The 4% Rule Doesn't Mean You Won't Go Broke in Retirement

How much money can you safely withdraw from your investment portfolio each year during retirement?

One answer comes from a financial adviser who 30 years ago weighed the past performance of the stock and bond markets in a portfolio composed of 60% equities and 40% bonds. He calculated that retirees could safely withdraw 4% of their savings during the year they retire and adjust that amount for inflation each subsequent year. He claimed a retiree wouldn’t run out of money for at least 30 years of retirement under this plan.

As a rough guideline, the 4% rule has some merit, but it’s far from a foolproof strategy. At the very least, it exposes early retirees to risk because, according to theory, it assures only 30 years of solvency. If you retire at 60, for instance, you’re likely to run out of money once you reach 91, according to this theory. But that’s not the only risk.

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Volatility can torpedo your plan

The biggest risk is market volatility, especially in the early years of retirement. Suppose Mr. and Mrs. Doe have a $1.67 million portfolio, invested 60-40 stocks and bonds — meaning they have just over $1 million in stocks and $670,000 in bonds. Say that in year one, their $1 million stock portfolio drops by 26%. If they also make a $40,000 withdrawal, their stocks would be worth just $700,000. The stock market would have to have a terrific multi-year run to make up for that loss plus future withdrawals. It could start their equities on a spiral toward zero prematurely.

Suppose their 40% bond allocation ($670,000) returned 4% that year, so there’d be no loss of value after a 4% withdrawal. That provides a nice cushion, and the couple could instead take all or most of their withdrawal from the bond portfolio — but that would leave them overly invested in stocks.

One way to reduce the risk is to lower the stock proportion. If you went with 40% stocks and 60% bonds to start, you’d have less risk because bonds are theoretically less volatile. But stocks, though more volatile, have given higher returns over time.

A way to ensure you won't run out

If you could predict exactly how long you (and your spouse, if you’re married) will live, it would simplify planning. But you can’t, and you may exceed the average by a wide margin. This is called longevity risk.

A lifetime income annuity lets you transfer this risk to an insurance company. Essentially, you’re creating a guaranteed lifetime pension. In return for a lump-sum payment, the insurer guarantees a stream of income for life.

It works much like any other form of insurance. Annuity owners who die younger than average subsidize those who live past their life expectancy. It’s the opposite of life insurance, where policyholders who live to a ripe old age subsidize insureds who pass early.

An income annuity can cover a single person or a married couple. A couple choosing the joint option ensures the same income will flow as long as either spouse is living. This option pays somewhat less income because it’s more likely that at least one spouse will live to a very old age.

The income annuity can be either immediate or deferred, with payments starting at a future date you choose.

Some tax implications

An income annuity pays more income than other vehicles because each income payment includes both non-taxable return of principal and taxable interest until your principal has been repaid. This assumes you’re using nonqualified funds — that is, an annuity that’s not in an IRA or other qualified retirement plan.

You may think, “Well, what’s the big deal since much of the income is just my own money coming back to me!” But remember, that ample income will keep flowing to you even after you’ve gotten all your money back if you live long enough. (Once that happens, the payments become fully taxable.) That’s the longevity insurance aspect.

Suppose Mr. and Mrs. Doe, both age 65, purchase a joint life annuity with $500,000 of nonqualified funds. As of January 2025, they could get up to $2,784 of monthly income, of which just $1,116 is taxable for the first 25 years of the contract. After that, the entire amount would be taxable.

The product they chose offers no payment to their heirs should both die before the principal is repaid. If they chose an installment-refund option that guarantees their heirs would inherit any unpaid principal, the monthly benefit would be slightly lower.

A higher-yielding, safe alternative to CDs and bonds

Retirees who buy an income annuity won’t need to have as much money in fixed-income vehicles, but just about all retirees need some funds in that bucket. This bucket includes bonds of various types (as individual bonds or bond funds), money-market funds, bank certificates of deposit and CD-like fixed-rate annuities known as multi-year guaranteed annuities (MYGAs.)

Each of these options has its pros and cons, and determining which mix best suits your needs takes some thought. Retirees and people about to retire, however, should consider MYGAs because rates are attractive today.

Like a CD, a MYGA pays a guaranteed interest rate for a set period, usually two to 10 years. There’s no sales charge, so all of your money goes to work for you immediately. Because nonqualified interest is tax-deferred until withdrawn, it can accumulate faster.

While annuities are not FDIC-insured, they are covered by state guaranty associations, up to certain limits, which vary by state. While this is a valuable backstop, it’s unlikely you’ll ever need to rely on it, especially if you choose a financially strong issuer.

How MYGAs can fill a gap

Today, you can get a great rate on a MYGA and lock it in for whatever term you’re comfortable with. For instance, you can earn up to 5.60% for a six-year guarantee or up to 5.55% for a 10-year term. If you only want to commit for two years, you can still get up to 5.20%.

Most MYGAs offer significant liquidity. Many let you take out up to 10% of the current value annually, penalty-free, after the first year. This makes them suitable for retirees who need income. Some annuities, however, have lower amounts or penalize all withdrawals during the term.

If you have one or more MYGAs that permit ample withdrawals, it provides great flexibility. Suppose the Does have a great year with their stocks, which are up 25%. They might decide to withdraw the entire 4% from their stock portfolio that year and leave all their annuity interest untouched and tax-deferred.

The following year, the market declines 15%, so they decide to use their annuities to fund the bulk of their 4% withdrawals. MYGAs with liquidity would let them tap their equities when the market is up and not be forced to sell when it’s down. (Note: Withdrawals of annuity interest before age 59½ are normally subject to a 10% IRS penalty.)

The best strategy for withdrawing money in retirement takes thought and planning and choosing the optimal financial vehicles. Income annuities and/or fixed-rate annuities may be a suitable choice for you.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities since 1999. Ken is a nationally recognized annuity expert quoted in national media and a widely published author. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356.

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