Stop Comparing Annuity Payout Rates to the 4% Rule

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.  

Income annuities tend to have nominal payouts. While Social Security retirement benefits are linked to inflation (technically the CPI-W), it is not possible to purchase an annuity today with benefits explicitly linked to inflation. Income annuities that offer some type of fixed cost of living adjustment (COLA) are also relatively uncommon. For example, in 2021, less than 2% of the 602,997 quotes run through CANNEX included any type of COLA, based on the CANNEX 2022 Annual Survey Experience Report. 

While there are a variety of potential reasons why retirees actively choose to not include COLAs, perhaps one of the most obvious reasons is the impact on the payout level.

For example, the average five highest quotes for a SPIA on a 65-year-old male/female couple with a cash refund provision was 6.22% from CANNEX on Jan. 3, 2023. If you include a 2.5% COLA, which is the approximate inflation expectation from the Cleveland Federal Reserve for the next 30 years, the payout rate declines to 4.61%. This is a significant decline, reflecting the notable increase in expected benefit payments over time.

Apples and Oranges

Comparing the payout rate on a nominal annuity (e.g., 6.22%, using the previous quote) to the 4% rule is incredibly misleading, because they imply two very different things. The 4% rule is a real (i.e., inflation-adjusted) income benefit designed to last for some fixed period. In contrast, the previously noted 6.22% SPIA payout rate is a nominal benefit that lasts for life; therefore, the 4.61% value would be more appropriate for comparison purposes, but even then, the values are indicative of two very different things.

Implying that 6.22% is “better” than 4% because the value is higher could result in a retiree making a decision that is based on incomplete (and misleading) information. While it is obviously important to be aware of the different levels of income that can be generated from different strategies, the values should be contrasted with care.

At a minimum, if you’re going to compare an annuity payout rate to the 4% rule, the payout should include a cost-of-living adjustment that is roughly equivalent to expected inflation (even though this is obviously an imperfect hedge).

Note, I don’t necessarily think retirees need portfolio income that increases annually with inflation, given observed spending patterns (i.e., the retirement spending smile as I’ve called it) especially since other forms of retirement income are already explicitly linked to inflation, such as Social Security retirement benefits, but I think it’s important to ensure the comparison is as accurate as possible.

Conclusions

While investors tend to value simplicity when attempting to distill the value of a given strategy or an approach to a single value, it is incredibly important the comparison itself be valid. 

Comparing the payout rate for a nominal annuity to the 4% rule is not appropriate because the fundamental structure of the assumed benefit is different (real versus nominal, respectively) as is the implied term (30 years versus for life, respectively).