When we face retirement after a lifetime of hard work, we want certain securities when it comes to our savings. First, we want to make sure we do not outlive our remaining funds. Secondly, we all want to have an adequate amount of money to cover our daily expenses and live comfortably. Financial planners have used the 4% rule to strike a balance between these two goals. But as you’ll see, this economic tenet does not provide the security most of us need.
The 4% rule is a rule of thumb first articulated by famed financial planner William Bengen in 1994. Essentially, this rule is meant to provide guidance for maintaining a reliable income stream for retirees on the principle of withdrawing four percent every year from your total investments or retirement account. The purpose of this rule is to create a sustainable income stream without outliving your retirement fund.
Although it is a reasonable starting point, the 4% rule does not account for several variables that will influence most people’s retirement. For starters, this is a rigid principle that does not consider changes in spending habits from year to year. Consequently, this is based on a hypothetical portfolio in which you would have invested 50% in stocks and 50% in bonds.
This rule also has other limitations, like assuming that your remaining time horizon is 30 years or that your current portfolio will even last that long. The problem with inflexible ideas like this is that they do not consider the variability of people’s financial situations and base its theory on historical market returns that might not hold true in the future.
Perhaps, the biggest flaw of this rule is the assumption of income, which, if you are investing in an equities market, is largely based on chance. Say, for instance, that you manage to save $1 million in total liquid assets by the age of 70. The rule here assumes that there is about a 90% chance that your savings can provide $40,000 per year for 30 years.
However, that does not consider the wide range of taxes you’d incur on those payments that could leave with a total usable sum in the low $30,000s. Furthermore, think about what it means to have a 90% chance of meeting your income needs over 30 years. Is that a risk worth taking, or would you rather have your income guaranteed for the remainder of your years and beyond?
Unlike investing through 401(k)s or IRAs, annuities offer guaranteed income for a more extended period, with none of the risks. This option answers the questions left by the 4% rule in several areas, but most importantly, instead of focusing on just the amount of assets you have a retirement, you can lock in an income based on those assets – which is really what we are looking for when we choose to retire. Here’s how annuities effectively offset the claims of the 4% rule:
Let’s say you manage to save $1 million by the time you reach 70 years of age, the same million you would have a 90% chance of surviving for 30 years. Instead of taking that risk, for half that amount, paid over several years, you can guarantee an income of $40,000 for the remainder of your life: no chances, no risks, just certain, reliable income paid directly to you.
Annuities provide certain income that you do not have to plan out for 30 years. There are no calculations or adjustments for inflation to make sure your money lasts for as long as you need it. For half of your savings, paid before you reach your distribution phase, you could secure a higher livable income for a longer period.
When your income is guaranteed, you open the possibility of creating more revenue streams with the remaining assets you did not have to put into annuities. This gives you a certain level of security to make riskier investments, with a higher upside, and without having to worry about your money being there when you need it.