Derek Tharp: An Alternative Approach to Calculating In-Retirement Withdrawals

Listen Now: Listen and subscribe to Morningstar’s The Long View from your mobile device: Apple Podcasts | Spotify | Google Play | Stitcher

Our guest on the podcast today is financial and retirement planning expert Derek Tharp. Derek is an assistant professor of finance at the University of Southern Maine, and he’s also lead researcher at Kitces.com where he writes about a broad range of financial and retirement planning matters. In addition, Derek is a senior advisor at Income Lab and he’s president of a private wealth management firm called Conscious Capital. Derek received his bachelor’s degree in finance from Iowa State University and his doctorate in personal financial planning from Kansas State University. He’s a certified financial planner, and he’s also a chartered life underwriter.

Background

Bio

Retirement Withdrawal Rates

“The Retirement Distribution ‘Hatchet’: Using Risk-Based Guardrails to Project Sustainable Cash Flows,” by Derek Tharp and Justin Fitzpatrick, kitces.com, Nov. 24, 2021.

“Using Probability-of-Success-Driven Guardrails to Manage Safe Retirement Spending,” by Derek Tharp, kitces.com, March 3, 2021.

“With Retirement-Spending Plans, the Odds Are Stacked in the Investor’s Favor,” by John Rekenthaler, Morningstar.com, Jan. 13, 2023.

“Justin Fitzpatrick: ‘Retirees Have a Superpower,’” The Long View podcast, Morningstar.com, July 12, 2022.

“Retirement Income Guardrails Beyond Withdrawal Rates,” Webinar, incomelaboratory.com, Jan. 12, 2022.

“Why 50% Probability of Success Is Actually a Viable Monte Carlo Retirement Projection,” by Derek Tharp, kitces.com, Jan. 6, 2021.

“Christine Benz and John Rekenthaler: Revisiting What Is a Safe Retirement Spending Rate After a Tough Year,” The Long View podcast, Morningstar.com, Dec. 20, 2022.

“What Is the ‘Retirement Spending Smile’?” by Wade Pfau, retirementresearcher.com.

“The Ratcheting Safe Withdrawal Rate—A More Dominant Version of the 4% Rule?” by Michael Kitces, kitces.com, June 3, 2015.

“Reframing Monte Carlo Results to Increase Trust in Dynamic Retirement Spending,” by Derek Tharp, kitces.com, June 29, 2022.

“Simplifying Retirement Income Planning Visualization Using the ‘Spending Risk Curve,’” by Derek Tharp and Justin Fitzpatrick, kitces.com, April 13, 2022.

“The Impact of Decreasing Retirement Spending on Safe Withdrawal Rates,” by Derek Tharp, kitces.com, Feb. 22, 2017.

Portfolio Construction and Tax-Loss Harvesting

“The Extraordinary Upside Potential of Sequence of Return Risk in Retirement,” by Michael Kitces, kitces.com, Feb. 20, 2019.

“Michael Kitces: Does Portfolio Customization Pay Off?” The Long View podcast, Morningstar.com, Aug. 23, 2022.

“Tax Loss Harvesting+ Methodology,” by Boris Khentov, betterment.com, Sept. 7, 2021.

“Tax-Loss Harvesting Best Practices (and How to Scale It Across a Client Base),” by Ben Henry-Moreland, kitces.com, Sept. 7, 2022.

“Quantifying the Value of Tax Loss Harvesting,” by Derek Tharp, retirementprof.com, Jan. 10, 2023.

ESG

“The Tricky Ethics of Socially Responsible Investing,” by Derek Tharp, wsj.com, Sept. 4, 2017.

Robo-Advice

“The Value of Robo-Advisor Technology: A Practical Tax-Loss Harvesting Case Study,” by Derek Tharp, retirementprof.com, Jan. 9, 2023.

“Why DIY Investors Should Still Use a Robo-Advisor,” by Derek Tharp, retirementprof.com, Dec. 7, 2022.

Transcript

Christine Benz: Hi, and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar.

Jeff Ptak: And I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Benz: Our guest on the podcast today is financial and retirement planning expert Derek Tharp. Derek is an assistant professor of finance at the University of Southern Maine, and he’s also lead researcher at Kitces.com where he writes about a broad range of financial and retirement planning matters. In addition, Derek is a senior advisor at Income Lab and he’s president of a private wealth management firm called Conscious Capital. Derek received his bachelor’s degree in finance from Iowa State University and his doctorate in personal financial planning from Kansas State University. He’s a certified financial planner, and he’s also a chartered life underwriter.

Derek, welcome to The Long View.

Derek Tharp: Thanks for having me.

Benz: Thanks for being here. We want to start out by talking about your many roles for people who aren’t as familiar with your work. You’re a senior advisor at Income Lab; you’re a professor of financial planning at Southern Maine University. You’re lead researcher at Kitces.com, and you’re also a financial planner at Conscious Capital. So, how do you divide your time across these many jobs?

Tharp: Certainly, it can be a bit of a challenge. But for me, I really do like—I’d say, the core of what I do is, I’m a professor. I do have my practice as well and then I am involved with Income Lab and Kitces and different organizations. But for me, it’s nice having so much that overlaps. If I’m working on a research project on retirement distribution strategies, my university likes that I’m doing that. It has some application to clients and practice that I’m doing. I might be able to write up a report for Kitces.com. So, just many ways that I think it all can overlap in a way that is nice and allows me to wear a few different hats there.

Ptak: What sparked your interest in financial planning to begin with?

Tharp: I started out actually on an engineering track in college just because always did well in math and science and seemed like the natural angle. But for me, as I got into the course work, I really didn’t see myself enjoying the practice of it as much and ended up not really knowing where to go. I did have an interest in finance and economics and went to pursue the finance degree. But then, really, I feel fortunate that I didn’t really know where I wanted to go in financial planning, ended up finding out my university did have a financial planning program. And then, an unfortunate aspect of that as well is, while I was at school, my grandpa was always the accountant and managed the finances for the family. But he developed some significant dementia, and suddenly my grandma didn’t know where to go and she turned to me with questions, and I had to learn on the fly and try and help her out and really learned about financial planning as a field through that experience and started down that path and never really looked back since.

Benz: I wanted to ask, did you have a financial planner role model along the way? Or more than one person perhaps?

Tharp: I would say that there’s definitely been more than one person, many advisors I’ve worked with and looked up to. I’d say two that I worked with initially, Eric and Jean Mote of Mote Wealth Management in Cedar Rapids, Iowa—they, for me, have always been people that I’ve come back to, and I just really like the way they engage with clients, the way they approach financial planning. So, for me, they’ve always been two role models that I like to think back to or asked myself how would they handle this issue if they were working with a client, and they’re definitely people who have been very impactful to me.

Ptak: How do you decide what issues you want to research and write about, practically speaking?

Tharp: I wish I had a good way to say I had a real methodical process to it or something like that. A lot of times it’s just following my interest and where I’m at a certain time. I do think I tend to have clusters of topics that I’ll just get really deep on for some reason, and something will catch my interest and dive deep into it. Back when I was doing my dissertation and graduate school work, I did a lot of subjective well-being assessment, financial satisfaction, even some things as personality relates to that and it’s definitely an area that I’ve continued to do some work in and I plan to do some in the future, but really did a deep dive there and in recent years have been focusing a little bit more on the retirement income spending and strategies around that, how to best think about retirement income. And then, there’s been a couple of different pockets of topics that something catches my eye and I go that way. So, I don’t necessarily have really a methodical way of doing it. It’s just what piques my interest at a given time.

Benz: You referenced retirement income and safe withdrawal rates. That does seem to be a big area of interest for you. You’ve written extensively about those issues. So, let’s talk about last year’s market environment. We had falling stock and bond prices. We had very high inflation. In hindsight, is that the epitome of the sequence risk that retirement planners, retirement researchers are talking about?

Tharp: I’m not sure if I would go that far yet, just because certainly it was something that I think for a long time people have been concerned about market valuations being high, interest rates being low, the fact that we could see these two things and we could go through a correction, while we also had rising rates and that could be detrimental for retirees. But I think when you really think about sequence of returns risk, it’s more not just what happens in one year, but getting hit with one, three, five years of extended negative market outcomes. So, for me, it certainly could be the start of a bad sequence, but I want to actually see a few more years of that before I’d say we’re really headed down that path. And as of right now, I don’t necessarily feel that way. I think this could just be very normal market correction and downturn and see things come back as normal.

Ptak: What steps would you suggest that retirees and, if they’re working with an advisor, the advisors that serve them, that they should take to ensure that their plans are still on track in light of what we experienced last year?

Tharp: I think the ongoing aspect of planning to me is really important, so making sure that a strategy is a good strategy to start with but then you stay on that path is really important. And for me, my favorite way to go about that is really the whole guardrails framework to planning where you actually have a plan upfront that isn’t just a static, the traditional Monte Carlo plan, say, that is just looking for some sort of probability of success result. It doesn’t really tell you when should I make an adjustment, how should I make an adjustment. So, really having a guardrails-type plan—I’m a fan of what I’ve written about and called risk-based guardrails. My co-author, Justin Fitzpatrick of Income Lab, we’ve talked about that as a way to think about a different guardrails framework than I think some of the more distribution-driven rate frameworks just because of some of the limitations that they have.

And I do think in practice the way many advisors or DIY retirees are doing a lot of planning is actually somewhat consistent with a risk-based guardrails approach. Like, if you’re using a Monte Carlo tool and you see the probability of success levels gone down, so maybe you cut back your spending a bit. Or you see the probability of success level has gotten higher, so maybe you can spend a little bit more. In a sense, that is very much an adjustment dynamic guardrails-type approach. But what you really get with the guardrails is predefining, OK, here’s where my lower guardrail is, here’s where I’m going to cut back if needed; here’s where my upper guardrail is and where I’m going to increase my spending if it’s appropriate. And just having that predefined, which I think more than anything, provides a lot of peace of mind, particularly as we’re going through a market like we have, where if somebody has a guardrails plan in place and they know their portfolio is at $1 million today, but they don’t need to cut back until the portfolio falls to $700,000, at least they know in advance when they’re going to cut back, what that cutback would be. And to me, that can provide a lot of peace of mind, in a way that just seeing that your probability of success has fallen from 90% to 67% really doesn’t tell you what to do or how to respond.

Benz: I wanted to ask about probabilities of success. I wonder if you encounter people—sometimes do with individual investors—where they’ll say, I want 100% probability of success. So, how should people set those risk-based guardrails if they want to use the probability of success to guide whether their plan is on track? What are reasonable bands—and obviously, this is personal—but how should people arrive at sensible risk-based guardrails along the lines of what you’re talking about?

Tharp: It’s a good question, and it’s one where I do think there is that tendency to shoot for 100% probability of success, which is probably in most cases not really what you need to do or maybe it’s excessively high in terms of the probability of success level. Some of my work I’ve been doing lately that I’ve found the most difficult time articulating or helping explain is really this idea though that there’s also a big difference between a one-time probability of success result and an ongoing targeting of the probability of success level. Even for myself, working through some of it wasn’t super-intuitive—some of the things that have come out from that. But one really striking finding was if we were to take two retirees and have them use Monte Carlo on an ongoing basis, so they’re actually targeting a consistent spending level or a consistent risk level over time, actually simulating somebody going through history using that strategy—what would it look like?

And the really striking finding—I have a Kitces article that talks about it specifically—but when we looked at comparing even a 20% probability of success as an ongoing target to a 95% probability of success as an ongoing target, the differences in maximum and minimum spending levels over a 30-year retirement period were nowhere near as big as I think most people, myself included, would have expected. So, it really turns out that if you are planning in a dynamic way, and you’re updating your plan on an ongoing basis, you’re really in a situation where using a higher or lower probability of success isn’t even at all really changing your risk of fully depleting a portfolio. It’s more like putting your thumb on the scale in favor of either current income, which would be a lower probability of success or legacy, which would be a higher probability of success. But the metric doesn’t really make sense in the way that we like to think about it once you’re starting off planning knowing that you do intend to make adjustments. If you’re doing just a once and done Monte Carlo simulation and you were going to say, OK, I’m going to pick my probability of success level, I’m going to run my plan, and then I’m going to follow that spending plan blindly and just charge forward, then the probability of success metric that people focus on actually makes much more sense. And there I would probably aim for 95% to 100%.

But I think it certainly starts to make less sense, at least intuitively, the way we think about it, as we shift to this ongoing planning approach. And there, really, I think it’s still for many people comes down to how much are they willing to tolerate, the possibility of a spending decline in the future. That’s one big lever there. And the less somebody wants to tolerate that, maybe the more their initial target should be higher, maybe getting into that 95%, 100%, maybe even—hard to think of a higher bit in terms of different levels—you could reach 100%, and you could still cut spending further, and that might be a prudent thing to do if you really want to reduce the risk of ever having a decrease other than the guardrails themselves for an ongoing plan. I think those can be often wider than a lot of people anticipate. So, using something like a 50% or a 25% lower guardrail for adjustment isn’t necessarily as extreme as a lot of people think. But I think intuitively where a lot of people land in practice is maybe somewhere like a 70% lower guardrail. I just don’t know if that’s actually what’s best in practice, and it’s an area of research that I do want to continue to pursue.

Benz: I thought that was such an interesting point that you made where you said if someone is starting out at their 25- or 30-year retirement and you’re telling them they can never look back on these decisions that they make right now about their withdrawal system, that of course they would want to err on the side of conservatism. They’d want to start really low in terms of the withdrawal rate because there’s this assumption that you can’t ever make any changes. But you make the point, and I know this is a big thing that Justin Fitzpatrick talks about too, is just that this is really a superpower that retirees have that they can make these adjustments to their withdrawal systems on an ongoing basis.

Tharp: Absolutely. And that to me is why the traditional Monte Carlo framework, the statistic that is most commonly referred to from that analysis, is just really disconnected from how most people are willing to actually make adjustments and plan in a dynamic way. And once you do that, it’s just a totally different situation and the metrics have really different meaning in a way that I think might not be well appreciated.

Ptak: I think you made the point that point-in-time withdrawal rate recommendations in addition to some of the drawbacks that you mentioned earlier, they ignore that income from nonportfolio sources, especially Social Security, is likely to change through the retirement lifecycle taken together with David Blanchett’s research that retirees tend to spend less as they age. Do you think that argues for starting withdrawals being higher in many instances?

Tharp: I do certainly think it does. This is one where Justin Fitzpatrick and myself, we wrote on this, and we used the term “the retirement distribution hatchet.” And if you plot out the typical retiree spending rates over time, and particularly if they’re deferring Social Security, you get this blade on the front end of retirement where your spending level is higher, the distribution rate is higher, but then the distribution rate falls significantly once somebody gets to age 70 and they’re taking their Social Security benefit, and we actually see that distribution rate fall and then we might even have a nice little arc in the handle as we look at something like Blanchett’s retirement spending smile on the way that spending actually does tend to decrease for many retirees over retirement.

I do think that is one reason why I actually like to use a very simple distribution rate-driven guardrails framework to explain guardrails when I’m initially teaching it. And to me, the simplest one—there’s Guyton-Klinger and Kitces’ ratcheting safe withdrawal rate and many different frameworks—but I like to even simplify that down and say, OK, let’s say, you started with a 5% distribution rate. If that distribution rate increased to 6%, then you would cut back your spending and bring it back to a 5% level. And if that distribution rate declined to only a 4% level, then you might increase your spending to get it back to a 5% distribution rate. I think it’s just a very simple framework for understanding how these guardrails type strategies work. But at the same time, that really doesn’t work in practice. It might be a nice research tool, but it really doesn’t work in practice because we see often that maybe a retiree has a 10% distribution rate for the first five years of retirement and then it drops to a 1% or 2% distribution rate from there going forward.

So, you really do have to be mindful of the limitations there and that’s where our risk-based guardrails framework, so whether you’re using Monte Carlo simulation or you’re using historical simulation and success rates there, but some other type of approach is really nice because it captures all that individual-specific spending pattern that’s there, whatever somebody wants to assume, whether that’s the traditional hatchet or maybe it’s even different and they want to make certain purchases or go on certain trips or they just have different financial goals that are out in the future. When you use a risk-based framework, all of that individual-specific information gets accommodated into the guardrails. If you’re using a distribution rate-driven framework, then you’re getting none of that. And so, to me, that is why I’m such a big fan of what we’ve called the risk-based guardrails approach to finding a retirement income spending strategy.

Benz: Just to follow up on Jeff’s question about the early years of retirement potentially being the higher spending years before Social Security comes online. Does that make that cohort who might be taking more from their portfolios in those early years, are they particularly vulnerable to sequence risk if they’re invading their portfolio at a high level in that period when perhaps the market is down? What should they be thinking about, people at that life stage?

Tharp: Yeah, you’re absolutely right that that does, it actually elevates the level of sequence risk compared with the traditional research on the topic because most research is assuming more of a constant distribution rate over time, and when you front-load those distributions, you’re even more heightening that sequence of returns risk. So, I do think it’s something to be mindful of. For me, oftentimes there’s different approaches to managing that. But one thing I like to do is to think from at least somewhat of a buckets-type framework. I like very simple bucket framework. So, maybe we even call it a two-bucket framework where we have our more stable investments—cash and bonds and those types—and then we’ve got our higher-growth-type investments like stocks.

But in many cases, when you look on the front end—let’s say that it’s a 65-year-old retiree who’s trying to defer their Social Security for five more years—I think there’s two big things that they have to help mitigate some of that sequence of returns risk. One is that they can set aside enough cash and bonds on the front end to hopefully be able to fund a very significant portion of the spending for that five-year period. I often like to try, through a buckets framework, try and target five to seven years at least worth of anticipated spending needs. And so, that could mean that somebody has that resource there, but if they know they’re going to be turning Social Security on in five years and their income is going to be jumping—nonportfolio income—is going to be jumping up because of that, to me, that can be one reasonable strategy, just setting aside enough on the front end to get through that blade of the hatchet.

The second thing that I think can be really useful is just the fact that you also have the option to turn Social Security on earlier if needed. So, certainly, in many cases, I think it’s worth trying to continue to delay. But if we hit just a really awful sequence of returns and it was very clear that this was not a great time to keep pulling heavily from a portfolio, you do have the option to adjust your strategy in a sense and take Social Security earlier. It’s not like you have to declare on the front end that you’re waiting until 70 and stick with that. So, I think those are the two ways that retirees in many cases can really mitigate that risk. It’s maybe a little bit harder for somebody who is say retiring at 50 or 55 and they have a 15- or 20-year period they’re trying to stretch—there I think there’s a little different set of challenges for many retirees.

Ptak: Wanted to shift to ask you about portfolio construction. Now that yields are higher, we’ve been hearing assertions that retirees should just build a laddered portfolio of TIPS and call it a day. Do you think that’s a good strategy?

Tharp: Personally, I don’t. I really like to just think about the long term, real rates of return. And even though nominal rates go up and down, and certainly, as nominal rates go up, people start to think, oh, this looks like a more attractive investment or attractive to be able to get a higher rate of interest income, perhaps from a certain type of account or investment. To me, I really like to keep the focus on those real rates of return and realize that if rates are going up because inflation is up, your real return from a given strategy may not change significantly from where it was before. And so, if I liked having stocks in a portfolio before to be part of a well-balanced portfolio for providing those long-term returns that are needed in retirement, I’m going to continue to like having stocks in a portfolio, even as nominal rates go up and the level of attractiveness of bonds and other type of investments from a purely nominal perspective might start to sound higher. But on a real basis, I don’t think there’s a strong reason to think that things have shifted significantly.

Benz: We’ve also been hearing a lot about the demise of the 60/40 portfolio in the wake of last year’s market crack where we saw stocks and bonds falling simultaneously. Is that argument overdone in your opinion?

Tharp: Yes, I think it’s very much overdone. Certainly, we saw last year where we knew it was a very real possibility of just going through a market where we didn’t see stocks and bonds offsetting each other the way that in many cases historically they have tended to do. But to me, I really think where that argument comes from a lot is that the 60/40 is such a good portfolio. It gets used by so many people. And if you really want to get a lot of attention and eyes on an article or a piece, I think saying that what a lot of people do is wrong or is flawed in some way does draw a lot of attention. So, I think those articles will always be popular. But to me, I think the argument is very much overdone. I’m still a big fan of the 60/40 portfolio, and I don’t think it’s going anywhere.

Ptak: What other assets in addition to stocks and high-quality bonds do you think retirees should have in their portfolios?

Tharp: I personally am comfortable with retirees going into retirement with stocks and high-quality bonds. I don’t necessarily think they need additional exposure. I do think to the extent somebody wants to diversify, certainly there are options out there. And we’re calling cash something separate, managing their cash through an effective way would be important. But I’m very comfortable with a very stock and bond-centric portfolio for retirees, and I don’t think they necessarily need exposure to other alternatives to fund a good retirement.

Benz: I wanted to ask about TIPS again. I think a lot of investors are having a crisis of confidence in TIPS given last year—most intermediate-term TIPS certainly fell in value at a time when maybe investors were looking to them to be ballast in a high-inflation environment. So, how should investors think about last year’s performance of TIPS? And also, if a TIPS-only portfolio doesn’t make sense to you, how much of, say, my fixed-income allocation, if I’m a retiree, should go in inflation-protected bonds? How should I go about setting that?

Tharp: When it comes to using inflation-protected tools, I think they’re really good in cases where you have clearly defined goals, and you could buy something where you can almost do a ladder-type strategy where you don’t have to worry as much about the price fluctuations in the interim that we see as interest rates move around. So, those are my preferred use cases, like, if a retiree says, I want to fund a large family trip or a wedding or something like that five years from now and it’s in that time frame where we really can’t be super-confident that being invested in the market is going to provide you enough time to come out ahead, those are scenarios where I really like the asset/liability matching of having a particular goal and putting some dollars toward that.

But otherwise, I think sometimes just the focus on the change in value of the bond portfolio, especially if you’re using something like a bond fund that is constantly adding new bonds to the fund, as investors, I think we just have to accept that there is some risk, prices are going to fluctuate and then we’re going to see prices moving up and down as part of being an investor. And to me, that doesn’t necessarily change how I would approach investing. I think I would just start with that in mind, and I would go back to something more like a guardrails strategy to really help fine-tune my spending and make sure that the strategy is staying on track. And then, in terms of the mix of inflation-protected securities, again, I think it really depends on the scenario. In some cases, I think diversified bond funds that do have a good exposure mixture in them are often a very good way for investors to go. But to the extent that somebody is trying to more precisely find an allocation, the more they have those specified particular goals that they can point to for the spending, the more I’d probably lean toward something like TIPS. And if it’s more just a generic retirement spending, then I get a little less particular in it being a TIPS security and more comfortable with it just being a diversified bond portfolio.

Ptak: I wanted to ask you about annuities as well and get your perspective on whether you think they’re underutilized in their retirement planning context, especially now that annuity payouts are trending higher along with interest rates. What do you think?

Tharp: I do think they are one of those tools that, particularly when we’re talking about income annuities and just the simpler products out there that—QLACs, similar types of products—that probably are underutilized when you look at mortality credits and the benefits that having an annuity as part of a retirement income plan can provide. But I think it’s one of those areas where it’s a tough dynamic for many people to want to take that lump sum and trade that off for the income. So, I think there’s some real psychological barriers to implementing that strategy. And in practice, I think it’s definitely the researchers and the academics, who tend to really keep pointing out there’s value in these strategies from a retirement income planning perspective. But when it comes to actually talking to people and weighing the trade-offs and actually going through the steps of funding an annuity in that case, I think there’s just a lot less consumer demand for the given set of dynamics than maybe the academics would prefer based on what we look at and say, yeah, this is a viable strategy.

Benz: It sounds like you tend to favor the simpler, lower-cost types of products, the income annuities, whether immediate or deferred. I’d like to know, do you think an annuity might make sense in the context of if I’ve decided my Social Security-claiming date is, say, age 70, could I use some sort of short-term annuity to help meet my living expenses during those early retirement years?

Tharp: I think it’s definitely a strategy that could be worth looking at. I definitely wouldn’t write that off by any means. I do think there’s a lot of individual factors there that could make that more or less attractive. One of those being—I’m a big fan of trying to use strategic Roth conversions in those years between when somebody retires and Social Security kicking in, and then RMDs kicking in. And so, in some cases, I actually am more in favor of trying to push any income that’s not necessary for funding lifestyle just out of that period that I can. So, if I could use something like a deferred annuity, in some cases, that could make sense, and just try to have more dollars in lower tax brackets available for conversions and other strategies. But of course, you need your core retirement living expenses to come from someplace. And if that was coming from something like an annuity, I think that is potentially a reasonable strategy to use in those early years. A lot of it’s just going to come down to having a real clear understanding of what somebody’s tax situation looks like, their retirement income situation looks like and then balancing all that to find the right combination of portfolio and annuity or other income for them.

Ptak: Are there aspects of retirement planning that you think merit more research than they’ve gotten to this point?

Tharp: I think there’s a lot of areas for sure. I’m particularly really interested in a lot of the psychology that gets tied to all of this. And as advisors or as consumers, we’re using software. How do we, when we present certain things, what does that actually do, what do people understand, where are we creating confusion? I’ve done some early research, I’d say, exploratory in nature with Michael Kitces on this, and we had some interesting findings just in terms of when you talk to people in terms of probability of success versus more of an adjustment-based framework, how that actually changes things like somebody’s assessment of preparedness for retirement or somebody’s feelings of confidence going into retirement. And so, I think, there’s a lot in that area that really remains underexplored, and it’s an area that I hope to contribute to in the future and I think is something really of great importance for retirees and making sure that we’re not unintentionally nudging people in the wrong direction with how software and other tools that we use are giving people information.

Benz: Well, just to follow up on that, I wonder if you can talk about underspending and whether that’s an area of study for you—that do some of these systems that we talk about potentially get people to underconsume relative to what they could consume during their lifetimes? Can you talk about that?

Tharp: Absolutely. And I do think it does. I think Michael Kitces has some nice writing on this particular topic where a lot of the really low withdrawal rate-type strategies, even Monte Carlo itself and planning to that tendency to want to be at the 95%, the 100% probability of success level really does push people in a direction potentially of underspending. And again, if we said we weren’t going to make any adjustments and we were just going to choose a strategy and we’re going to charge forward blindly, that level of conservatism might make sense. But when we start talking about planning and the dynamic nature, then the way that those metrics or those rules of thumb or other practices out there might be implemented certainly can lead people to underspending and really accumulating very sizable estates, which maybe that’s their goal, maybe that’s what they want to do and that’s OK. But for many people who say, I actually would rather spend a little bit more of this while I’m here or give more of it while I’m here, I think that definitely those tools can have a tendency to push us in the wrong direction.

Ptak: I wanted to ask you about tax-loss harvesting as well, which as you know, has gotten a lot of attention over the past few years, and it’s a topic you’ve researched extensively. Do you think the hype is justified? We put that question on Michael Kitces this past summer, and he stated that the direct indexing firms were overstating the tax savings to be had from tax-loss harvesting. What’s your take?

Tharp: I do think it is an area where the value of tax-loss harvesting is often overstated, in my opinion. I do think that it is a real strategy that has real value and can be worth doing. So, I’m not negative toward the idea. But for me, there’s a couple of different ways that at least a naive approach to it can easily overlook or overstate the value, the first being just taking the round-trip taxes into consideration. So, there are oftentimes software tools or other things that might really talk about the short-term benefit of getting that tax benefit now, but totally leave out the long-term increase in capital gains that’s experienced, at least assuming you eventually sell the position. So, you do want to make sure you’re accounting for all of that. But tax deferral and time value money does say that there’s still value in that. It might just be lower than what’s commonly stated.

But the harder-to-quantify cost in a sense of tax-loss harvesting to me is really getting yourself in a position where the taxes are driving the portfolio and not the investments, and that’s really hard to quantify. But to me, particularly with direct indexing, I think it actually even magnifies some of the problem where really you don’t want to be in a position where you’re holding on to a particular set of investments just primarily for tax reasons and because you want to continue to defer these taxes as long as possible, when in reality, it may not be the right investment to be in going forward. And when we think about how the composition of a portfolio can shift over time—and there’s ways to try and mitigate some of that—but for me, I often feel like you do end up in a situation where there’s too much aversion to changing investments when tax-loss harvesting is the major focus instead of just being more of an opportunistic strategy that’s there. And I guess the final thing is that also it’s often very short-term in terms of maybe there’s tax-loss harvesting in the first couple of years of investing, but oftentimes we get longer down the road and there’s going to be no losses to harvest unless you’re continuing to systematically invest, and then there might be something there. But in general, I’d agree that the value of it is often overstated.

Benz: Which types of investors and in which types of market environments will tax-loss harvesting be the most successful? I think you cited some research from Betterment where they looked at the value that they were able to add with tax-loss harvesting and one of the things, not surprisingly, that contributed to high alpha from tax-loss harvesting was the fact that the period they examined included a bad bear market, included that the great financial crisis.

Tharp: Absolutely. The two factors that’d be really important: one, is understanding somebody’s tax situation, because as we know, if somebody’s in the 0% capital gains bracket, tax-loss harvesting is a harmful thing to engage in. So, we would actually want to be tax-gain harvesting when we’re dealing with somebody who has low capital gains. So, all else being equal, the higher someone’s income is, I think the more value there is in there. You just also get more benefit from the potential offsetting of ordinary income with at least your $3,000 of losses that you can carry forward and take from year to year. So, that would be one factor is just individuals who are in higher tax brackets might benefit more.

And then, certainly, the market environment we’re in, anytime you’re trying to historically quantify the value of tax-loss harvesting, if you’re looking at a time period where you started off with downturns, that’s the ideal scenario. If you’ve seen 100% growth and then you see a 50% drawback, you’re still going to be in a position where you have gains. So, even though you’ve seen declines, you’re not going to have harvestable losses in that case. That’s why you just want to be mindful as you’re trying to evaluate the strategy of what methods are being used, what time period is being looked at. But overall, yes, I still do think it’s a valuable strategy and something to consider. I just don’t think it should be what’s driving the portfolio and you want to make sure it’s right for you as an individual.

Ptak: I wanted to ask you one more question about tax-loss harvesting, which is, do you think it would be more fruitful if a portfolio consists of individual securities versus managed products like mutual funds and ETFs? And actually, I’m thinking back to your comment of a few moments ago where there’s that unquantifiable potential cost of a drift insofar as the tax-loss harvesting wears the pants instead of the actual investing that should go on and trying to optimize that piece of it. So, I wonder, does portfolio construction, whether it’s individual securities or managed products, does that play any sort of role in that trade off that one is making when they’re engaging in tax-loss harvesting?

Tharp: I actually think while certainly the opportunities to find individual losses to harvest is greater, when you have a portfolio of individual securities, something like a direct indexing type approach, I think the risk of the strategy drift is actually greater in that case as well, because now you’re potentially planning around just all these different individual holdings and there’s going to be general drift in the market as well. Whereas I think, in my opinion, it might be a little bit easier to find two small-cap value-type funds that are, say, different enough to be able to be used in the tax-loss harvesting strategy but at the same time are going to be more similar in performance, whereas if you’re selling out of one particular company, even trying to buy another company in the same industry, just that level of performance difference that we see between two companies is so much greater, so much more variability than the performance difference we see between two funds that I actually become less of a fan of tax-loss harvesting in a direct indexing case just because of what I think would be even more risk of strategy drift than when you’re using funds to try to get that tax-loss harvesting opportunity.

Benz: We wanted to switch over to discuss ESG. Your private wealth management firm Conscious Capital has a focus on environmental, social, and governance factors. What do you view as the chief benefits of ESG for people who choose to invest in that way?

Tharp: I would say while I definitely started out my practice and I had a lot of focus and interest there, it probably necessarily isn’t even a core focus of what I do with my clients, although I certainly do have a number of clients who like to use those strategies. And for anybody that wants to, it’s something I do like to explore. But probably the branding of my firm has not kept up with maybe the drift of my clientele. But I do think that, for me, the biggest thing to really think about is what somebody hopes to get out of using an ESG or similar type of ethical or other type of screen on a portfolio? And I say that because there’s actually—and I had an article for The Wall Street Journal’s experts blog where I took it a little bit deeper dive into this. But when we think about different, almost philosophical frameworks or ethical frameworks, it is important to think about how somebody’s own framework aligns with that.

So, what I mean is, you could have somebody who’s more of a deontological rules-based type ethical thinker, and they might say, “I don’t care about the consequences of investing in a certain company; I don’t want to invest in tobacco or I don’t want to invest in companies that I see is doing environmental harm” or whatever that might be. And in that case, to me, using ESG, it becomes a very much easier decision to make because somebody isn’t saying, well, it’s not the consequences that’s driving it. I just ethically feel like I should not be doing this action. Whereas oftentimes, I think ESG gets pitched or marketed as something that’s going to have this big impact by investing and using this strategy, it is going to be impactful in some way. And if you’re somebody who has more of a consequentialist-type ethical perspective, and you say yes, it’s not the ends need to justify the means. Then, that’s the situation where I’m not so sure the case for ESG is as strong as many people have made it, and I think it’s actually fairly easy in the market if we had some profit-driven investors who that’s all they care about, and then we have investors that engage in trading for some other reason. In most cases, it’s relatively easy for the profit-driven investors to basically cancel out the effects that other investors might have had.

There are some threshold-type effects where yes, beyond a certain point, maybe the profit-driven investors can’t undo the actions. For me, I want somebody, if they’re going to use this strategy like ESG, to go into it with that in mind, knowing that they may not be having the impact that is often marketed, and if somebody is in that situation where they say, “That’s OK and even if it doesn’t have that impact, I still feel like this is the right thing to do,” then I think it can be a great strategy to use. And I also think one of the underappreciated aspects of ESG and other types of strategies, is really trying to reduce that individual aversion that might be there to investing or saving. So, getting people more excited, getting somebody saying, “OK, yeah. Now if I know that my portfolio doesn’t have some type of company in it, I feel much better about investing.” And if you can get that person to increase their savings rate by 1% or 2%, or whatever it might be, because they’re more excited, I think that’s an aspect of ESG that’s, to me, the most impactful—is really trying to get people to feel excited about their portfolio and good about their portfolio. So, they’re not averse to investing for those reasons.

Ptak: You’re a big fan of robo-advisors, especially for people who would otherwise go it alone. What do you see as the chief benefits versus a do-it-yourself approach?

Tharp: And I would say I’m a fan of robo-advisors, not just for individual investors, but also for advisors as well. I use Betterment for advisors in my own practice, and I’ve made that change about a year ago, and I’ve been really, really pleased with it. But I think the benefits that I see, in my opinion, are just the ways that you can automate. So many of the different things that are potentially value adding but are really hard to implement, unless you’re constantly monitoring your portfolio, and even then, still might not be the best way to go about it. So, a big one for me is just asset location. So, thinking about the ability to be able to hold investments across different accounts in a more tax-efficient way or at least an approach that we might have a reasonable basis to presume could provide some higher tax-adjusted returns. Tax-loss harvesting, which we talked about, and I do think can be overstated in some cases, the ability to automate a strategy like that while also having some protection in place when it comes to wash sales and avoiding some of the issues there that naturally can come up. I think that’s something where using a robo-advisor that’s at least capable of detecting that and managing across the household would be a really great thing to do.

For many retirees, I think the insurance, not literally insurance, but the protection that’s in place by having an automated strategy is very valuable. I can go back to, as I mentioned, my own grandpa, who was very capable of managing family investments, and he did a very good job until he got to the point where dementia and cognitive decline that was no longer a task that he could really take on for the family. And that’s just a very unique risk, particularly in retirement, that having a backup manager in place, and having that security in place, that if something did happen to somebody, their strategy is not going to get totally off-track, to me is a major benefit of using a robo-advisor.

Benz: We’ve been asking some of our guests, what are their go-to websites, podcasts, what they consume in order to stay up to date in their fields. What are your go-to resources?

Tharp: This will be a tough one for me, because I would say, I actually tend to go more outside of the industry. If you look at my reading and things that I’m doing, it’s often, in some ways, intentionally not a lot of industry stuff because I like to find those little nuggets and ideas and be able to bring them together and meet too. But as biased as it might sound in terms of also having an affiliation there, Kitces is by far one of the top resources I go to when I’m looking for information, reading Jeff’s tax updates, things like that. Those are just an area that I’m often going to. Podcasts like the one I’m listening to here; I do have a list of industry podcasts that I really enjoy. I like to catch those when I’m maybe driving or just have some time to listen into something, those are normal places for me to go. But yeah, I’d say, I actually spend a lot more time just going totally outside of our field and trying to pick up something that I can then take and bring back to the field is where I personally like to be more of a consumer of content.

Benz: What’s an example of something like that?

Tharp: It could really go all over the place. I’d say, sometimes it’s very academic in nature, maybe it’s reading, go back to some of the psychology stuff I mentioned before, and a lot of that was a deeper dive into just certain areas of personality, psychology, subjective well-being assessment, and maybe it’s going to the literature or maybe it’s going to more just books and podcasts or blogs that are really outside of our field. I’m trying to think of a good recent example. But maybe a topic I’ve been thinking a lot about recently is really a lot of that perception. And so, again, that comes from reading a wide array of different psychological books and work in that area, but really thinking about perception and Monte Carlo simulation and how we perceive that, and how that impacts us. A lot of my thinking there has been shaped more by reading researchers in those areas and some of their more academic books that dive deeper into those topics than it has been reading anything within the industry.

Benz: Well, Derek, we are grateful that you’ve spent some of your time with us and our listeners today. Thank you so much for taking the time to be here.

Tharp: Thanks for having me. It was a lot of fun.

Ptak: Thanks again.

Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Christine_Benz.

Ptak: And @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)