Fri, 5 Apr 2013
As yields remain low, today's retirees have to really think out of the box when it comes to building an income stream; noted advisor Harold Evensky and Vanguard's John Ameriks explore practical strategies to obtain income without overstretching for yield.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com, and welcome to our session, How to Build Your Income Stream.
In this session, we will talk about the challenges confronting retirees today, and we'll also talk about some practical strategies for navigating the retirement landscape. As in all of the previous sessions, we invite your questions, we welcome your questions. So, please use the Ask a Question button to the right of your viewer if you'd like to submit a question. We'll actually be taking some of your questions throughout this session.
I'm happy to introduce today two of the preeminent retirement experts in the United States, who have joined us here today. John Ameriks is here from Vanguard. He is a principal at Vanguard. He is also head of the firm's active equity strategies. He is an expert in a lot of different research topics, including portfolio construction, investments, and retirement planning. We're very pleased to have him here today.
Harold Evensky is also here. Harold has been called the dean of financial planning by Morningstar's Don Phillips. Harold is the founder and president of Evensky & Katz Wealth Management. He's also an adjunct professor of personal financial planning at Texas Tech University. So, thank you both for being here.
This is such an important topic, I think we could talk all afternoon about retirement planning and probably end it tomorrow morning, but I would like to pick up on the income in the title of this panel and use that as kind of a jumping off point. One theme we've heard throughout today is that investors are very interested in income, and I'd like to get your take on the role of income-producing securities within retirement portfolios. What are the pitfalls of anchoring strictly on income-producing securities and using them to try to wring your living income from? Harold, you want to take that?
Harold Evensky: Sure, I'm happy to. My answer is that it results in somewhere between a bad and catastrophic result. People need consistent real cash flow, not dividends or interest. And if you design your portfolio based on that, that's going to control the stock/bond allocation which clearly will have no relationship to what's appropriate. So, our approach is you design a portfolio for total return, then figure out how to get the cash flow out of it.
Benz: John, you're nodding.
John Ameriks: I completely agree with that, and I would say focusing on income, just as focusing on any single characteristic, when you're talking about investing, if there's a mistake you can make, it is focusing on just one thing. Investing is all about making trade-offs and thinking about trade-offs, and the notion that somehow targeting income is going to be best for someone is really, as Harold says, can be catastrophe from a lot of different viewpoints.
Evensky: I mean, if you think about it if today if you did that, you'd end up largely with fixed income with bonds, and it means when interest rates go up you're going to feel rich when in fact the value of your portfolio is going down. When interest rates go down, you will feel poorer; when your portfolio value is going up, and then over a time if you have a nominal return, inflation is going to eat you alive. So other than that it's a great strategy.
Benz: So, Harold one strategy that you've pioneered is this bucket strategy, and it's one that we've talked a lot about on Morningstar.com. People seem to really get it and like employing it and see how that total-return approach works. Let's talk about the bucket strategy that you use with your clients.
Evensky: The bucket strategy that I talk about and use would be called the two-bucket strategy, real simple concept. Originally, when I did it I had suggested two years. With some subsequent research, I had it down to a year. Basically carve out what you're going to need for living expenses and that goes in what we call a liquid, basically money market account. Set it up to pay yourself a check once a month like a payroll check. The investment portfolio is a long-term portfolio and then you manage that very cost- and tax-efficiently. As you're managing that at some point you need to rebalance, market collapses you're going to sell bonds. And then you look and say, "Geez, it's kind of down. Let me fill it up." The point is you can control when you're selling something as opposed to the market.
Benz: So you take sort of a total-return and opportunistic approach really to refilling that bucket number one.
Benz: So whatever has done well that gets trimmed and the proceeds go in there.
Evensky: That's correct.
Benz: John you've taken a slightly different spin on a total-return approach in the managed payout funds that Vanguard has. Let's talk about how those work and how they employ multiple asset classes to give that total return?
Ameriks: Sure. I'm happy to talk about that, and I think the strategy itself is built into a fund, so that's I think what makes it different. But I think the spirit of what we're trying to do is very similar to what Harold talks about, and when talking to folks from Vanguard you'll hear the same kind of things, focus on total return, make sure you have your liquidity needs taken care of, and then use the cash flow needs or the cash flows that you are receiving from elsewhere to tax efficiently manage a portfolio.
Now managed payout can make the task of rebalancing and maintaining a total-return target or spending target in one portfolio a little easier. It puts together a set of funds and a set of exposures at a different risk level to provide a sort of targeted level of withdrawals over time. And in looking at the managed payout funds, an investor has to consider "What's the trade-off I'm making?" Again, I mention trade-offs once before.
Here's the trade-off. The higher the amount of withdrawals I want to take now, the more I have to understand that that will lower the amount of growth I can expect going forward in my portfolio. And I really have to think about that.
So, yes there's one of the managed payout funds that has the highest payout that's called the Distribution Focus Fund. It's focused on taking the distributions. At the opposite end of the spectrum, is a fund that's bounced and diversified again, but with a growth target. It has a lower level of payout, and one can expect a higher rate of growth going forward. But it simplifies the process and tries to put it together in one place.
Benz: Go ahead, Harold
Evensky: The only other difference I can think of and one of the potential advantages certainly of this bucket approach is behavioral. If you're sitting with cash liquidity and the market collapses, you are a lot less concerned because you know where your grocery money is coming from. We've had the experience, the 1987 crash and others, that people aren't happy, but they are not nearly as panicked as when the whole portfolio has collapsed.
Benz: So, is one year enough though? I mean, do you have sort of a next line of reserves that you would tap into in that sort of situation?
Evensky: In any typical portfolio, certainly anything we would do, you are going to have some fixed income, some equity, the fixed income is going to be laddered, and you are going to have some short term. So we consider the short-term fixed income, we call it second-tier liquidity.
It's never happened. We've been doing this since the early 1980s, but we would sell at the short-end of our bond portfolio, again, not having to take any losses. And by that time presumably you're three or four years through an economic cycle.
Benz: So, are income and capital gains distributions then getting reinvested back into bucket two?
Evensky: All in the portfolio. Correct
Benz: So, Harold, this topic of bucket maintenance is one that kind of hangs people up. They wonder, how often should I be refilling bucket number one? Should I just be peeling off money and putting it in there on a monthly basis? How should people think about that if they want to set this up?
Evensky: Great question. My simple little two bucket, it's simply a function of managing the investment portfolio. So, there is no time frame. It's when you need to make an adjustment. Typically that's going to happen within a year's time.
There are other bucket approaches out there. There is the aspirational, that you have a certain bucket for your basic needs and a bucket for different things. The other one is age-based. You have a bucket for 65 to 70 and 75 to 80. I have no roughly idea how you can possibly manage those buckets tax- and cost-efficiently. They feel good, they sound good, but I don't think long term they work.
Benz: And it might be a part-time job in retirement, too, keeping those things up-to-date.
Evensky: That's true too, right.
Benz: Let's talk about what retiree portfolios should look like today. We've had a lot of talk about how the raw materials for the traditional retirement portfolio aren't looking so good, especially bonds where you see a lot of headwinds, where you have very low yields and the prospect of higher interest rates. Let's talk specifically about that fixed-income position. Should investors stick with bonds? I hear from a lot of investors who say, "Why do I need this asset class given all the risks, given that the yields aren't appreciably better than what I can earn on my cash, which is almost nothing right now?"
Ameriks: I have a sneaky suspicion Harold and I are going to agree on some of this, that we can definitely focus a little bit more specifically on, within fixed income maybe there are issues, but the bottom line for us when we talk to retirees about setting up portfolios is, there is a lot more that is similar to the process that you went through in accumulation than is different. And as a retiree when you're building a portfolio you've got to think at a very high level about asset allocation first. How much risk am I able to tolerate in the context of the entire portfolio, and what rate of return am I trying to target out of that and operate on that axis.
Bonds are going to be a piece of that. Harold and I talked a little bit at lunch, and we talked about this issue of clients having concerns about the bond market. We hear about interest rates are destined to go up. Well, nobody knows that for sure. People have been saying that for several years now, and it hasn't materialized. It may. That risk is real. But I would also say, again going back to the very first thing I said, focusing on one dimension is almost always a mistake.
Yes, there's a risk that interest rates will rise. There's also a risk the stock market will fall. And bonds are in your portfolio not because you expect them to provide great market-beating returns, but to provide protection in exactly that scenario. So, for that purpose bonds still make as much sense even though the rates right now are unprecedented in terms of how low they are.
Evensky: It's funny. People get very myopic. Zero return isn't very attractive, unless your stock investment has just dropped 20%. Then it's going to look really good. That's what diversification is all about. Markets do go up or down, so yeah, they still need their bond allocation.
Benz: So, Harold, would you say, though, the complexion of your clients' fixed-income portfolios has evolved a little bit as the prospect of rising rates has become a little more significant?
Evensky: I wish I could say it had. The fact of the matter is, we've been fairly defensive for years, as John just said, in anticipation of rates going up, and they didn't. When I say defensive, in a normal portfolio we would have an exposure in interest rates measured by what's called duration of around 5 years, so sensitivity is fairly modest and [we would be in high-quality [assets rated] A or better. We've [had a duration of] around 3.5 years and been in AA [assets] for probably four or five years. In hindsight, we gave up some return. So, that's one of the major ways of protecting against rates.
The other one is, we use funds, but we ladder. We have roughly a third in short term, one- to three-year bonds, and a third in we call short/intermediate three- to five-year bonds, and then a third in five- to 10-year bonds. The only change we've made there is we're concerned we believe rates will go up, we don't know when. But we think the short end may go up a lot faster than the intermediate. So, we've slightly moved a little bit out of the one- to three-years and increased the three- to five-years and five- to 10-years. But that's just playing it at the margins really.
Benz: So you've laddered the funds.
Evensky: We've laddered funds.
Benz: As opposed to individual bonds.
Benz: Because one prescription that I hear from a lot of investors is, "Forget funds, I am going to invest in individual bonds, hold them to maturity, and not worry about this interest-rate problem." John, you're laughing. Why is that not a good idea?
Ameriks: Well, we've talked about this with clients for a long, long time, and I think laddering of funds makes an awful lot of sense for someone who really is targeting specific duration or particular cash flow patterns over time, that can make some sense in that environment.
Benz: Laddering individual bonds.
Ameriks: Laddering individual bonds. But for most individuals, what they end up with when they build a bond ladder looks an awful lot like a bond fund, and usually they're doing it at expenses that are much, much higher than what they would pay in a diversified fund or they're paying costs that they're nowhere near as aware of because of the lack of transparency that can exist in the bond markets that are out there.
So, we think people need to be careful about that. At the end of the day if you've built the bond ladder and everything goes as planned, you're going to take what expires and reinvest it into the fund and continue to hold something that over a period of years is going to look remarkably close to a bond fund that had that kind of consistent duration.
Evensky: Basically people fool themselves thinking somehow they're eliminating risk by buying and holding on to it. They are eliminating one risk, and that's if you give it to a manager, to an active manager, they may do something wrong and permanently lock in losses. Presumably, you're going to pick a manager that at least does as well as a sort of buy and hold bond ladder. But if you're going to have a bond ladder and interest rates go up, your portfolio value went down. It doesn't matter if you hold it to the end. The reason it went down is because what you're getting back is really worth less than you originally anticipated.
Ameriks: I wouldn't do my outfit service if I didn't mention that if you don't want to take the active risk that's involved in dealing with a bond manager, there is a lot of indexed product out there that would give you a broadly based diversified portfolio that will get you the bond exposure that you need, and you won't run the risk that somebody times the market incorrectly.
Evensky: As John said, it's very expensive, far more expensive than investors typically realize to invest in bonds. You hear all the time, "It didn't cost me anything," because they don't see a commission, because it's a spread. And they don't know what that spread is, and that can be from 1% to 3%.
Benz: John, I want to pick up on something you said mentioning the indexed bond products, and certainly they're very popular. A lot of our readers like them and use them. But there has been some concern about how the Barclays Capital Aggregate Bond Index has evolved a little bit over the past several years, where now it is very dominated by government securities. Harold, I'm wondering if you can kind of pick up on that point. Do you have any trepidation about putting people in the index, or are you comfortable recommending indexed fixed income?
Evensky: We are, in effect, 100% active in fixed income, and almost 80% passive in equities, and it's because of those kinds of issues with the index that we're active.
Ameriks: So, I'll just add one thing on that, and that is I think there has been a lot of talk about this and the concern about the amount of government exposure that's in the index right now. There is no question that the government is active in the bond market right now and making purchases. There seems to be the conclusion is at this point that that's having some effect on interest rates. Although, many, many years ago when they tried to do this, I think the conclusion was that it didn't, but now we seem to believe that it is having that impact.
What a lot of people are missing about all of that is the impact that the government has affects the entire term structure in the bond market. It lowers rates. The issue is, is the spread any more attractive now than it's ever been? And there is mixed evidence. You can take the point of view that, right now corporate spreads are looking attractive or government bonds look less attractive than corporates do. But it's an active point of view. The marginal investor in the market is still going to set that price, and the average that's out there will reflect the composition of the market.
Benz: I want to discuss the whole suite of what I consider noncore bond products that have been very, very popular when we look at flows. So, emerging-markets bond, junk bonds, et cetera, it appears that investors are really attracted to the higher yields that in some cases they can obtain on these products. What role should such bonds play within investors' portfolios? I understand that's a very broad group, but things that aren't the core high-quality piece that people typically associate with retiree portfolios.
Ameriks: Well, I mean, from our point of view, again, I'd say we lean toward for a general recommendation to an investor who's looking to build a portfolio and doesn't particularly have a point of view on a manager or on a tilt, is that those strategies ought to reflect a very small portion of the portfolio because they're small portion of the market. Having some exposure can make some sense, but be careful, focusing on one dimension. I mean, there is no free lunch in the marketplace. Things can go on sale from time to time. But in general there's no free lunch and you are not getting something from nothing there. You are being exposed to more and more risk, and I think we're starting to see this a little bit in the high-yield area now, where the spreads have come in quite a bit.
Evensky: That's what worries us, people chasing yields and ignoring risk. We're in bonds to preserve principal. We're in equities, in a broad sense, for growth. We do use those kinds of investments, but they fall into what we would call the equity portion of the portfolio, not in fixed income.
Benz: So you would reduce pure equities, and then maybe…
Evensky: Right. We have what we call a satellite, a risk portion, and that can be emerging-markets fixed income or high-yield junk bonds. We use all of that, but not in our fixed-income portion.
Benz: We've also seen the emergence, and I don't want to make this whole thing about bonds, but I think it is top-of-mind for a lot of investors. We've seen the emergence of what are called unconstrained-bond funds. Harold, you are laughing. Are you using any of them in client portfolios?
Evensky: Yes. Very nervously because it's very inconsistent with our sort of normal concept that we like very plain vanilla. We have very targeted quality and duration in our fixed income. We recognize that this is a very risky period and an area fairly unprecedented. We don't know how to manage against that. So there are couple of managers, who were persuaded that they are utilizing and will utilize that flexibility basically to preserve principal, not to try and make more money for our clients. So think of that sort of as our tactical overlay to our fixed income.
Benz: Can you talk about any of the managers that you own?
Evensky: PIMCO and Goldman Sachs both have what they call unconstrained funds, which is a euphemism for saying they do anything and go anywhere.
Benz: One related question is, we've had what feels like almost a near mania for dividend payers, and we see it in terms of our traffic on the site. So I'd like you both to talk about that and talk about the role of dividend payers. I am talking to some seniors who say "Who needs bonds? Dividend payers give me a yield that's sometimes equivalent to what my bonds are giving me and the potential for dividend growth." What do you say to people who are of that mind-set?
Ameriks: I think we are back on the same theme again. There is no such thing as a free lunch there. One of my colleagues at Vanguard, our chief economist, has written a paper that high-dividend stocks are not bonds. They are still stocks, and they have the properties of equities. So, I think the issue with that is, again, if you focus on one characteristic, you are going to ignore everything else, and here you are going to ignore the amount of variability that can exist in those types of issues. Other area that I am a little puzzled by is people don't seem to take into account enough the tax issue that's related with focusing on income.
Benz: So, just discuss that to get people on the same page with you.
Ameriks: So, when you are looking at a portfolio and designing for total return, you are going to design first to figure out what return and risk is going to be, and then you are actually going to take actions to minimize the amount of taxable income that you're going to generate over time because that will maximize the total amount of resources that the portfolio throws off. By tilting in the direction of things that pay a large amount of income, you can actually get yourself into a circumstance where you are paying higher taxes only to reinvest, to reallocate, and then to continue to pay higher taxes through time than an alternative strategy. So there is not only a cost in terms of diversification but there's also a cost in terms of exposure to generally higher tax rates for these income-focused strategies.
Benz: So the issue is that you're getting that dividend distribution, you're paying taxes on it, and you're sort of losing control over your tax situation if that dividend is getting paid out.
Ameriks: That's right.
Evensky: And going back to sort of this assumption that they are going to always keep paying those dividends and keep raising them, which is absolutely certainly not guaranteed, and people forget if they stop paying on the bond they file bankruptcy. If they stop paying the dividends they send an apology letter, big difference. And it also means in terms of the nature of the investments you're concentrating in particular sectors or styles. We're big believers in value, which means we have a lot of dividends, but we're not focusing on dividends per se.
Benz: You're focusing on value stocks that happen to have some dividends.
Benz: We have a lot of ground to cover, and I would like to switch gears a little bit and talk about retirement-planning strategies and specifically, the distribution issue. And this topic of spending rates, how much you can safely withdraw from your portfolio is a huge one. We could do a whole session on that, and there has recently been some new research that's kind of poked at that old 4% rule. I'd like to get your take on that topic how investors should think about setting that withdrawal rate and maybe talk about some best practices for retirement distribution.
Ameriks: Well, we could take up the rest of the time.
Benz: I know.
Ameriks: Harold and I have taken 15 years of back and forth on drawdown zone and that was like kind of how we first met. I think the issue is around the spending rate.
Ameriks: Everyone wants to know sort of what's the optimal spending rate in retirement. There's been a lot of research around that. Look, I know we'll get into this maybe in a little bit more detail, but I want to get to the bottom line which is that I think these tools and these illustrations are incredibly useful for people pre-retirement who literally don't have any notion of what they're in for when they get to retirement. They don't know what to expect. They trying to figure out, "Well, I have been saving all my life, how am I going to convert that into spendable resources."
And there I think these rules that tend to focus on drawdown rates that are in the range of 3% to no more than 5% make a lot of sense as a general guideline to set broad expectations that as you save, if you are thinking about what can come from this portfolio, it really needs to be in this range. And hopefully that helps you to think about, "Well, am I ready to retire? Do I need to save more?" Once you get into retirement, it gets a lot more complicated than following any of these simple rules that are laid out in these strategies.
Evensky: I couldn't agree more. To me it seems like a silly debate. The 3%, 4%, 5% is much as I dislike rules of the thumb, 4% is not a bad rule of thumb pre-retirement to give you some of order of magnitude of what's realistic. But say when you get into retirement you better do a whole lot more planning than just using that rule of thumb. Some of your expenses maybe a mortgage; it doesn't inflate and it disappears. You've got so many moving parts, you can't plan just based on a specific number.
Benz: So, it sounds like there is maybe at least some agreement that being dynamic about your withdrawal strategies is a good practice, so focusing on what your portfolio has done and also focusing on your age. So, arguably you can sustain a higher withdrawal rate once you are in your 80s than you could when you were 65.
Ameriks: Absolutely. I think there are of a couple of tools that we have available that help people think it through on a very basic level, that kind of consideration, that as life expectancy shortens the amount that you can withdrawal goes up. But I agree with Harold that this is something that needs to be looked at case by case.
Many of the illustrations that people do involve computing the withdrawal rate--4%, 3%, what have you--that's the fraction of a portfolio accumulated at retirement that you start spending. And then those rules envisage that you will spend that amount and adjust it for inflation every year going forward until you literally run out of money.
It's a great academic exercise. It's sort of a rigorous framework to help think about what these magnitudes will look like. There may be the one individual [who behaves this way], just as there's the one individual that plows into the median on the freeway. People see problems coming.
In 2008, we were not getting a lot of calls at Vanguard asking, "Well, I'm ready to take my inflation adjustment this year because I withdrew 4% last year and so now I am going to increase that amount." The calls were more, "Wow, my portfolio is down, how much do I need to cut back?" And that's a much more sensible approach to thinking about portfolios over time. Ultimately, the withdrawal rate has got to reflect the performance of the portfolio. The trick is managing that in a way through time, and dynamic is the right answer. The difficulty is in the exact implementation.
Evensky: Yeah, I certainly agree there are times it needs to be adjusted. The problem I have is a lot of the strategies that are out there that suggest you adjust it very quickly just by a little bit, 5% or 10%, as a practitioner my experience is people's quality of life is at the margin, say, just 10%. That means you cut out going on the trips you were going to take; you cut out going out to dinner. That is not a small thing. So, I mean, we sit down at least on an annual basis and sort of look forward, and we might at some point have to adjust, but we're not sort of casually, "the market is down this year, let's adjust a little bit." We believe it needs to be expected to be fairly consistent for a long period of time.
Benz: So, say for clients with similar asset allocations and similar ages, would they get basically the same advice? What would be the swing factors?
Evensky: Well, let me say, you have two families next to each other, same age, husband and wife, same children and everything, but one of them has a pension and the other one doesn't. One of them has greater risk tolerance than the other one. One wants to join the golf club, so no [they would not get the same advice]. I always get frustrated by what I call the sociological solution, which is like women are more conservative than men, and I say, "Whenever I end up with families of 1.7 parents and 2.3 children, I'll use that kind of advice." But each individual is completely unique, and so, those kinds of assumptions are dangerous.
Benz: I'd like to get your take before we leave withdrawal rates. My colleague David Blanchett and a few other retirement researchers actually suggested a 3% rule is perhaps more appropriate given how low bond yields are currently. So, the raw materials for retirement planning just aren't there. They suggest a lower rate is probably safer. What's your take on that research?
Ameriks: So, we continue to update the numbers to try, again, to help people get a reasonable idea into their heads about what's possible in retirement. The analyses that have been done on this issue, the 4% rule are using data that go back to the '20s to the '30s that involve the last time we saw really, really bad markets and very low rates. So, they're in there; that's one data point. We have another data point. These are extreme events, so the data when we run these numbers does get adjusted, and we find that if the optimal spending rate was 4.00%, it's 3.75% now. So, you're down at the margin in terms of the math.
I think one of the big differences between--if I'm reading it right--the study that was done at Morningstar and some of the other work is around the very important assumption about costs, and I'm a big fan of focusing on costs, but a lot of the other work that gives you the 4% numbers doesn't involve the same degree, doesn't involve the same assumption about costs which I think was of 100 basis points of a fee that was paid to a provider over time. And that might be realistic or maybe not depending on where you're getting your investment services from.
Benz: So you are saying if you can peel back on that cost, get it down from 100 basis points to 50 basis points or whatever it might be.
Ameriks: I do think this issue of expenses is one of the things that people, maybe they get it a get little bit more; it's easier to get. Certainly, when I'm telling you that as a retiree you can take 4% of what you've accumulated over a lifetime of work, but "Oh, by the way for the services that I'm providing you, I'm going to take 1%. So, I'm basically taking a quarter of what I'm allowing you to spend in order to provide services." You just have to be sure that what you're paying for is delivering the value that you expect it to. I do think that in retirement a lot more people are going to be aware of these fees and charges.
Evensky: Just back to the 3% or 4%. As John said, that 4% is not the average of history. It's looking at all kinds of economic periods. This one is unique as it is, we've been through worse before. So the real difference is that 1% expense. But if it gets people to think, "Gee, I can't spend as much," then I don't have a problem with that. But again, planning your retirement based on either one of those numbers is kind of ludicrous. And the studies that we've done in my conclusion, we are going to live in a low-return environment for the long term. If you can save 0.5% managing expenses and taxes, I think you can increase your net-net-net by upward of 20%. So that's where the focus needs to be.
Ameriks: I agree with that, too. I also just want to be sure to say, look, there are reasons why you want to pay someone to help you with this.
Benz: This is complicated stuff, right?
Ameriks: We just heard [retirement experts Mary Beth Franklin and Mark Miller in a previous panel discussion] go through one of the--Harold and I were talking as we were watching that and just saying, "Look, that alone could make up for a significant amount of what it costs to get advice here." So people have got to think about that and how the value that's added in terms of getting good advice on Social Security, getting good advice on tax planning, getting a good behavioral coach in terms of investing, can make up for the bite that fees are going to take. It's just that people have to understand that's what they are paying for, and I would argue that they are not necessarily paying for a lot of outperformance that's going to come from the investments alone. There is not a lot of evidence for that.
Benz: One other topic related to planning, especially for people in accumulation mode thinking about retirement, is this question of income-replacement rate. So, here is another rule of thumb that has been out there, that 80% rule. How do you get realistic about what your income needs might be in retirement versus what they were when you were working?
Evensky: When someone retires, there is one real major change. They have a lot of time on their hands, and time costs money. Now you can start going to visit the kids around the country, take the cruises, join the country club; 80% is just absolutely a nonsensical standard. It's not at all uncommon for someone, in my experience, to spend 120% because now they have time to spend it. And the answer to how do you figure it out is individually person by person; you have to sit down and try and figure out, "Gee, I'm retired. What am I going to do and what's it going to cost?"
Ameriks: Christine, a lot of this is, when you talk about the 4% rule, you talk about how to think about spending. The complication here is that time has got to be invested. You have to have some knowledge and expertise, and I'm always struggling with what tools can we put out there that can very quickly, given the amount of time that someone at age 25 wants to spend on thinking about retirement, what can we give them that does no harm and at least helps to get them into the ballpark.
So, as a 25-year-old, maybe a replacement-rate analysis is useful. As you get closer to retirement, I think the best thing to do is look at what how you're living now. You know what you are spending now, or well, maybe you don't. Maybe you got to sit down and take a look. I've actually done some academic research about people not knowing what they are spending. Take a look at what you are spending now, figure out what that costs, see what you can do to do something to drive it forward. Make a reasonable assumption about inflation and then you can figure out, "Well, as a fraction of my income what is that going to be and what should my target be? How does it line up with my ability to get the right Social Security benefit, take income from other sources, draw down from a portfolio, can I get there?"
Evensky: The key is to think about what's going to change in your life. And a lot of those things are going to cost money that you weren't spending before.
Benz: We are getting some questions about annuities and the role specifically of single-premium immediate annuities in retirement portfolios. Good idea? bad idea? And also one of the questions was about what role if you have such a product, should it fill in your asset-allocation plan? If you have something like that does it mean you need less in fixed income? Let's talk about that issue.
Ameriks: I'll go first. And Harold and I were talking about this, so I know he disagrees I think a little bit with this. But Vanguard's approach on annuities is something I've been looking at for a long time and there is a value that's there. We talked a lot about Social Security earlier. It is a form of annuity. So, again, that's one thing I'd say is as people think about annuitization, they need to think completely about annuitization. It includes Social Security. It includes a pension for a lot of people still, and that will be the case, though those numbers will come down over the years ahead. It also includes things like Medicare. That is an annuitized benefit.
Benz: Specific benefit, but yeah.
Ameriks: It comes to you as long as you are alive. If you own a home, a form of that is in the annuity form. So, there is a lot of annuitized resources that people have, they should think about how they want to treat those. If they look at those sources of annuity income and find that that level of relatively steady resources is insufficient for them, it basically really makes them feel like they are living a very poor lifestyle. It's a very extreme set of circumstances. They need to take a look at, "Well, is there a way that I can increase that floor, I can get more of a baseline of income in retirement?" That's what an immediate annuity does. I think you've got to take out of it all of these considerations of is it a good investment? It's about, for me, the worst-case scenario, and what if I don't have other resources? What is the minimum level that I really feel I could get by within a worst-case scenario? I want to make sure that that's taken care of. I think in that framework it takes out a lot of the pushback that we get now about, "Well, I'm giving up these assets or interest rates are low."
Benz: That's what I was going to ask though. Right now, the interest-rate environment arguably makes annuities pretty unattractive.
Ameriks: There is no question about that, but it's the reverse side of a mortgage, right? I mean, you're always trying to find out when is the right time to borrow, when do I lock in?
Ameriks: You don't know. What you do know is as long as the insurance companies are around to pay the benefit, if I give them X now, I get Y. In that sense that's the proposition of the annuity. It's not much harder than that. It's do you care enough about that certainty to close off all the other options that X had before you converted it into an annuity.
Evensky: I think we sort of half agree on this. A lot of what I know about annuities, I learned from the work that John has done. Many years ago, I'd say I'd wash my mouth out with soap before I talked about annuities and I often get reminded of that. I now think it's going to be probably the single most important investment vehicle in the next decade. The reason, it's the only investment that can potentially provide an extra return beyond dividends, capital gains, and interest, and that's the mortality return.
Benz: So, you get that risk-pulling, yeah.
Evensky: Now, if you die before life expectancy, you may quote a bad deal, but you're dead, so who cares. If you live beyond that you're getting something extra. The key is, it doesn't really start coming significant until you're 70 or older. So, that's one thing to keep in mind. The second--and this is where I guess I do disagree with John--is the payouts now are very low because they're very dependent on current rates. We're not doing anything even I think particularly important because we don't see much risk in waiting. If someone is 70, they say "Well, with interest rates it takes three years for them to get to historical norm." The risk is that there's a huge change in mortality and all of a sudden they start paying a lot less. It's there, but we think that's very small. In addition, each year you get older that mortality starts kicking up fairly nicely. So, there's a fairly significant buffer. So, we think it's going to be important, but it's not something we'd recommend at this stage.
Ameriks: I don't have a problem with thinking about it, especially over a number of years, and we talked about this. Giving up X is a big deal to a lot of people; closing off the option to use that money in any other way makes them relatively uncomfortable. So, I've always talked about it look, annuitization decisions are not all or nothing. They're not "I have to convert the whole thing or none of it," and they're not now or never. You don't have to do it all right now and thinking about it is as staged over time, I think can make some sense for a lot of people who find the benefit in seeing the floor.
I've always said the one group of people that might care about the annuitization decision will be the heirs and the children, right. And so I've always said, insurance companies make a bit of a mistake when they market to retirees who see the portfolio going away, but I know in discussions that I've had with others, think about who you're going to depend on if your assets are not sufficient to support you in retirement, and think about taking care of them as a part of this problem, as well.
Evensky: The other issue that we have a partial disagreement is this flooring concept. Psychologically, it's terrific. You put enough in sort of a guaranteed income to provide your base. If you're immensely wealthy, you can do it. It's just, I think only a teeny fraction of people could remotely get to a flooring strategy. So, I'm not sold on just the concept of flooring, people just don't have enough money to do that.
Benz: How about fixed deferred annuities, also known as longevity insurance? Interesting product, something people should look at? You are nodding, Harold.
Evensky: I love it. I think that is going to be extraordinary because it meets the behavioral problem people don't want to give it up. It looks like a phenomenally good deal, someone at 60. So when you put this in, at 80 you are going to get this much. And you say, "Wow, that would pay me back in two or three years." Investors or people are lousy discounters of future value, and you may not live to 80. But it looks good and feels good. So I think it is going to be a vehicle that we will be able to persuade investors to use whereas an immediate annuity is much more difficult. So, I think it is going to be really important.
Ameriks: So, I agree with that framework. I mean, the tough part of it is even with these deferred annuities, and you are talking about orders of magnitude in terms of what needs to be committed of maybe a tenth of what it costs to get a fixed immediate annuity, people still have trouble with that, even they are looking at $10,000, and then say "Tell me again I don't get anything until I am 80 and what if I am 79 1/2 and I still don't get anything?"
So, there's still going to need to be some coaching around that and for people to understand why it is there. But I think the concept just intuitively makes more sense to people think that "Look if I am going to view this as an insurance vehicle, I wanted to pay-off if the 'risk' is realized. And the risk here is that I live a long time, now I get it. I am paying for an insurance policy." I think that's a little easier.
The one discouraging thing is there is some product out there like this. It's certainly isn't something that's kind of flying off the shelves at this point. So, I think more to be done, an interesting category. Another tool in the package of tools that I think planners and individuals need in retirement, but none of the things that we've talked about is going to be the be-all end-all for retirement. It's all going to be how these pieces fit together in the right way for an individual.
Evensky: One other thing, it's not uncommon for someone to say, "Well, I'll never live that long." And I keep saying, "What keeps us awake is not that you'll die early. We'll feel sad. What keeps us awake and what will keep you awake is that you won't die early." People tend to focus on the probability; "well, the probability is only 20%." Yeah, but it's the consequences. If you plan for living that long and don't and you leave some money on the table, that's not so bad. But if you don't plan for it and live beyond it, that's disastrous. So, it's how you think about the risk.
Benz: A related question, a related product. There have been some hybrid products that combine longevity insurance with long-term care insurance, and I'd like to talk a little bit about the long-term care landscape. But what do you think of those products? Are they generally too expensive to recommend because they think the more flexibility you give yourself within insurance product, the more it will cost you, right?
Ameriks: I'll probably defer a little bit of this to Harold, but just say that look I've done academic research that looks at that long-term care risk as one of the major reasons why people have a problem with annuitization because they're worried about not having the resources that they need to deal with a health crisis. So, the theory of this should be that a credible long-term care policy ought to have some value.
I think the thing that I struggle with a lot is the structure of the policies, thinking about the dynamics of that insurance industry. These are very long-term contracts in an industry where there's a lot of innovation and a lot of change in terms of how people are treated or how illnesses evolve. It's something that's very hard to insure and a consequence it is very expensive. I think the considerations that apply there apply to different subsets of the population. For some people, it may make some sense, for others it won't.
Evensky: Yeah, I'm a big believer in long-term care insurance. I think there are people that if it impacts the current quality of your life, you probably can't afford it. A lot of wealthy people can self-insure. The concern is the other spouse. So, I think it's very important for many people.
One of the reasons that it seems so expensive is the positioning, if it's $200 a day, I need that coverage. Well, the reality is if you're in long-term care, you're not taking those trips around the world; you're not going to be. So the reality is the amount of coverage someone needs is much smaller than what the cost would be. In terms of linking it to an immediate annuity, I just have trouble with something, patting your head and rubbing your tummy, because if you take one, then you don't have the other. If you need both, the whole idea just really doesn't make any sense to me. You've got two completely different risks and, say, if it covers one risk, then the other one isn't covered any longer. So, no, I don't…
Ameriks: Yeah, I think both types of insurance are probably useful, but I do agree with Harold that, where people can get into trouble is when things are all packaged up. So, not only do you have the long-term care, the annuity, but you've also got stuff with withdrawal benefits. So, it's all packaged into this instrument that really does take a CFA or an economist or CFP to work through all of the detail around what that actually is. And at some point that gets to be counterproductive.
Benz: Harold, you mentioned there is a certain level at which you say you're too wealthy, you don't need long-term care insurance. What is that threshold?
Evensky: It's a question of look at what your current lifestyle expenses are realistically with long-term care, and then try and make some reasonable assumptions that if one of the two spouses needs long-term care, what else is going to be cut out. For a lot of wealthy people, it's going to cost a lot less than they're currently spending. Again, there is no magic number. But if you figure that long-term care is going to cost you $80,000 a year and you're living at a $300,000 or $400,000 standard of living, you'd probably be able to afford the long-term care.
Benz: I'd like to close here by asking each of you to share in your experience, what is the biggest mistake that you see retired folks making when they attempt to figure out their financial plans?
Ameriks: All right, I'll go first. I think it's this notion that everything has to be different as soon as I retire. I think people look around for something that's going to be the answer in retirement, where they really haven't figured out the answers to the questions that Harold and I have been talking about. What is retirement going to look like? Am I even going to live in the same place?
My experience has been that people don't figure that out right away, especially in a married household. You have one spouse often that's retiring before the other, and they need some time to figure out, well, how is all that going to play out? So notion that, "OK I'm getting to retirement, and at that date I'm going to rejigger my entire financial structure," I think, is just a huge mistake. That's when you're not paying attention. You're trying to get too much done too fast. You won't pay attention to fees. You may end up in products that are inflexible or weren't what you thought they were. Take your time. It will evolve over time. Most people are not in the situation of having to do this all in one day or all immediately.
Benz: So make no great, big decisions right at first.
Ameriks: I think that's right.
Evensky: I think probably your listeners are the wrong people to tell this to, but [it's] not planning. We're just kind of "Oh, gee, I'm retired." Not even thinking about, what do I need to do it? What can I afford to do? That's clearly the biggest problem. When you look at the statistics about what amount of the population is not worried about it, that's scary because they should be. A lot of people are not going to be able to afford to maintain the standard that they've become used to. But the sooner they realize that, the closer they're going to be able to achieve it.
Benz: John, you've just told us there are no magic bullets, but I do have a question. I'm wondering if each of you can share with the audience what is the one simple easy step that every retiree can take to ensure a good outcome in retirement, at least in their financial lives.
Ameriks: Well, review the portfolio and take the inventory, I think sort of Harold set it up. I mean, in fact, disappointingly what we see is a lot of people that would come to Vanguard for advice or for planning, have a planning service, they're showing up five years before they want to retire, and there's just not a lot that we can do with five years in terms of planning. Yes, you can take the step finally of sitting down and looking through everything that you have and thinking about what's my asset allocation? What rate of return does it look like that portfolio we're generating? Am I comfortable with that level of risk? And what do I need? So, answering those three questions, doing the planning is the right step.
Evensky: I would follow, doing the planning and not using a 4% rule of thumb to do it. Do serious planning, and then for a specific, the simple one-bucket approach can make a huge difference in surviving through the ups and downs in the markets.
Benz: I think we'll have to let that be the last question. I want to thank my two panelists. You were terrific. John Ameriks from Vanguard; Harold Evensky from Evensky & Katz. Thank you so much for being here today.
Ameriks: Always welcome, Christine. Thank you.
Evensky: Thanks. That was fun.