Which Generates More Lifetime Income—Annuities or Portfolio Withdrawals?
New research by Mark Warshawsky, the retirement income guru who’s now a visiting scholar at George Mason University’s Mercatus Center, suggests more retirees should consider making an immediate annuity part of their retirement portfolio—and also highlights a reason why many people may simply ignore this advice.
When it comes to turning retirement savings into lifetime retirement income, many retirees and advisers rely on the 4% rule—that is, withdraw 4% of savings the first year of retirement and increase that amount by inflation each year to maintain purchasing power (although in a concession to today’s low yields and expected returns, some are reducing that initial draw to 3% or even lower to assure they don’t deplete their savings too soon).
But is a systematic withdrawal strategy likely to provide more income over retirement than simply purchasing an immediate annuity? To see, Warshawsky looked at how a variety of hypothetical retirees of different ages retiring in different years would have fared with an immediate annuity vs. the 4% rule and some variants. The study is too long and complicated to go into the particulars here. You can read it yourself by going to the link to it in my Retirement Toolbox section). The upshot, though, is Warshawsky concluded that while an annuity didn’t always outperform systematic withdrawal, an annuity provided more inflation-adjusted income throughout retirement often enough (with little risk of ever running out) so that “it is hard to argue against a significant and widespread role for immediate life annuities in the production of retirement income.”
Now, does this mean all retirees should own an immediate annuity? Of course not. There are plenty of reasons an annuity might not be the right choice for a given individual. If Social Security and pensions already provide enough guaranteed income, an annuity may be superfluous. Similarly, if you’ve got such a large nest egg that it’s unlikely you’ll ever go through it, you may not need or want an annuity. And if you have severe health problems or believe for some other reason you’ll have a short lifespan, then an annuity probably isn’t for you. Even if you do decide to buy an annuity, you wouldn’t want to devote all your assets to one. The study notes the advantage of combining an annuity with a portfolio of financial assets that can provide liquidity and long-term growth, and suggests “laddering” annuities rather than purchasing all at once as a way to get a better feel for how much guaranteed income you’ll actually need and to avoid putting all one’s money in when rates are at a trough.
But there’s another part of the paper that I found at least as interesting as the comparison of systematic withdrawals and annuities. That’s where Warshawsky says he worries whether the “lump sum culture” of 401(k)s and IRAs will interfere with people seriously considering annuities. I couldn’t agree more. Too many people laser in on their retirement account balance—the whole, “What’s Your Number?” thing—rather than thinking about what percentage of their current income they’ll be able to replace after retiring. And when choosing between, say, a traditional check-a-month pension vs. a lump-sum cash out, many people still tend to put too little value on assured lifetime monthly checks.
Although the paper didn’t mention this specifically, I think there’s a related problem of peoples’ overconfidence in their investing ability that makes them less likely to opt for guaranteed income. I can’t tell you the number of times after doing an annuity story that I’ve gotten feedback from people who essentially say they would never buy annuity because they think can do better investing on their own (never mind that’s difficult to impossible to do without taking on greater risk because annuities have what amounts to an extra return called a “mortality credit” that individuals can’t duplicate on their own). Along the same lines I’m always surprised by the number of people who pooh-pooh the notion of delaying Social Security for a higher benefit because they’re convinced they can come out ahead by taking their benefits as soon as possible and investing them at a 6% to 8% annual return (although why anyone should feel confident about earning such gains consistently given today’s low rates and forecasts for low returns is puzzling).
Clearly, we all have to make our own decisions based on our particular circumstances about the best way to turn savings into income we can count on throughout retirement, while also assuring we have a stash of assets we can tap for emergencies and unexpected expenses. There’s no one-size-fits-all solution. That said, I think it’s a good idea for anyone nearing or already in retirement at least consider an annuity as a possibility. If you rule it out, that’s fine. Annuities aren’t for everyone. Just be sure that if you’re nixing an annuity, you’re doing it for valid reasons, not because of a misplaced faith in investors’ abilities to earn outsize returns or because you’re unduly swayed by lump sum culture.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org.