawing down savings in retirement and annuitizing some of those savings for guaranteed lifetime income provides the best outcome for retirees.

“This combination of using some of your money flexibly, annuitizing a chunk of it, so you have some stability in the income, and then having Social Security is the best combined outcome for people,” Chavern said. “We thought this was a great piece of research. We're happy that it's out there, but we're happy about the conversation it provokes about exactly what is the best way to spend in order to have the best retirement life you can have.”

The strategy of annuitizing part of retirement savings especially benefits those who do not have a lot of savings.

“The lower the amount of savings you have, the better off you are annuitizing a chunk of that,” Chavern said. “These are people for whom market volatility is particularly dangerous. Market volatility may not just give them anxiety; it may reduce their capacity to pay the rent. So there were additional benefits for people who have less savings to obtain a secure stream of income from those savings.”

4% rule doesn't address longevity risk

The researchers noted that systematic withdrawals, such as the 4% rule or required minimum distributions, do not address longevity risks in retirement. In fact, they noted, the 4% rule “has significant failure rates at advanced ages.”

Converting retirement savings to an immediate life annuity upon retirement provides a predictable lifetime income stream, the researchers said. “For the most common individual preferences, however, complete annuitization of the entire account is unlikely optimal or desirable. Partial annuitization, either a one-time purchase or a gradual process, in combination with systematic withdrawals tend to work best.”

The issue of how to spend retirement savings after the days of punching a clock are over “is a complicated problem,” Chavern said.

“People think, ‘As long as I have the money, I’ll figure out how to spend it.’ Well, you need to figure it out now. And it turns out that’s a complicated problem where you have to make the right choices. And I hope there are a lot more studies on the question of how to spend your money, because that’s important to so many people.”

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