I turned my camper van into the parking lot at Lake Louise, Alberta. Snow-capped peaks loomed above. The sun was shining, and a group of cyclists began to congregate. I didn’t know where they planned to ride, or whether they might welcome a tag-along. But I ran over to the group and asked if I could join them.
After changing, I pulled my bike off its rack and we cycled towards Banff. It didn’t take long before one of the riders asked what I did for a living. So, beneath the towering peaks of the Rocky Mountains, the money questions came. One of my new friends, Cam, runs a soap-making business. He wants to pull some money out of his company and invest it. “I want to diversify from having everything in my business,” he said. “I want to invest the money so it can give me a stream of income when I retire.”
You might not have a business, like Cam. But you might still wonder how to generate income from an investment portfolio. “I want to be able to spend 6 percent of the money every year,” said Cam, “but I don’t want the principle to drop.”
Several years ago, Cam could have bought a long-term Treasury bond that paid 6 percent annually. But those days are gone. It was 1997 when 30-year Treasury bonds last yielded such returns. This year, the average annual yield on a 30-year Treasury bond has been just 1.54 percent.
Incredible Shrinking Interest Rates
30-Year U.S. Treasury Bonds
Treasury bonds, bank savings accounts, CDs and money market funds wouldn’t provide the income Cam requires. This might make him vulnerable to an annuity broker. If he bought a fixed income annuity, Cam could give an insurance company his money in exchange for a promise of 6 percent per year.
But the devil is in the details.
For starters, if Cam chose their highest interest-paying option (which would be about 6 percent annually) his heirs would lose the principle when he died. If he bought an annuity with survivorship clause, meaning his wife or daughter would benefit from the proceeds, he (and his benefactors) would earn far less than 6 percent per year. After all, the insurance company wants to ensure it makes a profit.
Even if Cam were single, without children, and if he went for the maximum annual income policy, inflation would take an ever-increasing bite. After all, Cam’s annual payout (in terms of dollars) would remain the same every year. If inflation were 2.5 percent during Cam’s first year of retirement, the buying power of his payment would be reduced by 2.5 percent that year. If inflation were 2.5 percent again, during Cam’s second year of retirement, his buying power would be 5.06 percent lower than when he first began the policy. If inflation were another 2.5 percent during Cam’s third year of retirement, his buying power would be reduced by 7.69 percent.
Few annuity salespeople would show Cam this. But if one did, Cam might ask the insurance broker for an annuity with an adjustment for inflation. Such policies exist. But they pay far less than 6 percent.
That’s why I believe there’s a better way for Cam. It’s based on the 4 percent rule. If Cam had a diversified portfolio of low-cost index funds, he could sell an inflation-adjusted 4 percent per year. When doing so, he could withdraw an ever-increasing amount of money that should last at least a 30-year retirement.
The 4 percent inflation-adjusted withdrawal rate was back-tested to 1926. In other words, anyone retiring in 1929 (before history’s biggest market crash) could have withdrawn an inflation-adjusted 4 percent per year, and they would have still had money left, 30 years later.
Let’s see how it would have worked for Cam if he retired 30 years ago, in 1990. Assume had $500,000 in a portfolio of indexes: 70 percent in a global stock index and 30 percent in a U.S. bond market index. This isn’t a cherry-picked allocation. The global stock index includes broad exposure to almost every country with a stock market: the good, the bad, and the downright ugly. We’ll never know which stock markets will perform well and which will stink, so it’s best to own them all.
The 30 years from 1990 to 2020 would have seen two significant market crashes: 2000 to 2002 and 2008 to 2009. But if Cam didn’t fret about the fluctuations of his money, he would have more today than when he first retired. Unlike with the high-interest paying annuity, he could bequeath that money to his heirs. And finally, a 4 percent inflation-adjusted withdrawal would have provided more overall income than a non-inflation adjusted 6 percent payout every year.
Note how the two compare in the chart below. If the annuity paid 6 percent, Cam would have received $30,000 in income during the first year of his retirement. This would have remained the same, year after year. After 29 years, his payouts would have totaled $870,000 (the 2020 calendar year would make it an even $900,000).
In contrast, if Cam invested $500,000 into a globally diversified portfolio of index funds (70% global stocks and 30% bonds) he could have withdrawn $21,221 during the first year of his retirement. That reflects 4 percent of his portfolio’s initial value, plus a slight increase for inflation that year. As the cost of living increased, however, Cam would have withdrawn an ever-increasing sum to battle the ravages of inflation.
The 6 percent annuity might look better out of the gate. But the picture soon changes after taxes and inflation. Annuity payouts are taxed as ordinary income. That makes them highly inefficient. In contrast, dividend income and capital gains are taxed far more leniently. That’s a plus for the portfolio of index funds.
What’s more, if Cam died after 29 years (assuming the example below) he could have bequeathed more than $1.4 million to his heirs, if he withdrew an inflation-adjusted 4 percent per year from a globally diversified portfolio of index funds. In contrast, if he died after 29 years with the fixed income annuity, his heirs wouldn’t receive a penny. They wouldn’t receive any money if he died in his first year of retirement, either.
Plenty of people might try to convince Cam that he could beat a portfolio of index funds. That’s possible. But academic evidence says it isn’t likely. Unfortunately, statistical probabilities are one thing; a salesperson’s rhetoric is another. That’s why Cam’s biggest risk might be a charlatan’s promise.
Inflation-Adjusted 4 Percent Beats Non-Inflation Adjusted 6 Percent
Starting Value: $500,000
|Year||Amount Annually Paid |
(Fixed annuity 6% annual payout)
|Amount Remaining That Cam Could Bequeath |
(Assuming death in the relative year)
|*Amount Annually Withdrawn from Investment Portfolio |
|Amount Remaining That Cam Could Bequeath From The Investment Portfolio |
(Assuming death in the relative year)
|Total Annuity Payments |
|$870,000||$0||Total Withdrawals From The Portfolio |
*Based on 70% global stock index, 30% U.S. intermediate bond index
**To August 31, 2020
***Withdrawals for 2020 not calculated, although it would be $30,000 for the fixed income annuity, assuming the 6% annual payment.
Further Related Reading:
- Index-Linked Annuities Offer A Clever Slight of Hand
- The Biggest Risk Of The 4% Retirement Rule
- Would The 4% Rule Work If You Retired Before A Crash?
- When The 4% Rule Could Fail Investors
- How Retirees Can Withdraw More Than 4% Per Year
- Should You Buy A Fixed Income Annuity For Retirement?
- Should A Lifetime Annuity Fuel Your Retirement?
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas