Stop Comparing Annuity Payout Rates to the 4% Rule

Income annuities tend to have nominal payouts. While Social Security retirement benefits are linked to inflation (technically the CPI-W), it is not possible to purchase an annuity today with benefits explicitly linked to inflation. Income annuities that offer some type of fixed cost of living adjustment (COLA) are also relatively uncommon. For example, in 2021, less than 2% of the 602,997 quotes run through CANNEX included any type of COLA, based on the CANNEX 2022 Annual Survey Experience Report. 

While there are a variety of potential reasons why retirees actively choose to not include COLAs, perhaps one of the most obvious reasons is the impact on the payout level.

For example, the average five highest quotes for a SPIA on a 65-year-old male/female couple with a cash refund provision was 6.22% from CANNEX on Jan. 3, 2023. If you include a 2.5% COLA, which is the approximate inflation expectation from the Cleveland Federal Reserve for the next 30 years, the payout rate declines to 4.61%. This is a significant decline, reflecting the notable increase in expected benefit payments over time.

Apples and Oranges

Comparing the payout rate on a nominal annuity (e.g., 6.22%, using the previous quote) to the 4% rule is incredibly misleading, because they imply two very different things. The 4% rule is a real (i.e., inflation-adjusted) income benefit designed to last for some fixed period. In contrast, the previously noted 6.22% SPIA payout rate is a nominal benefit that lasts for life; therefore, the 4.61% value would be more appropriate for comparison purposes, but even then, the values are indicative of two very different things.

Implying that 6.22% is “better” than 4% because the value is higher could result in a retiree making a decision that is based on incomplete (and misleading) information. While it is obviously important to be aware of the different levels of income that can be generated from different strategies, the values should be contrasted with care.

At a minimum, if you’re going to compare an annuity payout rate to the 4% rule, the payout should include a cost-of-living adjustment that is roughly equivalent to expected inflation (even though this is obviously an imperfect hedge).

Note, I don’t necessarily think retirees need portfolio income that increases annually with inflation, given observed spending patterns (i.e., the retirement spending smile as I’ve called it) especially since other forms of retirement income are already explicitly linked to inflation, such as Social Security retirement benefits, but I think it’s important to ensure the comparison is as accurate as possible.

Conclusions

While investors tend to value simplicity when attempting to distill the value of a given strategy or an approach to a single value, it is incredibly important the comparison itself be valid. 

Comparing the payout rate for a nominal annuity to the 4% rule is not appropriate because the fundamental structure of the assumed benefit is different (real versus nominal, respectively) as is the implied term (30 years versus for life, respectively).