Under the so-called 4% rule, a retiree can start by withdrawing 4% of accumulated savings, raise withdrawals to match inflation and, with certain assumptions (diversified portfolio, historic results for investments and inflation), be fairly confident the money will last for 30 years. The original research behind this approach dates back 20 years so it might be not surprising that advisors are evaluating alternatives.
“Recent studies indicate the 4% rule may have a high failure rate given today’s low interest rates,” says Ric Runestad, who heads a financial services firm in Fort Wayne, Ind. The possibility of repeated bear markets adds to the risk of this regimen, as inflation-expanded withdrawals could speed asset depletion.
If not a 4% drawdown, indexed to inflation, what strategy might produce meaningful cash flow along with longevity protection? One answer is to buy an immediate annuity. A trip through some online calculators shows that the current payout on a joint life annuity for a couple ages 66 and 63 might be about $55,000 a year, or 5.5% on a $1 million investment. That $55,000 a year would beat $40,000 (4% of $1 million), and it will be paid as long as either spouse is alive so running out of cash flow wouldn’t be a concern.
On the other hand, the $55,000 annual annuity payment would be fixed while the initial $40,000 withdrawal could reach $55,000 in 11 years, assuming 3% annual inflation. If all the numbers hold up, the 4% rule would provide this couple with larger payments in their 80s and 90s; the 4% rule would provide access to their principal and the chance to leave some savings to their children.
In practice, advisors might not want to recommend loading up on immediate annuities at today’s low yields. Mixing a smaller immediate annuity with a portfolio drawdown formula for the balance of a client’s savings could provide some longevity insurance as well as inflation protection and legacy potential.
Runestad suggests still another approach: relying on a deferred annuity—specifically, a fixed index annuity (FIA)—for lifelong cash flow. “With an immediate annuity,” he says, “asset value is essentially traded for a stream of income. Many baby boomers find the idea of giving their assets to an insurance company unacceptable. If they annuitize on Tuesday and get hit by a bus on Wednesday, the insurance company keeps their money. If they want to stop and then restart the income, they can’t. If they need to take additional money from the cash value, they can’t because there no longer is a cash value. All interest accumulated for the length of the contract belongs to the insurance company, not the annuitant.”
According to Runestad, with an FIA a retiree can have significant guaranteed income for life while still controlling the underlying asset. With this type of deferred annuity there is usually a possibility of a substantial market-linked return along with a floor to protect against market losses. Typically, an optional income rider allows investors to withdraw certain amounts for the rest of their life, even if market results lag.
“Some income riders,” says Runestad, “allow consumers to stop and start their payments, withdraw more than the set amount (with a corresponding reduction in future payments), and withdraw the entire amount of cash value (possibly triggering surrender charges).” Other benefits might include the chance to earn interest on the cash value during the payout phase and to leave funds to beneficiaries if the investor dies with money left in the cash value.
What’s the downside for clients? As with any annuity, the financial strength of the insurance company is vital. “First and foremost,” says Runestad, “I look at the company that is offering the FIA. A promise is only as good as the party making it, which holds true for insurance companies. Hence, we search out the global behemoths that are offering cutting edge products.”
Besides looking for sound insurers, Runestad tells clients that they are not guaranteed of any gains and their account value can go down with some FIAs, due the cost of the income rider.
Moreover, deferred annuities such as FIAs often come with surrender charges for five to 10 years. “We must ensure that the client has enough liquid funds outside of the FIA for emergencies,” says Runestad, “especially in the first year when some of these products don't have a free withdrawal amount. It is imperative that clients not get into a situation where they are losing money in order to access their money. Making sure the client has enough liquid assets available to them during the surrender period has become a matter of great concern across the industry and has resulted in much more stringent suitability.”
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.