New Research Shows Full or Partial Annuitization Leads to Better Retirement Income Outcomes than 4% Rule

Retirement Experts Mark Warshawsky and Gaobo Pang find value of annuities applies widely in retirement income strategies

Retirement planning today is not what it used to be.

Retirees in the previous century, and workers who were planning for retirement, often relied on traditional pensions that provided income for life. But these days, it is much more common for a worker to have a 401(k) or an individual retirement account.

401(k)s and IRAs are popular retirement savings plans. They give people control of their long-term financial planning. People can see how much they are saving. They also put the responsibility for investing for the long-term and withdrawing money in retirement on the retiree.

Managing money throughout retirement and making sure it doesn’t run out is not an easy task. It is an issue I have been studying for years, particularly on ways that retirees can maximize their retirement savings as they turn it into lifetime income.

Most recently I, along with researcher Gaobo Pang, looked at four strategies for withdrawing money from retirement accounts. Our goal was to determine which asset management strategies maximize retirement income. We did this research with the financial support of the American Council of Life Insurers (ACLI).

We started with a common strategy called the 4% rule — withdrawing 4% every year from retirement savings — 401(k)s and IRAs, for example — and increasing that amount annually with inflation.

In the second strategy we modeled a full nest egg of retirement savings that are used to buy a life annuity from an insurance company — or obtaining an annuity through an employer’s 401(k) plan if offered. This would provide an income for as long as you live, regardless of what happens in the economy or the stock and bond markets. Even if you live very long, to age 100, 105 or longer, which is certainly possible for some people these days, the annuity keeps paying out.

In a third example, we combined the two strategies: half of retirement savings withdrawn annually per the 4% rule and a life annuity purchased with the remaining half.

And the fourth strategy is a variant of the half-and-half approach where new annuities are purchased gradually. The initial 20% of savings is dedicated to an annuity, with the percentage ramped up through additional annuity purchases over time so that 60 percent is committed to annuities. At all times, the remaining retirement savings are committed to the 4 percent annual withdrawal strategy.

Which strategy performed best, according to individual preferences and situations?

First, the amount in retirement savings is important to consider.

The strategy that used the full amount of retirement savings to purchase an annuity delivers the best results for retirees with modest savings, $250,000 or less.

Meanwhile, the combination of annuitizing half of one’s retirement savings while withdrawing 4% annually works best for most people.

The advantage of the 4% rule in this model is that it keeps assets accessible — assets that might be needed for a big home repair, medical expenses, to cover an emergency, to leave an inheritance or for some other purpose.

But under the 4%-only strategy where money is withdrawn every year in retirement, there’s a risk of running out of money for people who live into their late 80s.

Of course, people ask: am I really going to live that long? With so many Americans living longer and longer, the fact is you might. If you’re married or in a relationship where finances are tied, at least one in the couple could live that long or even longer. The 4 percent strategy is riskier today than it was when first advanced in the late 1980s. Times have changed a lot since then.

Another very interesting finding coming out of our research relates to legislation passed by Congress that allows people to delay withdrawing assets from their 401(k)s and IRAs.

The new law makes it easier for retirees to buy an annuity and reduce the amount of money they are required to withdraw when they are in their 70s. The required minimum distribution rule, or RMD, forces retirees today to begin taking money out of their accounts no later than age 73. That will increase to age 75 in future years.

While Congress provides tax advantages for retirement savings, it does not want those advantages to last forever for the saver. People will have to pay taxes on their earnings at some point. For those who can wait to withdraw money until the RMD requirements kick in, perhaps because they continue working past traditional retirement ages, the 50/50 approach of partial annuitization and 4% withdrawals annually is optimal. That is because income received from your annuity reduces your required minimum distributions.

The surprise was how much this strategy reduces the amount a retiree has to take out from their savings after the annuity purchase. In some cases this 50/50 strategy significantly reduces the amount you need to take out, especially in the earlier years of retirement. The retiree gets to keep more assets than they would otherwise — they pay less in taxes on withdrawals.

To put our research findings into its simplest form, people with modest sums of retirement savings would probably do best to annuitize all of it. People with $500,000 or more would probably do best with annuitizing half of their assets and withdrawing at 4% annually the remaining half. In all events, the annuity would play a major role to optimize retirement income.

You can reach Mark Warshawsky on LinkedIn.