The recent rise in interest rates has changed the investment and lifetime income landscape. For example, payouts on immediate annuities have increased dramatically over the last year.
The rise in interest rates has led to an increase in LinkedIn posts (at least, that I'm seeing) where some individual is effectively asking why someone would settle for 4% when they can get 6% (or more!) with a (nominal) annuity, or some variation thereof.
This is incredibly misleading. The 4% rule is based on a real spending assumption (where withdrawals increase with inflation) while the majority of annuity payouts are nominal (constant over time). Additionally, income annuities provide benefits for life, whereas the 4% rule assumed a fixed retirement period (i.e., 30 years).
While portfolio withdrawal strategies and income annuities can both be incredibly effective strategies to help retirees fund consumption in retirement, they need to be discussed in the correct context to ensure retirees make the appropriate decision on how best to fund their retirement.
What Is the 4% Rule?
While the 4% rule, which is largely attributed to research that Bill Bengen published in the Journal of Financial Planning in 1994, has been around for almost 30 years, I'm amazed at the general lack of awareness around the details of the rule among some financial advisors even today.
For example, the noted 4% value corresponds to the initial withdrawal from the portfolio, where that amount is subsequently assumed to increase annually for inflation and the money is invested in a balanced portfolio with a retirement duration of 30 years (typically attributed to a 65-year-old married couple).
The percentage (4%) only applies to the income amount in the very first year of retirement; thereafter it's that original amount increased (or decreased) by realized inflation. For example, if you have $1 million at the beginning of retirement, you would take out $40,000 in year one (assuming a 4% initial withdrawal rate), and thereafter that same amount, increased annually for inflation.
While I think describing the rule as a multiple would be more accurate (i.e., you need 25 times your income goal, which is one divided by 4%), I think it's safe to say at this point that the 4% number is here to stay, though it is often taken out of context (e.g., as the ongoing withdrawal rate versus just the initial withdrawal rate).
Rising Bond Yields = Rising Payout Rates
The recent rise in interest rates has led to a dramatic rise in payout rates for income annuities, an effect that is visible when looking at something like the CANNEX Pay Index, which includes information on the payout rates for three types of immediate annuities going back to Jan. 5, 2005.
