Are Annuities the Best Strategy to Fund One’s Retirement?

Suppose you are retired, or soon-to-be retired, and you have no reason to leave a bequest. You have no offspring, or they are financially independent – or you want them to be – and you have no charities to which you wish to leave money. You just want to assure yourself of as much income as possible while you are alive. What is your best course of action? My research shows it’s almost impossible to beat an annuity1.

The comparison

In an August 14, 2012 article in Advisor Perspectives, Joe Tomlinson showed that annuities have been an extremely safe investment, and that there is no reason to believe they will not be in the future. Let us therefore, tentatively, say that they have a 99% chance of delivering their promised income (the only risk being the failure of the insurance company and the lack of adequate government funds to pay annuitants).

In this article I explore comparably safe, “safe withdrawal strategies” from a stock-bond portfolio, in order to compare the lifetime income they provide with the lifetime income from an annuity purchased with the same initial investment.

The annual payout rates on the annuities used in the comparison were supplied by and checked against numbers provided by CANNEX. The rates used were drawn from the column in Table 1, and were obtained a few weeks ago.2

The question is, what safe withdrawal strategy from a stock-bond portfolio maximizes lifetime income, while providing 99% certainty that the money won’t run out during the investor’s lifetime? And how does its total income compare with an annuity’s?

Many strategies have been proposed as “safe withdrawal strategies,” and many more are possible. Exploring every conceivable strategy to see which one maximizes lifetime income while offering a 99% chance (or any other strong chance) of not running out of money is a task I will not attempt.

I will test only two strategies. One was established as a norm by William P. Bengen in a seminal article, “Determining Withdrawal Rates Using Historical Data,” in the October 1994 issue of the Journal of Financial Planning. The strategy is to set a dollar number as a percentage of the investor’s initial portfolio to be withdrawn in the first year, and then to increase that dollar number for inflation each year thereafter.

For example, suppose that the initial investment is $1 million and that the withdrawal percentage is 4%, so that the first year’s withdrawal is $40,000. Suppose that inflation in the subsequent year is 5%. Then the withdrawal in year 2 would be five percent greater than the initial $40,000, or $42,000.

Bengen concluded by testing the strategy against historical returns and asserting that an initial withdrawal rate of 4% would be “safe.” More recent articles such as one in 2013 by Michael Finke, Wade Pfau, and David Blanchett have argued that a 4% withdrawal rate is too high to be considered “safe” in the current low-interest environment.

But because the Bengen safe withdrawal rate approach uses an unchanging percentage of (the inflation-adjusted value of) starting assets, it fails to withdraw more in scenarios in which assets increase rapidly. Thus, it often leaves money on the table.