We have all been there. I just paid $12 for the “double deluxe clear coat automatic laser” car wash. Once finished with the washing part I quickly sped up to the giant hair dryer that gave me 45 seconds to dry my wife’s entire 20 foot long SUV. I am stressed because I know without appropriately drying the car that the water spots that would be left over would make the car wash an exercise in futility. I feel my nerves clenching a bit as I watch the timer, making sure that at least 50 percent of my vehicle is dry when 50 percent of the time is up, 75 percent of my car is dry when 75 percent of the time is up, etc. Meanwhile Jack, my 12 week old Vizsla puppy, is barking wildly since he hates carwashes. In my mind I have the ‘80s rock band Europe’s song The Final Countdown going through my head as I watch the timer tick away while I try to maximize the drying time. Once I finish this highly methodical carwash process I am feeling stressed, sweating and ready for a nap. Although I might be exaggerating a bit, my point is when you are facing a “set amount” of a solution to solve a problem that is variable and subjective to the situation (length of car, humidity levels, drying time, etc.) it tends to cause stress!
Imagine a bleaker situation where a client is a healthy 90 year old, having been in retirement for 25 years, and now only has $20,000 remaining in her 50 percent stocks and 50 percent bonds (50/50) retirement portfolio. Watching that $20,000 dwindle away for that retiree in her final years would be much more stressful than watching the 45-second clock on a car wash dryer. But yet, I feel that the analogy is appropriate.
A New Take on the Four Percent Rule
With time in mind, let’s take a look at some numbers. In 1994, a “rule of thumb” for retirement income was featured in the Journal of Financial Planning entitled “Determining Withdrawal Rates Using Historical Data.” This study is what started the “Gold Standard” safe withdrawal rate of four percent. I think everyone in the financial services industry is familiar with this. Fast forward to 2013 and a study co-authored by Morningstar Inc. established that in this new world of volatile markets and low interest rates that the new safe withdrawal rate is actually 2.8 percent.
The following hypothetical example takes a look at how a fixed indexed annuity (FIA) with a guaranteed lifetime withdrawal benefit (GLWB) rider can lead to new options.
Napkin Idea to Demonstrate the Power of GLWB Riders
Assume Mary, a hypothetical client, is 63 years old and wants to retire in two years at age 65. Mary has $1 million in a 50/50 portfolio. Let’s assume what Mary would expect to take in retirement income from this 50/50 portfolio two years from now. We want to look at that hypothetical dollar amount that she would expect from that portfolio then ultimately compare that to what can be guaranteed from an FIA with a GLWB rider.
The first question we want to ask to get Mary’s expected retirement income number from the 50/50 portfolio is: What is a reasonable performance expectation for the portfolio between now and retirement? As I present across the country to financial professionals, many times they will give me the example of five percent for a 63 year old considering that 50 percent of the portfolio is bonds. So, including compounding, that means the portfolio will grow to $1,102,500. At that point you would utilize the four percent rule. That means that assuming the portfolio grows by five percent per year over the next two years, and assuming that the four percent is in fact safe, Mary should be able to take $44,100 per year (adjusted for inflation) for the rest of her life.
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Although the five percent growth assumption may be a reasonable assumption for Mary between now and retirement, as many consumers have found over the last 15 years expectations do not always come to fruition. Note: The S&P 500 has been chopped in half twice since 2000!
Below is an example of a “pay cut” that Mary may experience should the market decline by 20 percent between now and age 65.
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As many financial professionals know, the 5-10 year period prior to retirement is very crucial because of the example shown. Because of the developments that happened in the two years leading up to retirement, in this example Mary would be looking at a 27 percent pay cut—$32,000 instead of $44,100.
Another very significant assumption that we used for Mary was the “post retirement assumption,”—the four percent rule. In other words, even if the portfolio grows by five percent per year between now and retirement, it is still not guaranteed that her portfolio will be intact over a 30 year retirement using that four percent withdrawal rate. As a matter of fact, in the Morningstar study previously mentioned it was indicated that with today’s low interest rates, market volatility, and sequence of returns risk, there is nearly a 52 percent chance of failure using the four percent rule. Would you get on an airplane if there was a 48 percent chance of having the number of landings equal the number of takeoffs?
Hypothetical FIA with GLWB Rider
In this example I assumed that the GLWB rider on the fixed indexed annuity had a benefit base roll-up of 8 percent simple per year, then at age 65 the payout factor is five percent, not four percent! This example is not an exaggeration of what exists in the FIA world today. With the above graphic you can clearly see the value of GLWB riders on fixed indexed annuities. The FIA scenario provides more retirement income than the previous “reasonable” assumption of $44,100 coming from the 50/50 portfolio, and it certainly provides more income than the second scenario of $32,000. With an FIA with GLWB rider, there are no uncertainties about what the benefit base would be two years from now and no uncertainty that the five percent withdrawal rate would be sustainable. The life insurance company in this example guarantees the eight percent per year on the benefit base and also guarantees the five percent per year for the life of the client. Most important, regardless of how long Mary lives, she is not confined to a set amount of retirement dollars she can take. Yes, she is confined to the $58,000 per year in this example, but if she was to live to age 120 she would still be taking guaranteed withdrawals. In other words, she will not see that retirement carwash clock do the “Final Countdown” with an FIA.
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There are two additional items on the comparisons that I would like to address that may be going through the reader’s mind. The first might be around the fact that we only assumed that Mary’s portfolio would increase by five percent per year between now and retirement. As we all know, with stocks and bonds the client’s portfolio can far surpass a five percent rate of return. Understanding this, I asked myself this question: In order to generate the same income ($58,000) as is being guaranteed by the FIA, what would Mary’s 50/50 portfolio have to grow to between now and age 65 while utilizing the four percent rule?” The answer to that question is $1,450,000! Over a two-year period of time this is a compound average annual growth rate of 20.42 percent that one would need that 50/50 portfolio to grow by in order to equal $58,000 in retirement income. Is this likely to happen?
The second item I would like to address is the inflation adjustments assumed in the four percent rule. Some readers may be thinking that my example is an apples to oranges comparison because of the fact that by utilizing the four percent rule Mary would be able to increase her withdrawals from $44,100 each year by the inflation rate applicable in ensuing years, whereas my $58,000 GLWB rider example is assuming a flat retirement income stream forever. This is a reasonable objection, as inflation adjustments can be crucial. As a matter of fact, the “inflation rule of 72” says that a three percent inflation rate will chop the purchasing power of a dollar in half in only 24 years (72/3 = 24 years). Meaning that $58,000 would only have the purchasing power of $29,000 in 24 years assuming three percent inflation. To answer this objection about the “level income” nature of traditional GLWB riders, some carriers have responded with recent product developments. A few carriers in the FIA world have introduced innovative riders that have increasing income options. This is where the guaranteed income is adjusted upward during the income phase by the interest that is credited year after year. Although there is a bit of a sacrifice in the first year guaranteed income if the increasing income option is elected on the GLWB rider, in most cases the guaranteed income is still far superior to the 50/50 assumptions we utilized with Mary.
To wrap up, real lifespans (what really happens) are not set at the average. If they were, the retirement puzzle would be easier to solve because that would get rid of one big “what if.” Thus, there are psychological benefits and mathematical benefits to not being confined to a “set amount” of retirement income that the client can take. Fixed indexed annuities with GLWB riders can guarantee that The Final Countdown does not haunt retirees in their later years when they are supposed to be enjoying life. Unless, of course, they are at the carwash.
For Financial Professional Use Only. Not for use with consumers.
Guarantees are backed by the Financial Strength and claims-paying ability of issuing company.
Annuities are designed to meet long-term needs for retirement income. They provide guarantees against the loss of premium and credited interest, and the reassurance of a death benefit for beneficiaries.
An income rider or benefit (sometimes called Guaranteed Lifetime Withdrawal benefit rider or GLWB rider) is an additional feature available with some annuities and generally optional and come with additional costs. Income benefits are designed to provide income options above and beyond the standard annuitization or free withdrawal features in annuities.
Pursuant to IRS Circular 230, Partners Advantage Insurance Services and their representatives do not give tax or legal advice and cannot be used to avoid tax penalties or to promote, market, or recommend any tax plan or arrangement. Encourage your clients to consult their tax advisor or attorney.
The information contained in this article is not intended to serve as tax or legal advice and is not intended to provide financial or legal advice and does not address individual circumstances.
The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less that those shown. This illustration does not represent any specific product and/or service.
