In 1994, the now famous financial planner William Bengen developed what today is known as “the 4% rule.” Bengen gathered stock and bond performance data dating back to 1926 and modeled a hypothetical 50/50 portfolio using 51 different retirement scenarios with start dates beginning in 1926 and ending in 1976. The goal was to find the annual withdrawal rate at which a person would not deplete the entire portfolio over a 30-year period. In other words, he wanted to see what the sustainable withdrawal rate was over a 30-year retirement. He concluded that 4% (adjusted annually for inflation/deflation) would be a sustainable withdrawal rate for a typical 50/50 portfolio to last throughout a 30-year retirement.
Clearly the financial landscape is different today than it was when Bengen conducted his study. Investors have experienced two major bear markets in just the last 13 years, three decades of dropping interest rates, and an environment in which many believe there is a bond bubble that might be ready to burst. A 2013 study by Morningstar[1], in conjunction with professors from Texas Tech University and The American College, re-tested the 4% rule in today’s market conditions. The study examined the impact of a 4% withdrawal rate adjusted annually for inflation on a portfolio consisting of 40% stocks and 60% bonds. The study concluded that a 4% withdrawal rate could be maintained over a 30-year period only 48.2% of the time, a stark contrast to the 100% success rate in Bengen’s original study.
What has caused the success of the 4% withdrawal rate to drop so dramatically in such a short period of time? Simply put, current interest rates. Morningstar assumed in its study that interest rates would eventually return to long-term averages, but accounted for the current low interest rate environment within the first 5 to 10 years of the hypothetical retirement. The data showed that the negative impact of low rates is multiplied when experienced earlier in retirement. As many know, this sequence of returns risk may cause the portfolio to be prematurely depleted, even if interest rates and bond returns return to long-term averages. The study determined that to successfully fund a 30-year retirement over 90% of the time, the new safe withdrawal rate is 2.8% (adjusted annually for inflation/deflation). The authors of the Morningstar study build in a 100 basis point investment fee which Bengen did not include in his study.
Risk pooling is a tool that insurance companies use to manage various types of risks, such as longevity risk, by spreading the risk out over a “pool” of thousands of customers with various life spans. By utilizing their unique ability to pool risk, insurance companies, through products such as an annuity with an optional Guaranteed Lifetime Withdrawal Benefit (GLWB) rider, are in an optimal position to help solve the additional retirement risks brought about by the decline in the sustainable withdrawal rate. It is this “risk pooling” that allows life insurance companies to address these longevity risks.
Many industry experts agree that modern-day retirement planning requires more risk management than investment management. And who understands “risk management” better? Insurance companies.
Let’s put the concept of a fixed index annuity with an optional guaranteed lifetime withdrawal benefit into practice by reviewing a hypothetical example, conducted first without an annuity and optional rider and then with the annuity and optional rider.
Mary, age 63, has structured her $1 million portfolio into 40% stocks and 60% bonds. She needs at least $25,000 from her portfolio each year to cover her expenses. Let’s assume a 2.5% return on her fixed income portion, and 10% annual growth on her equity portion. After two years she would have about a $120,000 return, leaving her with around $1,120,000 to take withdrawals from over the next 30 years.
Using the 2.8% rule proposed in the Morningstar study, Mary would receive $31,606 (2.8% times $1,120,000) beginning at the end of year 2 and annually the withdrawal amount would be adjusted for inflation/deflation. But what if Mary’s portfolio instead drops 20% from $1,000,000 to $800,000? A 2.8% withdrawal on $800,000 leaves Mary with only $22,400, which is below the $25,000 she has indicated she needs annually to maintain her current lifestyle.
Now let’s assume that Mary instead protected 20% of her portfolio, or $200,000 taken proportionally from her portfolio, using a fixed index annuity with an optional guaranteed withdrawal benefit rider. After two years, Mary would be guaranteed an income based on a $232,000 contract benefit base* assuming an 8% simple rollup. Thanks to the optional guaranteed withdrawal benefit rider, Mary could begin taking $11,600 (5% of the benefit base from her contract) for the rest of her life, guaranteed.
Let’s now take the guaranteed $11,600 income created by the $200,000 annuity portion of Mary’s initial portfolio, and consider it alongside the remaining $800,000 of her portfolio. Assume the same results we saw in our 20% decline example and apply it to the $800,000 Mary did not put into an annuity in this second example. This reduces her $800,000 to $640,000.
Even at $640,000, a 2.8% withdrawal rate leaves Mary with an available withdrawal amount of $17,920 at the end of year 2 and adjusted every year for inflation/deflation thereafter. Add this figure to the $11,600 income she is guaranteed from her annuity, and her total combined annual withdrawal of $29,520 surpasses her $25,000 annual withdrawal need. Adding an annuity to Mary’s portfolio allows her to shelter 20% of her retirement savings from shortfall risk.
Given potential market volatility, low interest rates and perceived risk in the bond market, there has never been a better time to fully understand the power of a fixed index annuity with the optional guaranteed withdrawal benefit rider. Among the many benefits of incorporating a fixed index annuity into a retirement plan are: opportunities for more predictable growth; creating guaranteed income for life; principal protection; protection from index declines, protection from interest rate risk; and tax deferral until withdrawals or income payments begin[2].
As the 4% withdrawal rule takes its place among the officially “Endangered Theses” of retirement, fixed index annuities with an optional guaranteed lifetime withdrawal benefit may be a solution for helping your clients achieve their retirement goals.
*The benefit base is used only to calculate the rider income withdrawals and is not a representation of the contract value or surrender value.
For a more detailed discussion about the 4% rule and how to create sustainable retirement income strategies, go to Genworth’s The Index Institute and click on “Rethinking Retirement Income: New Strategies for an Uncertain World” in the white paper collection.
All guarantees are based on the claims-paying ability of the issuing insurance company.
The discussion of tax treatments in this material is Genworth’s interpretation of current tax law and is not intended as tax advice. You should consult your tax professional regarding your specific situation.
Withdrawals may be taxable and a 10% federal penalty may apply to withdrawals taken before age 591/2. In addition to a surrender charge, if you withdraw more than the free withdrawal amount, your withdrawal is also subject to a market value adjustment (MVA).
The MVA may increase or decrease the amount you receive. If interest rates go up after the contract is issued, the adjustment will be negative, reducing the amount you receive. If interest rates go down after the contract is issued, the adjustment will be positive, increasing the amount you receive.
Although the contract value may be affected by the performance of an index, the contract is not a security and does not directly or indirectly participate in any stock or equity investment including but not limited to, any dividend payment attributable to any such stock or equity investment.
[1] “Low Bond Yields and Safe Portfolio Withdrawal Rates,” David Blanchett, Michael Finke and Wade Pfau, Morningstar Investment Management, Jan. 21, 2013.
[2] There is no additional tax deferral benefit for annuities purchased in an IRA, or any other tax-qualified plan, since these plans are already afforded tax-deferred status. The other benefits and costs should be carefully considered before purchasing an annuity in a tax-qualified plan.