For years, the so-called 4% rule provided the baseline from which advisors launched strategies for retirement account withdrawals. The rule is simple, well-trusted, and relatively unlikely to fail—or at least it used to be. In today’s low-interest rate environment, the strategies that worked for the past 20 years are simply not cutting it, meaning that advisors and clients must readjust their expectations to uncover alternative solutions for providing sustainable retirement income.
While the word “annuity” may be a dirty one for clients who have traditionally sought aggressive investment returns (or worried about their high costs), the evidence cannot be ignored: new studies suggest that annuities are a competitive alternative to the newly old-fashioned 4% rule. For those clients unwilling to modify their retirement income planning strategy so dramatically, many advisors have discovered a new method for determining retirement withdrawal rates, inspired by the system used by the IRS itself.
The Problem With 4%
As the name suggests, the 4% rule suggests that if your client withdraws 4% of the balance from a retirement account each year, he will be able to create a sustainable retirement income stream with virtually no risk of exhausting the account assets. This strategy has worked for years, more or less, but there have always been problems, such as the failure to account for actual investment performance in any given year. It has generally been a safe bet, however, that the client will not run out of money, which is the greatest fear for many retirees.
Today’s low interest rate environment has, unfortunately, eliminated the primary benefit of the 4% strategy—namely, the 4% rule is no longer a safe bet. A new study (by Texas Tech professor and Research magazine contributor Michael Finke) has produced evidence that, because interest rates are about 4% lower than their historical average, the anticipated failure rate for the 4% rule has jumped from 6% to a whopping 57%.
These numbers cannot be ignored. The study found that the failure rate would remain at 18% even if interest rates increase in five years’ time, though there is no evidence to suggest that we will return to 20th century interest rates anytime soon, if ever. The bottom line: it is time for clients to oust the 4% withdrawal strategy.
The Annuity Solution
Even if your clients are tired of hearing about the benefits of annuitizing their assets, it is becoming a simple fact that retirement accounts are not yielding the returns that they have in the past, and the potential of a 57% failure rate by following the 4% rule should get clients’ attention. When the 4% rule’s failure rate was a modest 6%, there may have been reason for clients to reject annuity products as noncompetitive, but today’s reality has changed the picture. Annuities should be seen as more attractive than ever.
An annuity product is not perfect, however. It ties up your clients’ funds in an investment that is difficult to liquidate, meaning that the client cannot easily access the funds to provide for unexpectedly high health-related or other costs during retirement. This will provide some clients with incentive to purchase long-term care insurance that will protect them against unforeseen costs that aren’t usually reimbursed by Medicare.
Other clients will continue to insist that long-term care insurance is prohibitively expensive. This may be true for many, but luckily annuity products have also changed with the times, and many insurance companies now offer annuity products with critical care riders to provide long-term care benefits in addition to the traditional annuity income stream. The products also address the “use it or lose it” problem posed by long-term care insurance because most contracts offer a cash surrender value if the long-term care feature is never tapped.
The Beneficial IRS RMD Method
Studies have also identified the IRS’s RMD method as a better alternative for determining retirement account withdrawal rates than the 4% rule. Not only is the RMD approach almost as simple as the 4% rule—rather than withdrawing 4% each year, the client consults IRS tables to determine the applicable annual percentage—it offers much more flexibility.
The RMD rule is, in many ways, much more realistic than the 4% rule because it bases withdrawals on the current value of the client’s retirement assets. While this requires determining what that value is each year, it also allows clients to modify their consumption levels based on actual account performance. Because the withdrawal percentages are based on life expectancy and vary with age, it is unlikely that the client will outlive his assets using this method because the account’s rate of return is factored into the equation.
Many of your clients may be reluctant to abandon what they think of as a tried-and-true method for determining withdrawal rates, but recent studies provide a powerful argument in favor of seeking alternatives. Simply put, if the interest rate environment has changed, causing old strategies to fail, why shouldn’t your clients’ perceptions change along with it?
For additional articles by Michael Finke, please see his AdvisorOne author page.
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