Retirement Income Showdown: Annuities vs. Managed Payouts
Which is a better method of generating retirement income from your IRAs, 401(k) accounts, and retirement savings: Buying an immediate annuity from an insurance company, or implementing managed payouts, also known as the four percent rule or the installment method, in which you invest your money and draw it down systematically to avoid outliving your retirement savings?
Each of these methods has its pros and cons, and much has been written about their relative merits by passionate defenders of each method. One way to assess which method might be best for you is to estimate and compare the amounts of retirement income you can generate from your retirement savings. As an example to show you how to do this, I'll estimate the annual amounts of retirement income that retirees with $100,000 in retirement savings can generate in today's economic climate using each of these methods.
Before I show you the results of this comparison, I need to explain how I came up with my estimates.
With managed payouts, the four percent rule has long been advocated as a "safe" way to generate retirement income. Under the four percent rule, you invest in a portfolio balanced between stocks and bonds, withdraw four percent of your initial balance, and then give yourself raises for inflation each year thereafter. In theory, with this method, you have a very low chance of outliving your retirement savings for retirements that last 30 years.
Recently, however, some financial writers (including me) have questioned whether a four percent withdrawal rate is really safe in today's economic environment of low interest rates and below-average dividend yields on stocks, and given the level of investment expenses that are commonly assessed against invested assets. Initial withdrawal rates of two percent or three percent have been suggested as a safer withdrawal amount, reflecting these factors. For the purposes of this comparison, I'll show retirement incomes using initial withdrawal rates of two, three, and four percent.
To estimate the amount of retirement income from an immediate annuity, I'll use the information from Vanguard's Annuity Access service as of September 21, 2011, for a single man, a single woman, and a couple buying a 100 percent joint and survivor annuity (this annuity continues the income as long as at least one of the two is alive). I've assumed all of these people are age 65 when they retire. To make the comparison consistent with managed payouts, I'll use an inflation-adjusted annuity, which adjusts your income for inflation each year after retirement. I'll also show an annuity that increases at three percent per year -- these annuities are a slightly less expensive way to buy inflation protection compared to annuities that have unlimited inflation adjustments.
With these descriptions out of the way, let's take a look at the results of the retirement income showdown.
Next page: How much retirement income can $100,000 generate?
How Much Retirement Income Can $100,000 Generate?
Given all the assumptions described in the previous page, here's how much initial annual retirement income a single 65-year-old woman can generate under these methods as of September 21, 2011:
Here's the same chart for a 65-year-old man:
And here's the same chart for a married couple, both age 65:
As you can see, for a married couple, managed payouts with two or three percent withdrawal rates are beaten handily by the immediate annuity, whether it's inflation-adjusted or adjusted at three percent per year. Both types of annuities also win for single men or women compared to managed payouts with a four percent withdrawal rate and below. The comparison is somewhat close, however, for a married couple buying either type of 100 percent joint annuity compared to a four-percent withdrawal rate for managed payouts.
Note that the above annuity amounts are net of all insurance company and transaction costs; with managed payouts, you need to be vigilant about managing investment costs every year in order to minimize the chance of outliving your savings.
Next page: What are other considerations for deciding which method is best for you?
Which Method Is Best for You? Other Considerations
What other factors are important when making your decision?
Immediate annuities have these advantages:
- You're guaranteed a lifetime income, no matter how long you live. With managed payouts, there's still a chance you can outlive your assets, particularly if you live well beyond average life expectancies, realize below-average return net of expenses, or are a victim of investment fraud.
- Annuities are very user-friendly -- there's no need to invest or monitor your savings. The insurance company takes care of that for you. You'll appreciate this advantage when you're older and less able to manage your retirement savings.
- If you consistently achieve above-average investment returns for a number of years, you have the option of increasing your retirement income beyond inflation adjustments. Or you might have money left over when you pass away to leave to children or charities. These outcomes aren't possible with an immediate annuity.
- You have access to your retirement savings in case you have an emergency. With an immediate annuity, you typically don't have access to your retirement savings.
- You can always change the way you generate retirement income during your retirement; this usually isn't possible with an immediate annuity.
Annuities provide lifetime guarantees with protection against poor investment returns, but you forgo upside potential and you have no flexibility to access your savings. Managed payouts provide flexibility with the potential for growth in the case of favorable investment returns, but they offer no guarantees against outliving your savings or protection against unfavorable investment returns.
Still can't decide which method is best for you? Consider using both methods. You can buy an immediate annuity with part of your retirement savings, then invest and draw down the remainder. That's a little like having a fruit salad instead of eating just one piece of fruit.
Because a significant number of baby boomers are approaching their retirement years with little or no traditional pension benefits that guarantee a lifetime retirement income, how you generate retirement income with your retirement savings is a critical question. It's well worth your time and effort figuring out which method is best for you.
More on MoneyWatch:
- IRAs and 401ks: Maximize Retirement Income with Immediate Annuities
- IRAs and 401k: How to Generate Retirement Income with Managed Payouts
- Retirement Income Annuities
- Four Percent Withdrawal Rate May Be Too High for Today's Retirees
- IRA and 401kk Retirement Drawdown: Don't Die Broke
- Retirement Income Drawdown: How to Fix a Serious Flaw With the "Four Percent" Rule
- IRA and 401k Retirement Income Generators: A Guide to Evaluating Them
- IRA and 401k Retirement Income: How You Can Get Both Predictability and Flexibility
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