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Wade Pfau: The 4% Rule Is No Longer Safe

The noted retirement researcher discusses how pre-retirees and retirees can adjust their plans in times of market stress.

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Our guest on the podcast is retirement researcher Dr. Wade Pfau. Wade is a professor of retirement income in the Ph.D. in Financial and Retirement Planning program at the American College of Financial Services. He is also co-director of the New York Life Center for Retirement Income. A prolific writer and researcher, Wade has authored papers and books on a wide spectrum of retirement-related topics, including in-retirement withdrawal rates, optimal asset allocations for retirement, and the role of annuities in retirement portfolios. He is a two-time winner of the Journal of Financial Planning's Montgomery-Warschauer Award, a two-time winner of the Academic Thought Leadership Award from the Retirement Income Industry Association, and a best paper award winner in the retirement category from the Academy of Financial Services. His latest book, part of the Retirement Researcher Guide Series, is called Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement.

He holds a doctorate in economics and a master's degree from Princeton University and Bachelor of Arts and Bachelor of Science degrees from the University of Iowa. He is also a Chartered Financial Analyst.

Background

Wade Pfau bio

Books by Wade Pfau

Wade Pfau blog posts on Retirement Researcher

Wade Pfau Forbes columns

Wade Pfau blog posts for WSJ’s “The Experts”

Wade Pfau on Twitter

Asset Allocation in Retirement

Kitces, M. & Pfau, W. “Reducing Retirement Risk with a Rising Equity Glide Path.Journal of Financial Planning. Vol. 1. P. 38.

Pfau, W. “To Rise or Not To Rise: Stock Allocation During Retirement.Retirement Researcher.

Pfau, W. “4 Ways to Manage Sequence of Returns Risk in Retirement.” Retirement Researcher.

Benz, C. 2019. “Cut Stocks Or Add to Them? A Key Dilemma for Your Retirement Plan.” Morningstar.com, July 25, 2019.

Blanchett, D., Finke, M., & Pfau, W. 2013. "Asset Valuations and Safe Portfolio Withdrawal Rates." June 28, 2013.

Shiller P/E Ratio

Withdrawal Rates in Retirement

Wollman Rusoff, J. 2020. “Wade Pfau: Pandemic Tears Up 4% Rule.ThinkAdvisor, April 14, 2020.

Blanchett, D., Finke, M., & Pfau, W. “The 4 Percent Rule Is Not Safe in a Low-Yield World.Journal of Financial Planning, Vol. 26, No. 6, P. 46.

Pfau, W. 2020. “How Much Can Retirees Spend on March 11, 2020? It May Not Be What You Think.Forbes.com, March 11, 2020.

Pfau, W. “Using Reverse Mortgages in a Responsible Retirement Income Plan.Retirement Researcher.

Pfau, W. 2015. “Improving Retirement Outcomes with Investments, Life Insurance, and Income Annuities.” Forbes.com. May 23, 2015.

Finke, M., Pfau, W., & Williams, D. “Spending Flexibility and Safe Withdrawal Rates." Journal of Financial Planning.

Pfau, W. 2016. “What Is the 'Floor and Ceiling' Retirement Spending Strategy?Forbes.com, Oct. 18, 2016.

Pfau, W. 2015. "Making Sense Out of Variable Spending Strategies for Retirees.Journal of Financial Planning, Vol. 10, P. 42.

Bengen, W.P. “Conserving Client Portfolios During Retirement, Part IV.FPA Journal.

Guyton, J.T. & Klinger, W.J. “Decision Rules and Maximum Initial Withdrawal Rates.FPA Journal.

Blanchett, D. 2013. “Simple Formulas to Implement Complex Withdrawal Strategies.Journal of Financial Planning, Vol. 26, No. 9, P. 40.

Healthcare and Long-Term Care

Blanchett, D. 2013. “Estimating the True Cost of Retirement.” Morningstar.

Pfau, W. “What Is Age Banding and What Does It Mean for Retirees?Retirement Researcher.

Pfau, W. 2016. “Two Options for Funding Long-Term Care Expenses.Forbes.com. Jan. 12, 2016.

Finke, M. and Pfau, W. 2017. “Managing Long-Term Care Spending Risks in Retirement.AnnuityAdvisors.com.

Annuities

Pechter, K. 2019. " 'Safety-First' Income Plans, Per Wade Pfau.Retirement Income Journal, Oct. 10, 2019.

Hopkins, J. 2019. “3 Reasons Annuities Are the Unsung Heroes of Retirement Income Planning.Forbes.com. June 14, 2019.

Pechter, K. 2019. “The Reason for SPIAs, from Pfau and Finke. Retirement Income Journal, April 25, 2019.

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

Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Benz: Our guest on the podcast today is noted retirement researcher Dr. Wade Pfau. Wade is a professor of retirement income in the Ph.D. in Financial and Retirement Planning program at the American College of Financial Services. He's also co-director of the New York Life Center for Retirement Income. Prolific writer and researcher, Wade has authored papers and books on a wide spectrum of retirement-related topics, including in-retirement withdrawal rates, optimal asset allocations for retirement, and the role of annuities in retirement portfolios. He is a two-time winner of the Journal of Financial Planning's Montgomery-Warschauer Award, a two-time winner of the Academic Thought Leadership Award from the Retirement Income Industry Association, and a best paper award winner in the retirement category from the Academy of Financial Services. His latest book, part of the retirement researchers guide series, is called "Safety-First Retirement Planning." It was released in September 2019. He holds a doctorate in economics and a master's degree from Princeton University, and Bachelor of Arts and Bachelor of Science degrees from the University of Iowa. He is also a Chartered Financial Analyst.

Wade, welcome to The Long View.

Dr. Wade Pfau: Thanks, Christine. It's a pleasure to be here.

Benz: It's great to have you here. A lot of your work has focused on how retirees can position their portfolios and their plans for markets like the current one. We've had extreme volatility. You collaborated with Michael Kitces on some research that argued for this idea of a rising equity glide path, so retirees starting out conservatively. Let's talk about the thesis behind that because it does seem especially timely right now.

Pfau: Yeah, I mean, absolutely. The whole idea there, it's related to kind of different research I've done as well about this idea of lifetime sequence-of-returns risk, where for somebody who is saving for retirement and then spending in retirement, it's the years right around the retirement date that are the most pivotal to the success of their financial plan. And so, market returns early in their career and late in their lifetimes don't really have as much impact, and that idea of a rising equity glide path, it parallels that. We agree with the preretirement period, the whole target-date fund approach, where you're more aggressive when you're young, less aggressive near retirement. But that approach didn't ever really consider what you do post-retirement. And so, when we looked at it, we found that, well, actually as a risk management technique, you have that lower stock allocation near retirement, but then you can actually increase it later in retirement.

And the reason this is all relevant as well is, while target-date funds usually have you in a lower stock allocation in retirement, all the research about what your asset allocation should be if you're using an investment strategy to fund retirement, it has you to be much more aggressive throughout the whole retirement--50% to 75% stocks to retirement. And so, the point of the research was, if you're going to go investments only, you don't necessarily have to be that aggressive throughout the whole retirement period. But at least if you're willing to start at a lower stock allocation but increase it later, that that can really work as a risk-management technique that doesn't lower your spending and allows you to have a less-volatile asset allocation, but still have the same amount of risk that this idea that you're going to fund retirement just through investments can still work out for you.

Benz: At what point prior to retirement would one begin to embark on this de-risking process and how low would I take equities?

Pfau: So, preretirement, it's--we don't necessarily have any sort of issue with how target-date funds do things. It's really those when you're getting to be within 10 years of retirement, that that's where market returns are going to have a bigger impact. And so, that could be a good threshold of, OK, this is when I should start to seriously phase down my stock allocation, which is basically what most target-date funds are doing. In terms of how low it should go, so that depends. I mean, just like any sort of asset-allocation question, that really depends on a number of circumstances related to the individual.

The example we use in the research was, if somebody is looking at a 60% stock allocation through retirement, comparing that to, we'll start retirement at 30% stocks, but then work your way back up to 60% stocks. That's not a recommendation because it's just an example, but that maybe gives people an idea of what we have in mind in that regard, that you don't necessarily need to be 50% to 75% stocks for retirement. But you can't take it all the way to zero necessarily as well. But just something lower, and then work your way back up to that level.

Ptak: What do you think the choices are for someone that's in a situation where they're a few years from retirement and their portfolio was mostly in stocks, and so they're probably looking at losses of 20-plus percent at this point?

Pfau: Yeah, that can be very jarring. And so, in terms of ways--there's a number of different ways to manage sequence-of-returns risk. The whole idea of the rising equity glide path is not necessarily my recommendation as a best practice. So, we can also look in a lot of different directions as well. For people who are getting close to retirement, they've got to really assess the situation. Of course, we're always preaching the idea of stay the course, don't panic, don't sell off your stock positions after a market downturn. And that really still applies. But for people who are ultimately not going to behave that way and are going to panic and are going to sell their stocks, going into cash is really the worst thing you can do. And so that leaves open a number of different possibilities in terms of someone would be so much better off with an annuity than with cash, for example. And so, thinking about how the best option, you're not going to stay the course, you're going to lower your stock allocation. Well, there's ways to potentially still get a better outcome than simply sitting on the sidelines in cash and missing out on any opportunity for any sort of subsequent market growth.

Benz: What about the idea of using market valuations as sort of a signal that it's time to de-risk or does that seem too much like market-timing to you?

Pfau: So, that one--earlier in my career I was kind of more interested in that sort of approach. When we look at the historical data--and Robert Shiller has that historical data going back to 1871--it's kind of remarkable how well future market returns related to, like Shiller's CAPE ratio, the cyclically adjusted price/earnings ratio--that when it was above average, you lower your stock allocation and vice versa. And I think Shiller's research on that was just in the late 1990s. Once he kind of identified how well that relationship worked, that's pretty much the time it stopped working, because in the past 25 years or so, markets have been overvalued by that measure except for the brief period around the financial crisis in late 2008, going into 2009. So, somebody who followed those types of strategies would have had a lower stock allocation throughout and would have missed on what ended up, for example, this most recent bull market. So, I put less weight on that idea other than to use it to say at least--it's an argument in favor of at least stay the course. You don't necessarily want to do that sort of market-timing. But to the extent that you would have been better off going in that direction, that's a contrarian direction. That's saying, after market downturns there's a stronger case to be in the stock market. So, if you can use that to at least stay the course, that might help people overcome this notion of at least not converting into cash after a market downturn, which would be the opposite of what that valuation-based approach would be telling you to do.

Ptak: It seems like to some retirees though that would be a scary proposition right now, the idea of maybe averaging into the market given the violence of the downturn that we've seen. So, I mean, are there any sort of mechanisms or constructs you can suggest to somebody in that situation that maybe recognizes that putting on more equity rate is the sensible thing to do, because stocks became cheaper and it probably is going to contribute to their retirement success, but they have to overcome that wall of worry?

Pfau: So, in that regard, just rebalancing can be a big part of moving in that direction, because like, if you rebalance today, it means you're going to be moving from bonds into stocks. So, you're, kind of, implementing what that valuation-based approach would be doing without necessarily saying, OK, I'm going to really get more aggressive. It's not that you're then increasing your stock allocation necessarily, but you're moving back towards your strategic asset allocation. And so, if you can frame it that way, you are essentially buying stocks at the present. If you've really exceeded these triggers and thresholds that suggests you should be rebalancing, which a lot of people probably have experienced with the recent market volatility. So, framing it that way could be a way to move back towards your strategic asset allocation, which would involve moving from bonds into stocks at the present and at least gives you a way to implement what the research said was really moving in the right direction for the financial plan.

Benz: It's a rising equity glide path; it doesn't mean that I can start retirement conservatively and stay conservative. So, let's just talk about that, the triggers that one would use to make the portfolio more equity heavy over time.

Pfau: Well, it's interesting how with this conversation the two areas of research do overlap. Because what historically triggers the worst-case types of retirement outcomes are--you get a bear market in early retirement, assuming we're not in a permanent downturn, eventually markets recover again. And that's historically also triggered by bear markets follow bull markets. And so, bear markets follow times of high stock market valuations. And so, then that's what the rising equity glide path actually was designed to help. It's, you're in a lower stock allocation, when it matters, which is effectively after a bull market and then going into the bear market and then gradually you increase your stock allocation so that gradually as well bear markets resume to become normal again and you get a better risk-management outcome in that specific scenario. So, if you're implementing that and you're near retirement, that would have been suggesting you've been taking risk off the table as we've seen this bull market continue and continue, and then, at this point, you are entering retirement with a lower stock allocation. You're continuing to rebalance, you're in a better position to manage exactly what's going on right now. The whole idea is, later in retirement, market returns are going to have a less of an impact and so it's a way to then gradually just--if you are increasing your stock allocation over time, you're then benefiting from what is, if it's not like a long-term market downturn in terms of like a 30-year--if markets are going to be down for the next 30 years, nothing works. So, if you hit that worst-case scenario of markets are down in your early retirement, eventually markets recover and you're, kind of, naturally working into that with increasing your stock allocation over time. So, that's how it works as a risk-management technique.

Benz: Well, I think, that's an important point. And let's talk about people who might be listening or advisors with clients who have been retired for, say, 10 or 15 years, and now they're 85. This is all much less of a risk for them, correct?

Pfau: For the most part, yeah, if they've been following the kind of logic behind something like the 4% rule for retirement income, which is that guideline of how much you should be able to spend from an investment portfolio. Though it's subject to not working, it is designed to be conservative, and certainly if you retired 10 or 15 years ago, if you've been using that type of approach, it probably means your portfolio is continuing to grow in retirement. And so, when you look at meeting your spending goal, you're probably using a lower withdrawal rate today than what you were at the beginning of retirement. And then, if you're already say, age 85, using a lower withdrawal rate, yeah, you're very unlikely to run out of money at that point. And that's where you can afford to. You have more discretionary wealth; you can afford to be more aggressive while still maintaining safety for the portion of the assets needed to continue to fund your spending goal. And so, again, that's where naturally a lot of people might end up having something that's sort of like a rising equity glide path because their portfolio is growing throughout retirement.

And when you think from the household perspective, so thinking also about things like Social Security benefits, which behave like a bond, as you get older, the value of your subsequent Social Security benefits is declining as you age just as you're receiving them and spending them. Relative to your portfolio, if you keep the same asset allocation there, you actually have an increasing equity glide path from the whole household perspective. And so, a lot of people tend to end up doing that. And it's reflected through if you're spending conservatively, your investments are probably growing throughout retirement. And so, it becomes a bigger portion of your overall asset base as you age and you're increasingly becoming unlikely to outlive your portfolio if you got a bull market during your early retirement years.

Ptak: Do you think there's any validity to the criticism that sometimes leveled against the rising equity glide path idea that it doesn't sufficiently take into account the behavioral challenges that sometimes accompany increasing equity exposure later in life?

Pfau: Oh, yeah. Yeah, I mean, absolutely. So, I don't view the rising equity glide path as a best practice. It's more of an interesting mathematical outcome in terms of a risk-management technique. And also, it is something that naturally does get implemented by people, again, when you look from the whole household perspective. But the idea of actually looking at your stock allocation and increasing it as you go through retirement, there's a whole host of behavioral concerns. I do hear from a lot of people--because the media really picked up on that article since it is so counterintuitive. And I do hear from people who find that sort of logic really compelling and plan to do it in their own retirements. But I would agree, it's certainly not going to be for everyone because of the--usually you're not thinking to increase your stock allocation as you age. And so, it does have some practical considerations that make it hard to implement for a lot of people in practice.

Benz: Wade, you mentioned withdrawal rates, which are an important component of all of this. And let's get back to the declining market that we're facing currently--the obvious adjustment to make in the face of a declining market would be to reduce withdrawal rates. In fact, you wrote this week that it's important to understand that the 4% rule does not apply today. Basically, you made a very clear statement. So, why is the 4% rule broken essentially in today's environment?

Pfau: Well, there's a number of factors--people are living longer, and the 4% rule ignores taxes, it assumes investors are not paying any fees on their investments and so forth. But the biggest driver for what I'm talking about right now is the low interest-rate environment. Low bond yields mean low bond returns in the future. And there's not really any controversy about that. It's a very close mathematical relationship. If interest rates don't change, today's bond yields will be the bond returns. And then, of course, if you're holding bond mutual funds, well, if interest rates go up, you're going to have capital losses, which make things even worse. Or vice versa, if interest rates decrease further, you could have capital gains. But effectively, future bond returns are going to be very close to today's bond yields. And that means spending from bonds is going to be lower mathematically. And for the 4% rule, it's just based on U.S. historical data, where we've never seen interest rates this low. The one time we saw, like, for example, the 10-year Treasury yield fall below 2% was just very briefly in the early 1940s.

So, if you are just trying to fund retirement with bonds and starting in the early 1940s, you'd be looking at about a 2.5% withdrawal rate for a bond portfolio. But for a diversified portfolio, stocks came to the rescue of bonds in the early 1940s. Because this was now after the Great Depression, and stocks were undervalued. Going back to that Shiller analysis--stocks were undervalued in the early 1940s. And so, the long-term prospects for stocks were much better at that point. And they did come to the rescue. And for a diversified portfolio, the 4% rule survived in the early 1940s, when it's the only time we saw interest rates low like today. But today, we're dealing with this high-valuation environment, although it's ...

Benz: Less so now?

Pfau: ... less so now. And historically low interest rates, lower than the 4% rule ever had to be tested by. And so, it's not as clear how stocks can come to the rescue of bonds. So, you're really starting from a position where the 4% rule is under a lot more strain. And it's really sensitive to market returns. Like, if you just take historical average data and plug that into some sort of financial-planning calculator, which is kind of the naive approach that still gets used today, that will be assuming you're going to have 5% to 6% bond returns in the future. The 4% rule looks like it's going to work 95% of the time. But if you just lower returns to account for lower interest rates, and because of this idea of sequence-of-returns risk, even if interest rates normalize later to their historical averages, that's kind of too late if you're retiring today. Based on those kinds of projections, you're going to be looking at the 4% rule working more like 60% to 70% of the time, and that's usually not the amount of safety people want, that if you want that kind of safety of at least getting your strategy to work 90% of the time, the lower interest rates are going to push you towards something like 3% being a lot more realistic than 4% as a sustainable strategy in a low interest-rate environment.

Ptak: In addition to lowering one's spending rate, I think there are other solutions that you propose. For instance, in a recent Forbes article you wrote about adjustments retirees could make to potentially spend more in retirement without greatly increasing the risk of running out prematurely. One of the ones you discussed was the idea of adding what you call buffer assets to the plan. What do you mean by buffer assets?

Pfau: Yeah. So, I mean, just more broadly, I talk about four general ways we have to manage sequence-of-returns risk: spend less, fluctuate your spending or be flexible with your spending, reduce volatility at key points--and that's where that rising equity glide path would fit into that family--and then buffer assets. And so, buffer assets are assets held outside the portfolio that are not correlated with the portfolio and that can provide a temporary resource to spend from after market downturns to avoid selling portfolio assets at a loss and just try to give the portfolio an opportunity to recover so that you can then subsequently start taking distributions from the portfolio again.

So, there's three buffer assets that exist. And one of them I don't think is really a very good one, but the original sort of buffer asset is cash. The problem with cash is, if you're pulling cash out of your portfolio and saying, it's just sitting on the sidelines and not part of your portfolio anymore, that means your portfolio would be smaller at that point. And if you're trying to meet the same spending goal, you're going to be using a higher withdrawal rate from your portfolio. And cash as a buffer asset, it's just sort of a mental accounting framework that's not really doing anything to help you. The two buffer assets that have more ability to actually improve your retirement outcome--if you do have already the cash value in your whole life insurance policy; or if you don't have that, but you own a home and you plan on living in the home, a growing line of credit on the reverse mortgage Home Equity Conversion Mortgage program. Those are the two realistic buffer assets we have.

And it's just the synergies of--this is the sequence of returns risk that we're talking about, that if you get a market downturn early in retirement, it can really disrupt your ability to fund your retirement from investments. And so, these small changes you can make can have a huge impact. Just being able to source a year of spending from a buffer asset and leave your portfolio alone for a year can have a huge impact on helping to keep that portfolio sustainable or helping not deplete it so that even when these buffer assets do have a cost--and they do have costs--reverse mortgages and then borrowing from the cash value in your life insurance, both involve taking a loan that you need to pay interest on. But as long as that cost does not exceed the synergistic benefit of how you've helped to preserve your portfolio by not drawing from it at an unfortunate time, the gains to the portfolio can exceed the cost of the buffer asset. And so, you have more net benefit at the end where you've met your spending goal. And when you look at your legacy as what's left in your portfolio, plus the value of your buffer asset, which would be the death benefit for life insurance or the value of the home for the reverse mortgage, and then subtracting off the loan balance due, you're going to be in a better position at that point. And that's how the buffer asset can actually be a very powerful way to help manage this risk and help you to spend at a higher rate from your investment portfolio as well.

Benz: You nicely addressed the cost question that was running through my mind, but I guess one aspect of the cost of whole life insurance is whether that was an ideal allocation of capital at the time the policy was purchased. Do you factor that into the analysis at all, into the cost analysis?

Pfau: Yeah, so on the life insurance side, I've run the numbers going back and done this a number of different ways now. So, usually, like a 35 or a 40 year old, who decides they need more life insurance for their family for the normal reasons to protect their family in their preretirement years. And then looking at should they buy term and invest the difference, or should they start thinking ahead to retirement and then use whole life insurance? So, that's the way to then incorporate because whole life insurance is going to have a much higher premium than term insurance. You will get to retirement with less in your investment account. But then, comparing, well, you have less in your investments, but with the whole life insurance and how they work together, how does that impact your retirement plan? And by using the risk-pooling powers an insurance can provide, it can actually create the ability to spend more and have more legacy from this sort of integrated strategy, net of the cost of the insurance again, because it helps to manage… It's hard for an investment portfolio to manage longevity risk and sequence risk. It just ultimately means you have to spend less. And to have these synergies where you're not necessarily so dependent on always taking from your portfolio, that's where there's a few different ways you can use the life insurance. But if you're just thinking in the context of the buffer-asset approach, it can work so that, yes, you have a lower investment portfolio, but all things considered, when you can use a higher withdrawal rate from your investments, because you have that buffer asset and when you get that synergistic ability to help preserve your portfolio in times of trouble, you do get a better outcome at the end. And that's what this sort of research about buffer assets tends to show both on the reverse-mortgage side and on the life insurance side.

Benz: You mentioned variable spending, Wade, as a way of potentially addressing a market downturn. So, a very crude way to do that would be to simply use a fixed-percentage withdrawal and take the same percentage out of a portfolio every year regardless of what the portfolio value is. But that's obviously not ideal from a quality of life standpoint. So, let's walk through how one could create a sensible variable withdrawal strategy.

Pfau: Yeah. So, what you explained would be the opposite end of a spectrum of extremes. So, the 4% rule is one extreme. Well, it's 4% of your initial retirement assets, which tells you how much you can spend. And then you just keep spending that same amount every year and you never adjust based on market performance. There's always going to be a withdrawal rate, but you don't care what it is, you just keep spending the same amount. So, then what you described is the opposite end of the spectrum, which is, you just spend a fixed percent of what's left every year. So, you're always using the same withdrawal rate every year, but your spending will fluctuate, and it could fluctuate quite dramatically just based on how your portfolio is doing. So, those are the two ends of the spectrum.

And then, there's a whole host of strategies in between that try to develop some sort of compromise between thinking you should make some adjustments to your spending. And that does help manage sequence risk. But you don't necessarily want to adjust your spending too much. In practical terms, just following the required minimum distribution rules to define spending in retirement, that's going to be related to the fixed-percentage strategy, but it actually is pretty closely aligned with what academic research shows is the optimal way to spend beyond that as well. So, different advisors have proposed different types of variable spending strategies.

One of my favorites is actually Bill Bengen defined it and he's the one who created the 4% rule initially. But he talked about a floor and ceiling approach, where you spend a fixed percentage of what's left every year, but you decide you're going to have a floor that you don't want your spending to fall below a certain dollar amount, and then you have a ceiling where you're not going to let your spending go above a certain dollar amount. So, as long as you're within that range, you just spend a fixed percent, but you apply the floor and the ceiling. And because you have that floor, it can be the case in the way this helps to manage sequence risk by adjusting your spending that that floor might not be all that much less than what the 4%-rule logic of always spend the same amount every year no matter what, would have had you spending so that you have the potential to spend more on average, and even on the downside, not really spending all that much less. So, that can work very well to help manage the sequence risk. And that's a pretty easy strategy to implement. And I think it has a lot going for it. It's one of my favorites.

There's a lot of other strategies out there as well. Jonathan Guyton developed his decision rules with William Klinger that are a lot harder to implement in practice and do call for occasional 10% cuts to the distribution that are permanent. But that could be another option as well. I mean, there's other options if you want to… I don't know how deeply you'd like to go into this area.

Benz: That's a good summary. Before we leave required minimum distributions as maybe a benchmark that someone could use, just talk about the virtues of that. It updates with my age and my portfolio value, and so that is valuable?

Pfau: Yeah. So, the academically optimal way to spend is, you're going to adjust your spending every year to reflect your portfolio value and your remaining longevity. And so, as people age, their remaining life expectancy gets shorter. And so, naturally, people can spend a higher percentage of what's left as they age. And so, the required minimum-distribution rules are an existing guideline we have to guide that sort of spending. Now, they are conservative, because they're based on assuming a zero-percent return for the asset base. And they're also based on a couple where one spouse is 10 years younger than the other spouse. So, you could play around with making them a little more aggressive if you want to spend a bit more aggressively. But generally speaking, that's what academics are saying: spend an increasing percentage of what's left every year as you age. And that can be the most efficient way to spend down your assets in retirement. So, that's where they get attention as an easy way to implement a more efficient and optimal type of way to spend down assets in retirement.

Ptak: Do you have any thoughts on how retirees should factor in the role of healthcare expenditures when thinking about their plans?

Pfau: Yeah, that's an important expense. It's part of the budget that is generally difficult for people to wrap their minds around how that's going to work in retirement. It's not just the healthcare expenses, but also long-term-care expenses, which both tend to increase with age. And different individuals are going to have a different experience with that. But on average, David Blanchett at Morningstar has a good research article about that in terms of the retirement-spending smile, which shows as people go through retirement, a lot of their expenses tend to decline with age, but by the time they get to their mid-80s, the healthcare expenses and long-term-care expenses, and the fact that those types of expenses tend to grow faster than inflation, start to pick up and so overall spending starts to go back up again. And so, you get this sort of smile for how expenses go throughout retirement. But ultimately, that sort of pattern is less conservative than just assuming your spending always grows for inflation. And so, it allows you to either use a higher withdrawal rate or to retire with less assets. Because if you build in this ability to reduce your spending with age but then increase again at the end, then overall you need less assets to fund that retirement.

Now, for people budgeting in healthcare expenses, they need to get a handle on Medicare and all its various options. Medicare, of course, doesn't cover everything. But if you add in enough supplements to it, you get a pretty good sense of what your annual health expenditures are going to be, at least for the things that are covered by Medicare. You need to budget for dental and vision and hearing aids and things that aren't covered by Medicare. But at least you have a pretty good sense there of what out-of-pocket expenses might look like. And if you're not necessarily going the route of paying for kind of a Medigap or a supplemental policy, then you will have a little bit more variability where if you don't have as big a health expenses, you'll have a lower bill for the year. But you would have more variability in terms of if you end up needing more healthcare services in a given year, you'll have more deductibles to meet in copays and so forth.

But overall, people can get a sense of what their health expenditures may look like in retirement. There is more software now as well to help people get better estimates based on any sort of illnesses or medications they may need and how to strategize around that.

Benz: You referenced long-term care. There are no perfect solutions to the long-term-care issue, but the hybrid products--the hybrid life long-term-care products--seem to be coming on strong. How do you feel about those products?

Pfau: Yeah. So, that's where most of the innovation and growth is and it's usually connected to a life insurance policy. They can be connected to annuities, but with the low interest rate environment, there hasn't been as much development there. So, I think they can provide a good option for people in terms of--the worries people have about traditional long-term-care insurance are the risk of the premium increases and then the whole idea of this sort of use it or lose it, where if they don't end up needing long term… This is true with any insurance, is if you don't end up needing the insurance, you feel like you've been paying premiums unnecessarily. And so, the hybrid policies kind of provide a workaround with that where you have life insurance, and it wouldn't be as large of death benefit as it could have been if you just were paying that premium for pure life insurance. But you have the ability to spend from that death benefit to cover long-term-care expenses. And there's different ways these policies are set up. Some are as simple as you can sort of get access to your death benefit in advance to pay for legitimate long-term-care expenses. Others may go beyond that, where first year you're spending down your death benefit, but it may be structured so that you have additional spending power for long-term-care expenses beyond that.

So, there's a lot of different ways those policies can be set up. But they do help to just put some sort of limit on what kind of out-of-pocket expenses you might be facing for long-term care so that you leverage some of your dollars more to get that risk pooling and insurance. It can make it cheaper than self-funding if you end up having a big long-term-care expense in retirement. It helps to narrow the range of possibilities. If you don't have any long-term-care event, you're paying for insurance that you're paying more, but it helps to reduce some of the extreme potential costs you might experience with a long-term-care event.

Benz: It seems that there's some enthusiasm in the marketplace, or at least among retirement researchers, for a product that would have a very long elimination period where you wouldn't be covered and then you'd be covered in case you had some sort of catastrophically long long-term-care event. Do you have a sense of whether there's any traction for such products or is it a regulatory issue that's holding that back?

Pfau: Yeah, so, it's really a high-deductible type of policy. And that's what some of these hybrid policies do. If it's life insurance connected with an additional pool of long-term-care funds, it really behaves like this sort of high-deductible policy, because the benefits you're receiving for a long time are really just your own premiums that you paid in and then funding from that death benefit. And it's really once, only once you get past that point, that you're now spending an additional pool of insurance funds dedicated for the long-term care. So, in practical terms, some of these hybrid policies can really behave as that sort of very high-deductible policy. On traditional long-term-care insurance, we don't see that as much. And so, I don't have a good sense of whether that's a regulatory thing or just it's not as attractive for consumers. Could be kind of a mix of those factors.

Ptak: Maybe shifting gears to fixed annuities--one issue with fixed annuities is that you're locking in really low rates today, which is a theme that you sounded earlier in the conversation, albeit in a different context. What's your thought on that issue? It doesn't look likely to go away anytime soon.

Pfau: There's different ways we can address fixed annuities if we're thinking about for lifetime income. Yeah, if you're buying a single premium immediate annuity, for example, you're locking in today's yield curve. And sometimes that gets used as an argument to say, well, you shouldn't do that, you shouldn't buy an annuity when interest rates are low, you should wait for interest rates to increase. Now, that argument doesn't necessarily work for somebody who's already in retirement. And the interesting thing about it is, because the mortality credits that annuities provide--which is the idea that you pay your premium--those who end up not living as long, some of their premium helps to subsidize the payments to those who end up living longer. That whole process is not impacted by interest rates. And so, when interest rates are low, the mortality credits become all the more important. And it's true that when interest rates are low, annuities will cost more to fund spending.

But the problem is investments. The cost of funding retirement grows faster with investments than the cost of funding retirement with an annuity. And so, relatively speaking, the case for annuities become stronger when interest rates are low. And this is especially true for somebody who's already at retirement. Because if they follow this idea of, well, I'm not going to buy the annuity today, I'm going to wait for interest rates to go up. So, in the meantime, they're spending down their assets to fund retirement. If they're trying to invest for yield right now, if they're trying to invest for longer-term maturities so that they can get more yield to the extent the yield curve is not completely flat right now, they're exposed to a huge amount of risk where a slight interest rate increase is going to result in those huge capital losses. And if they're otherwise just keeping the money in cash because they're worried about interest rate increases. While they're spending down these assets, they're not getting the mortality credits yet, they're not getting the interest-earning potential that the insurance company general account has because it can invest for longer term since it's using a buy and hold-style asset-liability matching framework. Even if interest rates increase, so that you get a higher payout rate from the annuity, when you multiply that by a lower remaining account balance due to the risks of the investments as well as the fact that you're spending them, you're not necessarily going to get more income. So, at the end of the day, for people who are already retired, it's not necessarily worthwhile to be thinking in terms of waiting for interest rates to increase before you consider using an annuity. The case is actually, on a relative basis, stronger to go ahead and do that today.

Benz: Annuity is obviously a very big umbrella. What types of products do you favor?

Pfau: I think, ultimately, a competitively priced annuity of any style can work. The easiest annuity to think about is what I was just describing, the single premium immediate annuity. So, that can be a good starting point for people. But there can be a role for other types, and the other types, essentially like deferred annuities where you don't annuitize the contract immediately. Whether it's a variable annuity or a fixed-indexed annuity, they can both provide that potential to have liquidity for the assets as well as some upside growth potential for the assets while still being able to support lifetime income through an optional--it's usually called like a guaranteed living withdrawal benefit--so that you can still get that protected lifetime income. And especially with the variable annuity, where it can really add value, is if it helps people to invest more aggressively than they otherwise would.

And so, like today, again, if people are panicked and really thinking they're going to leave the stock market permanently, just moving their assets into a variable annuity and keeping a similar asset allocation so that they don't panic and sell all their stocks, they just move their stocks to the variable annuity. But they feel more comfortable doing that because they add the optional benefit that will support lifetime income, which then means, if stocks continue to go down, spending is protected from further losses. But if the market recovers, then you can have this potential for the growth value of the assets and increases in spending. That could be a great solution for somebody in today's market environment where that could really add a lot of value. Or otherwise, just looking at the payout options on different types of annuities and going with what you feel most comfortable with. Sometimes the indexed annuities can have payouts that are similar to the single premium immediate annuities. And so, you might not necessarily end up really giving up all that much in terms of guaranteed downside to keep the liquidity and some limited upside potential for that asset base as well.

So, not all annuities are created equal, and a lot of the annuities that get pitched at the free chicken dinner-type seminars are not necessarily what I have in mind. But there are good annuities out there. And there are good annuities in any of these general categories that can play a role in a retirement income plan, the single premium immediate annuities, the fixed-indexed annuities, or the variable annuities.

Benz: It seems like there's been sort of this cultural divide among advisors, either they're sort of investment people or they're insurance people, never the twain shall meet. Do you see that changing? Do you think that advisors are increasingly attuned to the value of adding some sort of lifetime-income product into the mix?

Pfau: Yeah, I think, it is slowly changing and it's really what the research points to is that you shouldn't be either one or the other. It's the integrated strategies that annuities can be very powerful for meeting retirement-spending goals. And then, that also frees up more capacity to having an aggressive investment portfolio to help cover other more discretionary types of goals. And that's ultimately a more efficient way to approach things. And so, the investment managers who hate annuities and think that investments are the way to go, they're really missing the boat on how hard it is to manage this longevity and sequence-of-returns risk with their investments. And then, on the other side, as well, I suppose somebody who thinks everything should be in an annuity is not necessarily going to create the best solution either. But increasingly, I think we do see more financial advisors who are willing to really think more seriously about this and not let their business model overwhelm their decision-making, which happens on both sides because we always hear about annuities being commission based, and so there's a conflict of interest.

But on the investment side, there's a huge conflict of interest where if you're charging based on assets under management, when you tell the client to get an annuity. Now, there are fee-based annuities, so advisors can incorporate these into their practices. But otherwise, they're telling the client to get an annuity, and that means taking away assets that they can charge fees on. And so, they were very biased towards just saying investments should work fine for everything. But it's bringing the two together and integrating them in a more thoughtful manner that I think we are seeing increasingly more financial advisors are open to how this is really the best way to serve their clients.

Ptak: Some have tried to productize it, this fusion that we've been talking about. Vanguard recently threw in the towel on the managed-payout concept for retirement income. Do you think retirement deaccumulation can be productized in this fashion, especially for people in a defined-contribution context where tax considerations aren't an issue?

Pfau: Yeah, it'd be great to see more of that. It is unfortunate. Vanguard had--they used to have--three different managed-payout funds and then they merged them into one and now there's none. So, it wasn't apparently very popular with consumers. But it is a nice concept that it's a balanced mutual fund where it's thinking about asset allocation, but also thinking about providing distributions, because that really helps people. It's complicated to know how much can you spend from your investments in a sustainable manner. And so, having that sort of product that helps to make those decisions, and the idea between having three different versions is, there's no guarantees behind any of these, but you can at least say this one, you start with lower spending, but you've got a much better shot that your spending will keep up with inflation. This one is managed more towards always giving you the same spending, which won't keep pace with inflation, but maybe that's what you're looking for. Having those different types of managed-product solutions, I think, can be very helpful and could be a great resource for employer-sponsored retirement plans. So, yeah, I mean, absolutely, it would be great to see more innovation in that regard and to see that being used as an option by consumers, which I guess so far apparently, people aren't really paying attention to those options. But I think there's value there and hopefully, we'll see new developments.

Benz: Going back to annuities, is the SECURE Act's provision that gives the plan fiduciary a safe harbor for offering an annuity, a positive development in your view?

Pfau: Overall I think so. Because again, not… So, I think annuities can add great value, but not all annuities are created equal. So, if this does help to get more competitively priced annuities into employer plans to help individuals to replace those pensions, the traditional company pensions that we did away with in favor of defined contribution and just managing your investments in a 401(k). So, to the extent we can see more adoption of annuities in employer plans to give people those lifetime-income options, I think that's a very important development. I do think we just need to be careful to make sure that the annuities that are incorporated aren't excessive in their fees. Because of the complexity of annuities, they can be not transparent, and it can be easy to incorporate too high a fee. And so, we need to make sure that that market is competitive and that good annuities are what gets included in the plans.

Benz: One question that we've put to a number of our guests who focus on retirement research is whether the U.S. is in the midst of or on the precipice of some sort of a retirement crisis. What's your take on that question?

Pfau: I know there's a lot of discussion about that out there. At the end of the day, a lot of Americans will ultimately just end up depending primarily on their Social Security benefits. And it really behooves them to be thoughtful about their Social Security-claiming strategy. And to the extent that people can fund their retirements OK with Social Security because they just simply don't have anything in their 401(k)s, and well, home equity can play another role here as well. But yeah, I mean, ultimately, some people are going to be stressed in retirement. There is, to some extent, a crisis in that people are not going to have a lot of reserves available to deal with the unexpected expenses that may show up in retirement. But to the extent that people can adapt--and they may be looking at spending less once they're retired--but to the extent that they can adapt, it does seem like we can muddle through. Of course, something like the 4% rule is really not at all even a relevant consideration for most Americans, because they just don't have enough assets where if we're talking about spending a couple of hundred dollars from your portfolio, that's not going to make a huge difference relative to the Social Security benefits that they have already. So, yeah, I think there's some limited crisis, but it may be overblown to some extent because I think a lot of people do adapt OK with the resources they have.

Ptak: The stock market's volatility and low bond yields, things that we've touched upon earlier in the conversation, they're certainly front and center today. But are there any other retirement risks we haven't touched upon that you think we ought to be mindful of?

Pfau: Everything just basically can be categorized as the longevity, you might end up living a long time, the market volatility and how the fact that you are spending from your investments actually amplifies market volatility in your retirement. We didn't really talk much about inflation, but then that's always a risk as well. And then, other than that, it's all these different types of spending shocks where people might be getting an unexpected bill, whether it's long-term care, healthcare, helping adult family members, the need to help support grandchildren and so forth, all these different types of potential expenses people might face and they hadn't anticipated. That pretty much covers the range. I mean, there's a lot of other spending shocks as well, but everything sort of fits into one of those categories. So, I think we did have a basic discussion at least about most of that.

Benz: Wade, you referenced inflation. I think it might be tempting if I were embarking on retirement now to discount that as a problem in perpetuity--just assume that it will not be

Pfau: Yeah, I mean, it certainly can be. The way you can kind of understand what the markets expect inflation would be is to just look at the difference between treasury bond yields and TIPS, or Treasury Inflation-Protected Securities. And markets just priced in low inflation under 2% for the next 30 years. So, I think, in getting into this discussion as well, I kind of sometimes get into some issues where I think you should plan for inflation. I think TIPS can be important in retirement. I do think if you're thinking about an annuity, you don't necessarily need to build inflation protection into that. And then, I'll hear the kind of the response as well, I'm too young, I didn't grow up in the early… Well, I was a kid in the early ‘80s--I didn't really appreciate what inflation can do. And so, inflation has been low for a long time now and people may not give full credit to what it could potentially do if it ever rears its head again.

And yeah, it's a risk. I think one easy way to help manage the risk is you delay Social Security because it does provide you that inflation-adjusted protected lifetime income with deferral credits. I think that can be a role for thinking about, to the extent you have bonds in retirement, having them be inflation-protected. And then, beyond that, as well of course, a diversified investment portfolio doesn't fully protect inflation, but at least along with these other resources, gives you a shot. And then, as well, with like the David Blanchett retirement-spending smile, just naturally, a lot of people's spending doesn't keep pace with inflation because they go on less vacations or they go to fewer restaurants and things as they age.

So, ultimately, I think you need to be aware of inflation. And I understand that some people would say you have to be hyperaware of inflation. And I don't go that far. And that's maybe because I'm too young to really appreciate what inflation can do. But I think you do need to at least have a healthy appreciation of what inflation could potentially do. And having everything in cash means you have no way to help manage that sort of inflation risk for anyone thinking about that in the current market environment.

Benz: Well, Wade, this has been a really thought-provoking conversation. Thank you so much for taking time out of your schedule to talk to us today.

Pfau: Oh, absolutely. My pleasure. Thanks for having me on.

Ptak: Nice talking to you. Thanks so much.

Pfau: OK. Yeah. Thank you.

Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter @Christine_Benz.

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

Benz: 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. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. 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 and governed by 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.)

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