Update: Annuities Versus the 4% Rule of Thumb

Publish Date: May 28, 2024

The below analysis on GLWBs Versus the 4% Rule has been updated to today’s GLWB offerings.

I recently saw somebody write about how we should not compare annuities to the 4% rule.  Although I agree that there needs to be additional disclosures and education in the annuity part of the conversation, I disagree with not comparing the two.

Re-Anchor Clients in Reality, Not Fairy Dust.

I believe that consumers tend to “anchor” their retirement income expectations on the wrong thing and therefore should be “re-anchored” on reality.  For instance, consumers should be educated on the fact that William Bengen’s study in 1994 showed that in order to sustain a stock/bond retirement portfolio for 30+ years in retirement, the consumer should take out no more than 4% of their retirement account balance that first year in retirement, adjusted each year thereafter for inflation.  Consumers should also be aware of the new updated studies that show “rules of thumb” of 2.3% – 2.8%.  Note:  When using these comparisons versus annuities, it is important to discuss that annuities generally do not have “inflation adjustments”, as the 4% rule incorporates.  More on that in a bit.

This “re-anchoring” is important because many consumers know that the S&P 500 has gone up double digits on average for the last century and therefore overestimate what withdrawal rate they should utilize.  They have seen the glorification of the “stock and bond” markets and have likely seen the mountain charts like the Ibbotson SBBI Chart.  You know what charts I am referring to; those that show that the stock market has done double digit returns forever and that their $1 invested back when Adam met Eve (sarcasm) would be worth enough to purchase their own private island today. 

Thus, if a consumer has in their brain that “stocks and bonds” have always performed 7%, 8%, 10%, 12% then they will tend to believe that their retirement withdrawal rate is beyond the 4% that the research shows.  Even if a consumer has heard of the “4% withdrawal rule”, they may have not had the math laid out for them yet that is specific to their situation. It is important to explain to those that love their stocks and bonds – as I do –  that even though the S&P 500 could average 10% over the coming years, does not mean they will not run out of money by taking only 4% of the retirement value from their “stock and bond” portfolios!  How is this possible??  Because of sequence of returns risk that the “stock” portion can subject the client to and the low interest rates (still) that the “bond” portion can subject the client to.  And because of these two risks (sequence of returns and low rates), a client should not overestimate what their portfolios can do as far as withdrawal rates.  If you would like a graphic that helps you explain “sequence of returns risk” to your clients, email me.

To demonstrate my points in the previous paragraphs, I want to cite a study by Charles Schwab.  In their “2020 Modern Retirement Survey” they asked 2,000 higher net worth pre-retirees and newly-retired-retirees about how much money they had saved for retirement and also how much money they expected to take from their retirement portfolios.  The answers from the participants were that they had $920,400 in retirement savings (on average), that they planned on spending $135,100 per year from those portfolios (on average), and that they were generally confident in those dollar amounts allowing them to live the retirements they would like. 

I would argue that a 14.68% withdrawal rate ($135,100 Divided By $920,400) defies any retirement research I have seen!  Naturally, Schwab then points out that – contrary to these participants’ beliefs – a $920k portfolio will run out in only 7 years (obviously not including interest/appreciation)!  Clearly, these consumers should have the math explained to them.  Even if the consumers understand the new “rules of thumb”, they may be experiencing cognitive dissonance that should be addressed by the financial professional.  By doing so, you will “re-anchor” their expectations to the new realities of 2.3%, 2.8%, or 4% withdrawal rates, which will set you up for the annuity conversation that we discuss below.

I am not suggesting an agent go into a big dissertation on these individual studies.  I just believe that going over the simplified math – specific to the client’s portfolios – based on these new “rules of thumb” should be done in order to show the power of annuity GLWBs.  Although generous, using the old 4% rule of thumb will suffice in explaining the annuity value proposition.  By demonstrating this math to the clients, you will be “re-anchoring” their expectations to realistic numbers.  And only then do I believe they will realize the true power of GLWB Riders.

The GLWB Conversation

Here is what my conversation looks like many times that I will walk our hypothetical client through.

Let’s say our 63-year-old has $100,000 in a stock and bond portfolio. I start by discussing how this 63-year-old may have the expectation that her $100k grows by 5% or so per year between now and retirement in two years.  Well, based off her $110,000 (not including compounding) value at that point, what withdrawal should she take in her first year of retirement?  This is where I discuss the 4% withdrawal rule, which usually surprises them because their “anchoring” is off, as we discussed.  I also discuss the reasons for the withdrawal rate being only 4%, as we also discussed earlier in this article.  But then I will show her $100k growing to $110k in two years at retirement.  If the client wants us to assume a 20% return over 2 years, fine!  I will do that instead.  The math still works.

By the end of the two years, her $100k has grown to $110 k.  That is when we figure the first-year withdrawal, which comes out to $4,400.  Again, that $4,400 is supposed to increase with inflation, per the 4% rule.

That $4,400 is assuming everything goes correctly.  That is, that she gets 10% appreciation between now and age 65, and also the 4% being is indeed sustainable over her 30-year retirement. 

That is when I will switch to the annuity.  On one of the industry’s top annuities/GLWB riders right now, her $100,000 will “rollup” by 10% simple interest rate for two years, then that value of $120,000 will have a payout factor of 7.5% for a 65-year-old.  Note:  Technically this 10% rollup is not limited to just 2-years.  It depends on when she activates income, which in our example is 2-years.  That means that there will be a $9,000 payment starting two years from now, guaranteed for life!!!  That payment will go on forever.  This GLWB payment is 105% higher than what our 4% withdrawal rule will provide.  And you don’t have the “hoping and praying” with the annuity.  Usually at this point in the discussion, the responses are in three different areas:

  1. Seems too good to be true!  How can the company do that.  This is a topic for another article.
  2. What if everybody lives forever???  Will the company go out of business?  Again, a topic for another article.
  3. But what about inflation???  The 4% rule includes inflation, and the annuity does not.  Let’s discuss.

Level Annuity Payment Versus 4% with inflation

Although I believe we are being generous to the situation by using the 4% rule instead of the more updated and lower rules of thumb, it would be disingenuous to not explain the lack of inflation on the level payout GLWBs.  Note:  There are some GLWBs that have increasing income, but lets leave the conversation to the level income for now.

This objection about annuities not having inflation included, versus the 4% rule is a reasonable objection, as inflation adjustments can be crucial. As a matter of fact, the “inflation rule of 72” says that a 3.5 percent inflation rate – for example – will chop the purchasing power of a dollar in half in only 20.5 years (72/3.5 = 20.5 years). Meaning that $9,000 would only have the purchasing power of $4,500 in 20.5 years assuming 3.5% inflation.

So then what provides the highest “cumulative income”, our GLWB or the 4% rule example?  Below is a graph from a spreadsheet I created to show what provides more income – the $9,000 (GLWB) without inflation adjustments or the $4,400 (4% Rule) with inflation adjustments. Note: For the inflation adjustments, I assumed 3.5%.

As you can see above, the inflation adjusted “4% rule” ANNUAL income crosses over to where it is more than the $9,000 in the 22nd year!!!  You can see the two lines crossing over. The dollar amounts represented by the lines are in the right axis.

Now, what is more important however is, what is the “cumulative income” from each strategy over a period of 40 years? That is represented by the bars and the left axis labels. As you can see, the Cumulative GLWB Income (Black Bar) stays higher than our cumulative 4% rule all the way through the 30-year retirement.  As a matter of fact, it takes approximately 40 years for the 4% rule to catch up to our annuity income on a cumulative basis.  In year-40, $364,776 is the cumulative income from the 4% rule at that point in time and $360,000 is the cumulative income from our annuity.  So, in this example, only if the client lives beyond age 105 will she have garnered more income from the 4% strategy than our annuity. 

Lastly, this analysis is being generous to the 4% rule because we are not incorporating the “time value of money” of the amount of excess GLWB payments we got above and beyond the 4% rule in the early years.  Technically, those excess dollars reinvested would equate to even more than what our “cumulative” black bar is actually showing.

Clearly, there are other scenarios that we could run that can benefit or degrade the story on either one of the two solutions.  For instance, we could run the 4% rule assuming a much higher return than 10% over two years; for example 20%.  We could have taken into consideration capital gains taxes on the 4% rule of thumb versus income taxes on the annuity.  But then we could also apply the “time value of money” to the excess annuity payments on the annuity.  We could also use the 2.8% withdrawal rule.  Or, one could add different inflation rates. Etc. etc.

In the end and with all of this said, the story should be that consumers need to anchor their expectations reasonably AND ALSO that annuities have a great place in many consumers’ portfolios, with or without inflation.

Written By:  Charlie Gipple, CFP®, CLU®, ChFC®

Written By: Charlie Gipple, CFP®, CLU®, ChFC®

Charlie is the Founder and CEO of CG Financial Group, a financial services company that serves consumers as well as financial professionals. CG Financial Group, LLC is one of the fastest growing marketing organizations in the country for annuities, life, and long-term care because CG Financial Group is different! Charlie is recognized throughout the industry as one of the foremost thought leaders and subject matter experts on retirement planning, life insurance, long-term care planning, tax planning, and estate planning. He is also an industry keynote speaker conducting 100-150 speeches per year. He has spoken at the MDRT Top of the Table as well as other large forums and has also appeared on TheStreet.com and AM Best TV. With over two decades of experience, Charlie is unique in his broad knowledge across the life insurance, LTC, annuities, and retirement planning. His writings appear monthly in various financial magazines across the country. He holds a bachelor’s degree in Finance from the University of Northern Iowa, is FINRA Series 7 and Series 66 licensed and also holds the CFP®, CLU® and ChFC® designations.

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