If you don’t have an old-fashioned defined benefit pension and your Social Security is only going to be part of the mix, what is the best way to create a regular source of income from retirement savings?
Should you pull a steady paycheck from your nest egg by relying on some variation of the “4 percent rule,” limiting your withdrawals to 4 percent of your total nest egg, plus potential increases for inflation? Or should you take a big chunk of your nest egg and buy an immediate life annuity?
The right answer is a little of both, says Mark J. Warshawsky, visiting scholar at the Mercatus Center at George Mason University in Arlington, Virginia, and the principal at his own advisory firm, Relias. Warshawsky calculated the outcomes of both methods using the historical experiences of retirees beginning in 1919. He assumed that people would retire at 65 and at least one person in a couple would survive to age 95 — a demographic reality for 20 percent of couples today, he writes in a new paper.
Why not pick one or the other? Because both methods have drawbacks, Warshawsky says. Here — in a nutshell — are the key drawbacks to each.
- Due to inflation, the annuity loses about half of its value as the average retiree buyer ages. The apparent solution, buying an inflation-adjusted annuity, is expensive, cutting the return significantly. Plus, only a few insurers sell inflation-adjusted annuities and a buyer is locked into purchasing from one of them. Between the high price and the limited number of sellers, Warshawsky says, “I wouldn’t go there.”
- On the other hand, relying on the 4 percent or “William Bengen” rule leaves a retiree vulnerable to running completely out of money. If the economy has a series of terrible and unpredictable shocks or if the retiree lives too long — or both — the money will all be spent. “The risk is very significant. You don’t want to be impoverished in your old age,” Warshawsky says.
His answer is to divide your nest egg and combine the 4 percent rule with a ladder of immediate annuities.
A modified version of the 4 percent rule
Warshawsky’s version of the 4 percent withdrawal rule is different than the original Bengen rule. He advocates a fixed percentage. Let’s say you start with $100,000 in savings. The first year, you take out 4 percent, or $4,000. That leaves you with $96,000, which you invest, and you potentially finish the year with, maybe, $97,000. The next year you can spend 4 percent of $97,000 or $3,880. If you had a very good year, and your nest egg climbed back up to $100,000, you could go back to taking out $4,000. If it was a lousy year and the account fell to $90,000, you would only allow yourself to spend $3,600. “This is a less-risky strategy (than the original 4 percent rule). It significantly reduces the risk that your money will run out,” Warshawsky says.
He acknowledges that government rules may override this strategy because of required minimum distributions, or RMDs. But he thinks that for most retirees, RMDs won’t disrupt this strategy until they reach their 90s.
Laddering immediate annuities also reduces the possibility that a retiree using this strategy will come up short. While inflation eats away the spendable value of an annuity, Warshawsky thinks two factors offset this problem.
- Laddering the annuities will make it likely that at least some of them will have a more generous return.
- Most retirees spend less money on everyday expenses as they age. If they also purchase long-term care insurance, it will kick in if the biggest expense risk — costly health care issues — arises.
Warshawsky is working on a second paper that will define specifically how much nest egg should be devoted to each investment and offer more precise timing advice.
He says stay tuned. That should be available in the fall.