How Does an Immediate Annuity Compare to the 4% Rule?

Written by Hersh Stern

immediate annuity 4%

How can you get the most from your nest egg when it is time to retire? Often retirees will put two options side by side: One is an immediate annuity; the other is placing the funds in a conservative portfolio and drawing it down by 4% a year.

Many financial advisors quote research that indicates a 4% yearly drawdown is likely to preserve a portfolio over a long retirement. The 4% is the initial withdrawal, followed by increases to match inflation.

Let’s see how the two options compare with the help of two imaginary brothers.

Bill retires at 65 with $1.5 million in his retirement account. In Year One, he takes out his 4% which is $60,000. Bill boosts his withdrawal each year by the inflation rate. It is likely that he will be able to do so for 30 years without running out of money, depending on his annual return.

Bill’s brother Jim also retires at 65 having saved up $1.5 million, but he’s got a few more expenses and wants to spend more than $60,000 a year. Jim chooses to put his money into an immediate annuity which guarantees him income for the rest of his life – however long that may be.

An average annuity payment on $1.5 million for a man Jim's age would be about $8,3000 a month. That's $100,000 a year, or over 7% of his $1.5 million nest egg. (These monthly and annual income figures change daily and were published in September 2018.)

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Cash Flow vs. Control

Which brother took the better approach? Certainly $100,000 a year is better than $60,000, and the lifelong guarantee is very reassuring for Jim. What’s more, the additional yearly cash flow will allow Jim to defer Social Security until he reaches 70, providing a larger benefit for himself and his spouse.

Nevertheless, Bill has more control over his finances. He can take more or less than the scheduled amount from his retirement account each year, depending on his personal needs and future investment performance. If he chooses, he can access larger sums from his account, as well.

If Bill stays with the basic plan, his withdrawals will keep pace with inflation. If inflation is 3% a year, his yearly withdrawal will top Bill's $100,000 payout in 20 years, by age 85.

Going forward, Bill will have more cash flow than Jim when they are elderly which can come in handy if long-term care is needed. However, should the brothers live longer, Bill may start to worry that his nest egg will be depleted.

Bill could also decide to take smaller withdrawals than scheduled, to leave some of his retirement account to heirs, while Jim’s one-life annuity would leave nothing for a beneficiary.

Bill's 4% solution offers access to capital, income growth potential and the possibility of bequeathing some wealth to loved ones. While Jim could get those features in an immediate annuity, the more options he chooses, the lower his monthly payments will be.

However, Bill’s strategy lacks guarantees. Poor portfolio decisions or untimely bear markets could force him to lower his annual withdrawals and change his prospects significantly.

Best of Both Worlds

Both Bill and Jim chose approaches with distinct strengths and weaknesses.

Fortunately, you are not locked in to one path or the other like our hypothetical brothers. By choosing to both purchase an immediate annuity and keep cash in a portfolio for the 4% approach, you can maintain flexibility and have an income stream that is guaranteed for life.

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Comments (8)

  1. Darin
    2015-03-09 15:17:20

    The "real" interest rate on annuities right now is maybe 1.5% if that. Anyone can do the math and see that Bill will do "much" better than Jim and leave monies to his heirs.

    Yes Bill will have some white knuckle market moments, but at 4% SWR his account will probably double, whereas Jim will have nothing.

    When the "real" interest rate of annuities gets above 2-3% I think part of one's monies could go there as a cushion for market drops, but otherwise, a good old balanced fund or funds will do much better than an immediate annuity.

  2. Hersh Stern (
    2015-03-09 15:20:50

    Hi Darin,

    You raise good points. However, there's been rigorous testing by Prof. Wade Pfau of the idea that a combination of stocks and immediate annuities even at today's low rates may be the best way to optimize a retirement income portfolio for a robust set of circumstances.

    See "Mitigating the Four Major Risks of Sustainable Inflation-Adjusted Retirement Income":

    A similar recommendation was made by Stanford University and the Society of Actuaries in "The Next Evolution in Defined Contribution Retirement Plan Design":

    Both studies were released in the current low SPIA interest rate environment. I appreciate reading your point of view but I don't agree with it. A large number of our clients don't have the fortitude to white knuckle another 2003 or 2008 selloff. Even if that means foregoing significant "alpha" returns when the going's good, the emotional, stress cost to watching a 50% drawdown is something they never want to experience again.


  3. John
    2015-04-07 12:46:26

    It is my understanding that Bill can take out only 4% of his current portfolio every year not 4% of his original portfolio plus an inflation adjustment. Is that correct?

  4. Hersh Stern (
    2015-04-07 13:11:23

    Hi John-

    The 4% rule is based on the portfolio's initial balance; subsequent market performance isn't dynamically factored into the withdrawal rate — even though it can dramatically affect the portfolio's balance.

    So in my example, Bill removes $60k ($1.5MM x .04) and adjusts the $60k figure by cumulative inflation. But he ignores dramatic changes in the value of his portfolio. That's why if there is a protracted bear market (over several years) there's a small risk the 4% rule will lead to early depletion of the portfolio.

    In particular, an unfavorable market climate in the early years of retirement increases the risk of asset depletion because capital preservation during those early years is critical to the portfolio's ongoing growth yet the 4% withdrawals will be taken from a smaller base.

    Conversely, if Bill's returns are higher than expected in the early phase of retirement but since his withdrawals are static he will be leaving money "on the table" that could have been used for greater enjoyment.

    Finally, there a many other issues with an arbitrary flat withdrawal rule (which applies equally to the 4% method and also annuities). For example, it doesn't take into account personal changes in health or lifestyle that naturally occur with age. Many retirees need more flexibility in their cash flow to handle the inevitable ups and downs of life.


  5. Keith
    2015-04-08 13:01:01

    I am retired, 63 years old and have a 401K valued at $350,000. How should I balance my portfolio?

  6. Hersh Stern (
    2015-04-08 13:23:33

    Hi Keith-

    I'm going to punt on this one. This is a question that should be answered by a qualified financial planner, which I am not. A financial planner can review your overall retirement goals with you and help you to figure out how to invest so you maximize your return while minimizing your risk. Together with your planner you can design a course of action with specific allocations to achieve your financial goals.

    If buying an annuity is part of your overall plan, of course, contact me again and I'd be happy to help you.

    Here's a good article on how to find a financial planner:


  7. Terry
    2015-11-24 08:17:07

    Hi Hersh, if the Fed raises interest rates in December as expected, will that have a effect on annuity returns next year?

  8. Hersh Stern (
    2015-11-24 08:18:26

    Hi Terry-

    Yes, there is a correlation between annuity rates and interest rates. You can see that in the following chart I update every month at our site:

    Keep in mind, the Fed has said it will move very gradually.