Retirement planning can be a daunting task for most individuals, especially in the absence of a defined-benefit pension to complement Social Security benefits. The unpredictability of key factors such as life expectancy, health, market performance, and inflation levels makes it challenging to determine a sustainable annual income from one's savings.

The widely accepted 4% rule, which suggests withdrawing 4% of your investment portfolio annually, adjusted for inflation, is a guideline that many retirees follow. This rule, originating from the research of financial advisor William Bengen in 1994, is based on a balanced portfolio of 50% US large-cap stocks and 50% intermediate-term Treasuries, with an assumption of a 30-year retirement period. Bengen later revised his recommendations to a withdrawal rate between 4.5% and 4.7%, reflecting the increased diversification in investment portfolios.

While the 4% rule serves as a useful starting point, it is not a one-size-fits-all solution. Retirement spending should be tailored to individual goals, needs, and financial standing, with the primary aim of avoiding outliving one's savings. The rule has its limitations; for instance, it assumes a high probability of never depleting the retirement funds. According to Morningstar's simulations on a $1 million portfolio over 30 years, the median ending balance was $1.5 million for balanced portfolios, indicating that the rule is conservative. This could be beneficial for those who wish to leave an inheritance, but it might come at the expense of a more comfortable retirement lifestyle.

The 4% rule also fails to account for the variability in annual spending needs and the fact that the average life expectancy for individuals turning 65 is less than 30 years, as per the Social Security Administration's estimates. For many, the prospect of "guaranteed income for life" is enticing, which is what Social Security and annuities can provide, albeit with varying structures and complexities. Annuities offer a steady stream of income for the remainder of one's life, and a new research paper published in October explores a strategy that balances the desire for guaranteed income with financial flexibility, while maintaining a high likelihood of not exhausting retirement funds.

The study compared strategies such as strictly adhering to the 4% rule versus investing half of a $1 million portfolio in an annuity and managing the remaining funds more aggressively in equities. The hybrid approach, as described by co-author Mark Warshawsky, CEO of ReLIA Strategies, and senior fellow at the American Enterprise Institute, performs well under various personal circumstances and preferences, offering higher annual income and a substantial amount of money left at the end of the 30-year period.

The research, funded by the American Council for Life Insurers but independently conducted, suggests that individuals with very large retirement funds of $5 million or more might fare better under the 4% rule, while those with limited funds (e.g., $250,000) might benefit more from using most of their nest egg to purchase an annuity to mitigate the risk of running out of money. However, the complexity and confusion surrounding annuities may limit their practical application for now. As Craig Copeland, director of wealth benefits research at the Employee Benefit Research Institute, notes, "Annuities are not easy to understand, and the finality of them in most cases has dissuaded people from getting them."

Nevertheless, as policymakers and employers recognize the shift from pensions to 401(k)s and other defined-contribution plans, which places the onus on individuals to manage their retirement income streams, annuities may become more prevalent in workplace plans. "It’s not just about getting employees to retirement but helping them figure out what to do once they’re in retirement," said Rob Williams, managing director of financial planning at Charles Schwab.

For those nearing or beginning retirement, Williams recommends working with a financial advisor to develop a sustainable and disciplined approach to drawing down their nest egg and discussing the potential advantages and disadvantages of purchasing an annuity with some of their funds. "Those two things can work well together but not always in isolation," Williams added.