What Can Scholarly Research Tell Us About the Merits of Annuitization vs. Drawing Down Unannuitized Wealth? Do Low Interest Rates Post COVID-19 Change the Rules of the Game?
Studies on the best ways to draw down wealth during retirement have claimed that households following the so-called 4 percent rule, which calls for consuming 4 percent a year of accumulated wealth during retirement, are at relatively low risk of outliving their wealth. This literature review investigates what, if anything, financial advisors can learn from the literature that models the relative merits of purchasing an annuity as opposed to following the 4 percent rule or other similar strategies. This review argues that the 4 percent rule and other similar rules of thumb are overly simplistic and that they fail to use household financial resources in the most effective way. In contrast, strategies that optimize the use of financial resources are too complex for most households or their advisors to implement. Annuities likely dominate the set of drawdown strategies that households could feasibly implement. This review argues that the 4 percent rule will be even less appropriate in a COVID-induced low-interest-rate environment. At current and prospective interest rates, the 4 percent rule, if we retain such a rule at all, must become the 3 percent rule.
In an influential paper, Bengen (1994) argued that households that spend 4 percent a year of the value of their wealth during retirement historically faced a very low risk of outliving their wealth: this is the so-called 4 percent rule. This review critically appraises the literature on the 4 percent rule and concludes that, even before the COVID-induced decline in returns on financial assets, the evidence for the 4 percent rule’s benefits was questionable. In addition, this review concludes that the rule violated many of the precepts of the life-cycle model of preretirement saving and postretirement asset drawdown. Given plausible assumptions regarding prospective returns on financial assets, this review calculates that a 3 percent rule is the new 4 percent rule. In any case, most retired households would obtain a significantly higher and more-secure income by purchasing an annuity than by following the 3 percent rule.