Comparing Lifetime Annuities and Structured Withdrawals

A rigorous new study out of George Mason University takes a strong positive stance on using lifetime annuities over structured withdrawals.

An academic analysis by Mark Warshawsky, of the Mercatus Center at George Mason University, examines two commonly proposed solutions for controlling outflows from defined contribution (DC) plans—the purchase of immediate lifetime income annuities and the well-known 4% rule.

As explained by Warshawsky, far more workers are relying on 401(k)-style retirement plans than in years past. He suggests this trend will continue as more employers move toward DC-style retirement benefits.

“While we know how to pay in to this new generation of retirement plans, we have not yet determined how best to structure the payouts,” Warshawsky writes. “Now that more workers with 401(k)s or individual retirement accounts (IRAs) are retiring, it’s time to address this question quickly and decisively to help retirees get orderly, lifelong payments.”

Relatively few plan sponsors and advisers today are coaching their participants to strictly follow the 4% rule, also known as the “Bengen Rule,” according to which participants spend down 4% of their retirement asset per year—increasing the percentage over time to address inflation. But many advisers and sponsors put their own spin on controlled withdrawal programs that build off a similar philosophy, Warshawsky proposes, with the main benefit being that participants maintain control over their assets.

“There are theoretically more complex strategies and products on both sides of this debate, but both practically and for policy purposes, an empirical investigation into the basic choices is an excellent starting point for discussion,” he notes.

Running his analysis, Warshawsky finds that lifetime annuities “are preferable to structured withdrawals because their income flows are generally higher and present less risk.” Even for those who do not wish to annuitize their entire DC account balance, Warshawsky argues there are strong positive benefits that come with purchasing an immediate life annuity with at least part of one’s 401(k) or IRA balances.

Many of his supporting reasons will be familiar to retirement industry practitioners—first and foremost is that individuals tend to underestimate their own lifespan, leaving them at a significant risk of spending down assets too quickly in retirement. While the risk of an individual dying before breaking even on an annuity purchase is real, they do not run the risk of running out of money entirely. 

Warshawsky says the data is pretty clear that, whatever the withdrawal structure, participants need to save a lot to have a successful retirement. Both the value of annuity income streams and structured direct withdrawals will be diminished over time by inflation. This is another reason he believes annuities are preferable—they are subject to inflation risk but not market risk. 

Interestingly, because the specific needs of each household are different, Warshawsky “discourages government policymakers from taking a strong stance and harming those that might be better served by setting up an effective direct withdrawal.”

The full analysis is available for download here.