How a Fixed Index Annuity Guarantees Inflation-Protected Income in Retirement

by Hersh Stern - Revised Friday, November 29, 2024

One of the single greatest fears current retirees face is the prospect of outliving their retirement income and savings.

One popular strategy to help stretch a retiree’s income during retirement is known as Bengen's Four-Percent (4%) Drawdown Rule. The premise, born in 1994, contends that retirees can safely withdraw 4% from a balanced stock (50%) and bond (50%) portfolio for 30 years while annually raising the withdrawal for inflation adjustments. By limiting annual withdrawals from a retirement portfolio to less than 4%, this theory suggests that a retirement portfolio should produce income over the course of an individual’s lifetime. While this concept has become the practicing standard of many financial professionals over the past two decades, it isn’t entirely foolproof.

In 2008, Nobel Laureate William Sharpe reported that the 4% Rule isn’t without flaws. If the current economic climate was considered in the equation, approximately 57% of today’s retirees would be at-risk for outliving their assets.

Fast forward to 2013 and this may no longer be the answer for new retirees. In two white papers by Dr. Wade Pfau “Breaking Free from the Safe Withdrawal Rate Paradigm: Extending the Efficient Frontier for Retirement Income” and “Mitigating the Four Major Risks of Sustainable Inflation-Adjusted Retirement Income” the case is made that the 4% rule may need to be adjusted for today’s interest rate environment.

Dr. Pfau plotted 1001 different financial product allocations, evaluating what the likely end value of each mix would be and the probability of the asset producing sustainable income for life. Surprisingly, the study’s findings suggested the traditional mix of stocks and bonds produced one of the poorest levels of results. The combination found to produce the best results was comprised of traditional stocks and fixed SPIAs (Single Premium Immediate Annuities ). Pfau’s second study further examined fixed income annuities, focusing particular attention to those offering fixed indexed components. This paper’s findings suggest that fixed index annuities (FIAs) produce the best outcomes in terms of ongoing income and longevity protection for current and future retirees. Pfau concludes that a portfolio utilizing the 4% rule has a high probability to fail but through changing the bond portion to a fixed index annuity and a 30-year inflation income rider of 4%, there’s a high chance of success. (See examples of fixed index annuities in the table below.)

The reason for Pfau's conclusions are that while traditional stocks and bonds have provided strong returns over time in previous decades, the current era’s market volatility has weakened actual annual portfolio performances. To help mitigate the potential eroding power of inflation, products such as fixed indexed annuities with inflation protection added should be considered by current and future retirees.

Addendum:
In a review by Dr. Michael Finke, Dr. Wade Pfau and David Blanchett titled "The 4 Percent Rule is Not Safe in a Low-Yield World" by utilizing the U.S. economic climate in 21st century for their analysis (as opposed to Bengen’s 20th century historical data), these researchers found the 4% rule has a 57% failure rate.

Additionally, in his recent study titled “Breaking Free from the Safe Withdrawal Rate Paradigm: Extending the Efficient Frontier for Retirement Income”, Dr. Pfau found the following results by including 1,001 unique financial product allocations:

1. The ending death value of each asset mix and (2) its probability to provide 30 years of the retiree’s income needs defines efficient retirement income with a mix of different investment products.
2. A combination of stocks and bonds represented the weakest retirement option but best performing products, according to Pfau, included “the combinations that best meet both criteria are those consisting of stocks and fixed SPIAs.” He also included as a product mix in his study, a fixed indexed annuity (FIA) with a 30-year inflation-adjusted income rider.
3. The FIA (including worst-case guaranteed projections) compared well against the stock/SPIA combination with 3% assumed inflation; however, it outperformed other product allocations utilizing a 4% assumed inflation rate.

More Coverage:

The University of Iowa
Breaking Free from the Safe Withdrawal Rate Paradigm by Wade Pfau