Distribution Methods for Assets in Individual Accounts for Retirees: Life Income Annuities and Withdrawal Rules

Abstract

This article examines the two basic, opposing methods of how to pay out assets from 401(k) plan accounts and IRAs to retired workers. The first method is the immediate life annuity, and the second is a rule to withdraw a fixed percentage of 4% of the initial account balance, increased each year after the first year by the rate of inflation. The lifetime income levels and risks these methods produce are calculated using a historical simulation of asset returns, interest rates, and inflation, as well as recent data on the pricing of immediate life annuities. This article is the first to conduct this comparison using a standard methodology over a long time period.

The life annuity is judged to be an effective instrument to produce lifetime retirement income—generally somewhat better than the commonly used withdrawal rules, in terms of a usually much higher level of income and lower risk of running low on resources. The life annuity is subject to inflation risk at longer horizons and lacks liquidity and bequest value. Given the desirability of balancing the advantages and disadvantages of the two methods, the optimal strategy would seem to combine the methods, ideally reflecting the unique preferences and situation of each retired household.

TOPICS: Retirement, wealth management