License to spend: fading the 4% rule

The American retirement system has long been focused on one principal aspect: getting workers to save early so they will have enough money to live on during retirement. While the U.S. retirement system offers Social Security as a broad, government-run savings vehicle, the income replacement rates offered by Social Security are not designed to provide enough money for most workers to count on throughout their retirement years.

The Social Security monthly check for the average retired recipient is currently $1,907, or just under $23,000 a year.¹ Given this low level of income, U.S. workers need to have some form of private retirement plan. The growth of the 401(k) plan, and the diminishing number of employees who are enrolled in a DB plan, have shifted the burden of managing retirement savings into the hands of individual workers. 

This transition has led to a mentality and culture of accumulating assets. When today’s workers log into their retirement savings accounts, they see a total balance of their accumulated assets, a mix of contributions and market returns that have occurred over time. What they don’t see is a monthly income benefit they will enjoy in retirement, akin to the monthly paycheck they are used to seeing deposited into their bank accounts during their working years.

A new mentality is required when workers reach retirement as they are forced to pivot toward drawing down accumulated assets. This new reality can be a difficult pill to swallow. 30+ years of consuming articles about saving and not touching account balances except in case of emergency can lead many workers to believe their 401(k) balances are inviolable. Research suggests that 25% of retirees reduce their spending upon entering retirement, with the numbers especially concentrated in those who are using accumulated savings balances in retirement (as opposed to those who rely on guaranteed sources of income such as Social Security, DB plans or annuities).²

The approach to spending in retirement has historically been governed by the so-called 4% rule. This is a loose guideline that says a retiree can withdraw 4% of their balance in the first year of retirement, and then in subsequent years adjust for inflation and make withdrawals accordingly. For example, a retiree with a $1 million dollar balance would withdraw $40,000 in the first year, and then in a 2.5% inflationary environment, $41,000 in the second year, $42,025 in the third year, etc. This rule, however, was designed for a 30-year retirement time horizon and does not consider the prevailing interest rate or market returns on a portfolio. In today’s environment where the 10-year Treasury alone at auction is yielding around 4%, it certainly seems inadequate given yields that are available in other asset classes.³

The role of guaranteed lifetime income

We think a more helpful approach to retirement planning is to evaluate the income levels needed to sustain the worker’s retirement, then go back into asset allocation and withdrawals from that starting point. Studies have shown that the spending habits of many workers change as they enter retirement. While retired workers are no longer spending as much money on work- and commuting-related expenses, such as prepackaged meals and clothes, the overall spending picture is somewhat mixed. The psychological impact of retirement and the transition away from a regular employer-provided paycheck can also impact spending and savings habits.⁴ These studies also showed that new retirees increased their liquid savings, again suggesting a possible nervousness about retirement and the changing income routines it represents.

Workers entering retirement can benefit from guaranteed income solutions. These solutions offer the ability to feel similar to the end-user to the income that many workers are used to receiving during their working years. The role of an in-plan, institutionally priced annuity allocation that grows throughout a career, and can be converted into a stream of lifetime income at the point of retirement, is a way to smooth the transition for workers at the point of retirement.

Such products encourage workers to think about their retirement income needs and more confidently achieve their spending goals.

The annuity advantage

TIAA has also run the numbers on the advantages that an integrated annuity can have for income levels in retirement compared with the 4% rule approach. Let’s look at a hypothetical example, based on a $1 million balance. According to the 4% rule, the participant would withdraw $40,000, or $3,333 per month from retirement savings, in the first year of retirement.

Compare this with a participant who annuitizes a third of their $1 million balance. As of March 1, 2024, for a 67-year-old who selects a single-life fixed annuity with payouts ensured for at least 10 years, we can assume that income rate is 7.8%. In a year this retiree would get $26,000 in annuity checks from the $333,333 they converted into guaranteed income. Now if they apply the 4% rule to the remaining $666,667 of their original balance, this gives them an additional $26,667.

Combining the two streams, by annuitizing a third of savings with a fixed-rate annuity, our hypothetical participant would get a total of $52,667 in 2024 — 32% more than the original $40,000. That’s $1,056 more per month in the first year of retirement. Obviously, the assumptions underlying this are constructed on prevailing interest rates, and generally, the higher the interest rate, the higher the advantage offered by annuities. The annuity also continues to offer this income stream even if the market were to experience a downturn, which could impact the withdrawals under a 4% rule.

A further consequence of securing necessary expenditures through a combination of an annuity and Social Security, is that it potentially allows a retiree to accept more risk with their remaining balance. If a retiree is concerned that their assets may run out in retirement, they may allocate more conservatively than they otherwise need to. Whereas, for a retiree who doesn’t have to be so conservative, they could potentially allocate to a higher risk tolerance, which could generate more returns for the portfolio. Depending on risk appetite for the investor, allocations to more illiquid investments, such as private markets, could also be a way to further diversify the balance of retirement assets.

The other consequence of securing necessary expenses through the use of guaranteed income products and Social Security is that it could allow a retiree to feel empowered to use their remaining balances on discretionary spending, such as travel. And the data backs this up, showing that those with more guaranteed sources of income spend around 75% of their income, whereas those who are more reliant on self-directed withdrawals spend around 65% of their income.⁵

The role of advice and knowledge

Financial literacy especially is something that can be built throughout a worker’s career. As part of an ongoing human resources program, financial literacy can help to build knowledge of both saving and spending best practices. TIAA research has focused on longevity literacy as well. This research covers for both underestimating and overestimating the length of time that will be spent in retirement, and the potential role that guaranteed lifetime income solutions can play in securing the dollars that are necessary for income throughout retirement.

Another element is engaging workers with financial advisors. A number of best practices can help educate workers around financial planning and further those discussions around what savings they have and how that will translate to income in retirement. This should include one-on-one financial education-based conversations, regardless of job rank, to engage employees throughout their careers. Specifically, younger individuals should be a focus so that they understand the benefits of saving sooner. And it is worth ensuring that any advisors brought into the workplace are drawn from a diverse group that represents the individuals seeking financial advice. This can help bridge gaps, and help minority employees by offering a deeper understanding of idiosyncratic factors that can impact financial preparedness.

It is also worth considering individuals that are at the lower end of the pay scale, as regardless of financial literacy, individuals that may be struggling to make ends meet have different needs, focused on emergency savings and having a buffer for immediate expenses.

The ability of retirees to spend is worth consideration alongside their ability to save. These need to be balanced, and the role of guaranteed lifetime income to help retirees meet their necessary expenditures while giving the greatest freedom for discretionary spending needs to be highlighted. Programs that can help to educate employees throughout their careers, and provide financial advisers and holistic views of the way retirement savings plans operate can help smooth the gap between an employee’s work years and retirement years. Knowledge and preparedness can help and allow retirees to enjoy their golden years to the fullest.