Wade Pfau: The Risks of Retirement Today

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Our guest on the podcast today is Wade Pfau. He is 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 American College Center for Retirement Income and RICP program director at the American College. Pfau has written several books, including his most recent, Retirement Planning Guidebook. He is a co-editor of the Journal of Personal Finance, and he publishes frequently in a wide variety of academic and practitioner research journals. He hosts the Retirement Researcher blog and is a regular contributor to Advisor Perspectives, MarketWatch, and Forbes. Pfau 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

Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success, by Wade Pfau

Wade Pfau books

Wade Pfau blogs posts on Retirement Researcher

Retirement Income Strategies

"Selecting a Personalized Retirement Income Strategy," by Alejandro Murguia and Wade Pfau, Retirement Management Journal, Dec. 1, 2021.

"Determining Your Retirement Income Style," by Wade Pfau, financialplanningassocation.org, 2021.

"Two Philosophies for Retirement Income Planning Part One: Probability-Based," by Wade Pfau, forbes.com, Dec. 18, 2019.

"What Is a Safety-First Retirement Plan?" by Wade Pfau, retirementresearcher.com.

"The RISA Framework: A Systemized Approach to Personalizing Retirement Income Strategies for Clients," by Wade Pfau and Alex Murguia, kitces.com, April 20, 2022.

Inflation and Other Risk Factors

"Bill Bengen: Revisiting Safe Withdrawal Rates," The Long View podcast, Morningstar.com, Dec. 14, 2021.

"Inflation, Deflation, Confiscation & Devastation—The Four Horsemen of Risk," by Wade Pfau, retirementresearcher.com.

"Wade Pfau: TIPS and Annuities Good Bets When Inflation Is High," by Ginger Szala, thinkadvisor.com, March 31, 2022.

"The Changing Risks of Retirement," by Wade Pfau, retirementresearcher.com.

"The Four Approaches to Managing Retirement Income Risk," by Wade Pfau, papers.ssrn.com, Dec. 31, 2019.

"Don't Panic on Sequence of Returns," by Amy Arnott, Morningstar.com, May 16, 2022.

Withdrawal Rates

"Wade Pfau: The 4% Rule Is No Longer Safe," The Long View Podcast, Morningstar.com, April 29, 2020.

"Retiring Soon? Why the Popular 4% Withdrawal Rule May Be a Bad Idea," by Greg Iacurci, cnbc.com, April 13, 2021.

"What Is the 'Retirement Spending Smile?'" by Wade Pfau, retirementresearcher.com.

Annuities

"Retirement Income Strategies With Annuities," by Wade Pfau, retirementreseacher.com.

"Wade Pfau Takes a Balanced Look at a Retirement Product Some Advisors Love to Hate," by Ed McCarthy, thinkadvisor.com, July 22, 2022.

"David Lau: Taking High Commissions Out of Annuities," The Long View podcast, Morningstar.com, June 21, 2022.

"Are Annuities Too Expensive?" by Wade Pfau, linkedin.com, July 2, 2021.

Long-Term Care

"Costs and Incidence of Long-Term Care," by Wade Pfau, retirementresearcher.com.

"Managing Long-Term Care Spending Risks in Retirement," by Wade Pfau and Michael Finke, lecp.naifa.org, Jan. 7, 2020.

"Hybrid Long-Term Care Insurance Policies," by Wade Pfau, retirementresearcher.com.

Other

"Laura Carstensen: 'I'm Suggesting We Change the Way We Work,'" The Long View podcast, Morningstar.com, Sept. 14, 2021.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Benz: Our guest on the podcast today is Wade Pfau. Wade is 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 American College Center for Retirement Income and RICP program director at the American College. Wade has written several books, including his most recent, Retirement Planning Guidebook. He is a co-editor of the Journal of Personal Finance, and he publishes frequently in a wide variety of academic and practitioner research journals. He hosts the Retirement Researcher blog and is a regular contributor to Advisor Perspectives, MarketWatch, and Forbes. Wade 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 back to The Long View.

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

Benz: It's great to have you here. Now, we want to spend some time today discussing the challenges of the current environment for retirement planning. But before we get into that, let's discuss retirement income styles, which you discuss in depth in your book, Retirement Planning Guidebook. It sounds like you think identifying a personal retirement income style is really foundational to the whole retirement planning process. It can help inform any number of decisions that a pre-retiree might make subsequently. So, can you discuss this concept of retirement income style?

Pfau: And I do view this really now as step one of when you're starting to think about that transition toward retirement. First, identify your style, and it just speaks to, generally, how do you think about choosing your retirement income strategy? We've known for a long time that there are different options. They are usually summarized as what I call total returns, but systematic withdrawals is another name, this idea of using the diversified investment portfolio and spending from it throughout retirement. Then you have time segmentation or bucketing strategies, which generally just look at asset allocation in a different way: bonds for shorter-term expenses, stocks for longer-term expenses. And then, you have essential versus discretionary-based strategies, which look at building a protected lifetime income floor to cover core retirement spending and then investing on top of that for more discretionary types of expenses. And with the retirement styles—this is work I did with Alex Murguia—we break the essential versus discretionary into two sections. There is income protection, which is more about using fixed annuities to build that protected income floor; and then risk wrap, which is more about using variable annuities to build that protected income floor. And I think any of these styles are viable and legitimate. They have different features. It's not that one approach is clearly superior to any of the others.

And so, the idea of the retirement income style awareness is based on a questionnaire—just what resonates with the individual. Listeners of the podcast are probably already aware there are different options for retirement income. But when you get beyond that more sophisticated-type audience, they may not be aware that there's different options, and I worry that too often when someone turns on their car radio, they might hear a commercial that's very focused on a total return investing approach. Or they might hear a commercial that's pitching some sort of annuity product, and they don't really get this sense that there are multiple viable strategies. So, it's really, how do you start thinking among the strategies; how do you choose an approach that resonates best with you as an individual? And the whole purpose of the retirement income style awareness is to help people understand where they might want to look as a starting point to building their retirement strategy around how they want to source the spending for their essential or core retirement spending needs.

Ptak: You think a key factor for retirees to consider is whether they prefer a probability-based or a safety-first approach. Let's start by talking about what a probability-based approach to retirement income would entail. It sounds like having comfort with market risk is important. Is that right?

Pfau: Absolutely. In trying to develop a questionnaire we just read as much as we could about retirement to see how people were describing trade-offs to be made or preferences that you could either go one direction or another, and then we test those out and the data tells us that what we call probability-based versus safety-first is one of the primary factors to explain a strategy. And you're absolutely right, probability-based… I used to talk about two schools of thought for retirement and these terms live on in this primary factor for explaining the retirement style.

Probability-based is more of this idea that I'm comfortable relying on the risk premium for the stock market. I believe that stocks will outperform bonds over reasonable holding periods that I can rely on for my retirement, and therefore as a way to spend more than I could with bonds alone, I can invest aggressively in a diversified investment portfolio, gain risk premium from the stock market, and fund the higher lifestyle throughout retirement. And so, that's the idea of probability-based. Usually, markets go up over time, so probably the strategy will work. But it relies on this taking market risk that some people are very comfortable doing; other people may not be so comfortable.

Benz: How about the safety-first approach? What types of income sources would fall under that umbrella? And what type of retiree would a safety-first approach be most appropriate for?

Pfau: And the opposite side of it, if you're not probability-based, you're safety-first, and that's about using contractual protections to provide more certainty—of course, nothing is truly 100% safe—but more certainty around the assets used to fund your core spending in retirement. It can be individual bonds, holding individual bonds to maturity. You don't get any premium from that, but at least you're using the fixed-income asset not as a less-volatile stock that is subject to market losses when sold to fund spending, but you hold the bond to maturity, and you know exactly what you're going to get. Or this could involve risk-pooled approaches which, income annuities, indexed annuities with living benefits, variable annuities with living benefits, although not as much the variable annuities, but more either like individual bonds or fixed annuities to provide contractual protections, principal protection but as a way to then source spending to not have to worry about market volatility when it comes to the assets designed to source that spending.

And so, this is more for retirees. It's people's preferences, and we do see, other than gender—where women do tend to tilt more toward safety-first, men do tend to tilt more toward probability-based—there is not a whole lot of differences in demographic categories. So, it's really just a matter of at the individual level how does someone feel about these sorts of trade-offs? Are they comfortable relying on the stock market? Or would they prefer the contractual certainties provided by individual bonds or the additional spending power through the risk pooling of a fixed annuity?

Ptak: You note early on in your book that a retiree's comfort with income fluctuations, or lack thereof, is another important distinction to make. You call it optionality versus commitment. How should retirees help themselves identify in advance whether they are comfortable with fluctuations in their income streams?

Pfau: And this is the other primary factor, and it's not one I really would have guessed about in advance, but the data really spoke to this idea that some people have an optionality orientation. They really want to maintain as much flexibility as possible. They want to make changes. They're more comfortable having a variable spending stream in retirement because they are just more comfortable with an investment approach where they can systematically spend from that, and they don't want to commit to anything. Whereas there are other people in the population who are willing to give up some optionality and who actually may favor committing to a strategy that if I know this strategy will solve for a lifetime need, I'd like to take it off my to-do list, commit to this strategy. It may give me some limitation on some upside potential there, but at least I know I've got a strategy that will work for my situation, and I may feel better as well about protecting other family members or protecting myself against cognitive decline and so forth by committing to a strategy that will solve for a lifetime need. So, where that preference lies between optionality and commitment is really the other primary factor. And then, when you combine the two, that's where you start to get to these different retirement styles.

Benz: One thing I've wondered about, Wade, is whether someone's income while they're working might influence their views on this optionality versus income. If you're someone who has had a very steady paycheck, maybe a teacher who is in a union. Is someone like that more inclined to want a commitment-based income stream where they will get a fixed amount or a fixed real amount?

Pfau: That's a great question, and it's something we haven't really had the chance to specifically explore about asking about pre-retirement careers and then retirement styles. But certainly, there is a very good analogy there in terms of when you're choosing a career, the retirement equivalent would be, you hear the radio saying, "Everybody should be a salesperson. You have unlimited upside potential. It's based on your performance," and so forth. Then the next commercial on the radio is, "No, everyone should be a government worker or a teacher. You get a defined-benefit pension. You have stable income. You know exactly what you're getting." And I think people do self-select a career based on their preferences around some of this. Whether or not there is that same sort of underlying risk-taking or whatever the case may be between your career choice and your retirement style, I would not be surprised if people who do choose careers with more stable incomes and defined benefit pensions did show up to be more in the income-protection quadrant of the retirement income style awareness matrix. Likewise, people who do have incomes more tethered to market performance and commission and so forth, maybe more of a total return approach.

What we do see is, in addition to gender helping to explain styles, net worth does help to explain styles. And so, when we look the representative survey that we did with 2,800 Americans, those with net worths more than $1 million did tend to tilt more toward the total return and a probability-based, optionality-oriented style; and those with a net worth under $1 million did tend to tilt more toward the safety-first, commitment orientation, income protection style. And that might speak to this question somewhat just because it's a question of how does somebody get that higher net worth. Maybe they had to take more risk, and then, for some people, that risk paid off for them and allowed them to have a higher net worth and so forth. So, we do see that, and that's the best I can really say about whether speaking to that question. But it's certainly something that would be really interesting to look at in the future where when we do these surveys, we also ask people about their career choices to see if they do line up with their styles.

Ptak: You also discuss the timing of retirement income as an important factor for retirees to consider when deciding on the right retirement income approach. You call it front-loading versus backloading. What does that mean?

Pfau: With the retirement styles, there's the two primary factors, and that's really all you need to determine the style. But then, we found there are four secondary factors that, as an additional overlay, can help further explain somebody's retirement style and strategy choice for retirement. A very important one of these is what you spoke to, Jeff, with this idea of front-loading versus backloading, and this is really reflected in the general retirement planning literature around this idea that Moshe Milevsky talks about longevity risk aversion. How worried is someone about outliving their assets? So, those with the backloading preference, are more worried about outliving their money and are more willing to spend less today to better protect their future self. Whereas those with a front-loading preference, approach this differently. It's more along the lines of, I know I'm alive today. I know I'm as healthy as I ever will be today. And so. I want to make sure I get the full satisfaction that I can out of retirement. I don't know if I'll be alive in the future. In order to get the most satisfaction out of my retirement, I'm willing to spend more today and then, if necessary, cut back on my spending in the future. And that's the front-loading preference, whereas again, the backloading preference is, no, I want to protect my future self. I'm willing to spend less today to ensure that even if I live to be 90 or 95 that I'm able to still have funds available to maintain my lifestyle. And again, there's no right or wrong answers to any of these. It's all just individual preferences—do you have a front-loading preference or backloading preference? Everyone is different in this regard.

Benz: You note that an assessment of all of these factors can help retirees plot themselves into one of four quadrants, which you outlined really quickly at the top of the conversation: total return investing, income protection, what you call risk wrap, and time segmentation or bucketing. You mentioned each of these styles earlier, but can you quickly outline what each entails and also which of the factors that we just talked about would map you to one of those four quadrants?

Pfau: The RISA matrix, the Retirement Income Style Awareness matrix, it's plotting probability-based on the right, safety-first on the left, optionality on top, commitment on the bottom, and then, based on the scoring there, total returns is often used as a default. That would be the upper right-hand quadrant where individuals who are probability-based are comfortable relying on the market, and they have an optionality orientation. They want to keep their options open as much as possible. That's the total return investing strategy. That's kind of the idea of the 4% rule, the idea of using aggressive diversified investment portfolio and spend from it in a systematic manner throughout retirement. That's really the preferences being described there. And if you look with the secondary characteristics, there's more of a front-loading preference with total returns. There's an accumulation mindset that I want to continue to focus on risk-adjusted returns in retirement. There is a time-based flooring concept. It's a little bit less important. And also, a technical liquidity concept, and that's total returns.

Then, the opposite of that would be the lower left, where safety-first, I want contractual protections to cover my core spending, and I'm comfortable committing to a strategy. So, that's more of this flooring approach where if I have an income gap, if I don't have sufficient assets, reliable income assets, to cover my essential spending need, I might look to fill that gap with some sort of a fixed annuity with protected lifetime income. And also, down there, you see there's more of a backloading preference. So, these are people more worried about outliving their money. There's a distribution mindset, more of a focus on predictable income over maximizing returns. True liquidity in terms of how they think about assets for reserves and also a perpetual flooring. So, that's income protection.

And then, the other two strategies—it's really fascinating, and for me, this was the most interesting part of the research was—time segmentation and risk wrap were both behavioral strategies defined by the financial-services world to explain preferences that aren't entirely consistent. So, first, with time segmentation, safety-first, I want contractual protections, but I also want optionality. And so, I don't necessarily want to commit to a strategy, and kind of the compromise developed in financial services was, well, let's use a sort of bucketing idea, and let's have this shorter-term bucket with fixed income holding individual bonds to maturity. That's my safety-first. But then, behaviorally, now I have this time horizon—if I have five years of spending covered, I can weather a five-year market downturn before I have to sell stocks. And so, everything else then goes into this growth portfolio that provides the optionality for the retirement plan.

And then, in the lower right, that's risk wrap. This is probability-based. I'm comfortable relying on the stock market, but commitment orientation—I want to commit to a strategy that will work. Also, backloading, I'm worried about outliving my money. And also, technical liquidity—I just look at whether or not an asset is liquid. So, this is describing the characteristics of the variable annuity with a guaranteed lifetime income benefit, that's really evolved just since the 1990s that you can have with one financial product upside potential, downside spending protection, so a guardrail understanding of what the worst-case scenario would be, technical liquidity for that annuity asset, as well as protected lifetime income because you're worried about outliving your money, you're willing to spend less today to better protect your future self. And so, that combination of characteristics really describes: I might look to build a floor with some sort of protected lifetime income approach that still gives me plenty of upside potential and so forth within the annuity product.

Ptak: We're currently seeing inflation at its highest level since the 1980s, as you know. Does inflation hit retirees harder than it does the general population? Or is it situation dependent?

Pfau: I think it's situation dependent and in one way, you could say, yes, inflation hits retirees harder because often to the extent that salaries grow with inflation, you have a built-in inflation hedge when you're working. Now, I recognize not everyone's salary may be keeping up with inflation right now, but at least there's more potential to have a hedge for inflation when you're still working that you lose in retirement. But then, at the same time, the answer might partly be no, because plenty of research now indicates that most retirees, their spending need won't fully keep up with inflation throughout retirement. And so, even if their inflation is high, they may have a little bit of flexibility there because they're naturally going to spend less as they age to not need the full inflation protection in the way that people might need more during their working years. So, it's definitely situation-dependent. But it's kind of a toss-up—it hits retirees hard; it hits non-retirees hard. It's a tough situation for everyone.

Benz: When we had William Bengen on the podcast last year, he likened the timing of inflation to another form of sequencing risk. Basically, if inflation occurs early on in your retirement, that's really bad, because spending tends to build off of those higher levels. Do you share that concern?

Pfau: I do. And this is something I've pondered for a long time. I've heard about this idea of the sequence of inflation risk. And it seemed like it shouldn't exist because most of the basic research about spending rates in retirement just uses the real returns. So, it takes inflation out of the analysis. And in that regard, it seems like inflation shouldn't matter. But it seems like it does. And I guess, this idea of thinking about sequence risks really applies, because if there's a 10% inflation rate in the first year of retirement and then it gets back to normal afterward, say, you've permanently raised every future expense—every future year of spending has been impacted by that first-year inflation rate. So, it would have a bigger impact on the retirement plan compared with, say, saying maybe 20 years into retirement, there's a big inflation experience—that's only going to impact a lesser number of years of spending.

So, in that regard, it seems like it's important. And certainly, in the historical data, the worst-case spending scenarios happened at high-inflation periods in the late 1960s, where those retirements began at a time with high inflation and then especially going throughout the 1970s' high inflation. Whereas in more recent years, I used to have a lot of worry around people who retired around the year 2000 just because of where the markets were for their retirements. But they had low inflation and that does seem to be a saving grace that even with markets that aren't performing all that well, if inflation is low, it's not putting as much pressure on the spending need. And now, we're now getting into this perfect storm again, where inflation is higher, markets are volatile, there's been heavy losses and so forth. And yes, I do think inflation is important and it's still hard to fully articulate. But yes, it does seem to me that there is this idea of a sequence of inflation risk, and so Bill Bengen was definitely talking about something real in that low inflation can go a long way toward helping with a portfolio in retirement spending. When you have high inflation again, it's a concern.

Ptak: Something that's striking is that higher inflation would seem to complicate planning for people with all different retirement income styles, albeit not equally. But the safety-first people, for example, may not be generating income that's completely insulated from inflation. Are they especially vulnerable in a high inflationary environment? For instance, if they're getting a good share of their portfolio—portfolio income, I should say—from a fixed annuity that doesn't include an adequate inflation adjustment?

Pfau: They could be. The main tools people have for dealing with inflation are like the TIPS and I Bonds, inflation-adjusted bonds, or equities, and it's, of course, not a perfect hedge, but the hope that over time the earnings and revenues of businesses will grow with inflation and therefore, stocks will keep up with inflation. So, beyond that, traditional bonds do not work well with inflation. Fixed annuities are not going to work well. But if it's just simply a comparison of Treasury bonds versus fixed annuities with providing lifetime income, the fixed annuities should always work better than the traditional bonds just because they can meet a spending goal with less assets and that's really getting into the strategy of thinking about annuities as a bond alternative. If I can put less assets into an annuity than I need with bonds to meet the same sort of lifetime spending need, that frees up more assets to remain invested for upside and hoping that stocks will keep pace with inflation and so forth. So, it's not obvious that a safety-first approach would underperform or would be harmed more by inflation, certainly not when compared with traditional bonds. But when you have approaches that do use more of an inflation-protected bond approach, that would have obvious benefits in a higher-inflation environment for sure.

Benz: Your book includes a comprehensive catalogue of risk factors that people face with their retirements, and some of them, like inflation and longevity risk and sequencing risk, which we've kind of touched on already, will probably be well known to people listening. But we hear less about some of the other risk factors that you talked about. Can you discuss some of the risk factors that are less well known that you think are worth considering as people approach retirement planning?

Pfau: I generally organize retirement risks as either longevity risk, market risk, and then spending shocks. The way I define a spending shock is, you have to spend more than you anticipated in your retirement budget. So, inflation could be a market risk, or it could be an example of a spending shock if you get hit by higher-than-expected inflation and therefore have to spend more. But some others, like divorce can be a huge spending shock when you're trying to account for dividing assets to create two separate households, each household not wanting to cut the spending in half, it can lead to a more expensive overall environment. Family responsibilities of having to help raise grandchildren or support adult children who may not be able to develop their careers they'd hoped for, and so forth. That can be a spending shock.

There's definitely the idea of public policy risk, which is we have the rules—the tax rules, Social Security rules, and so forth—and those rules can be changed, and they can be changed in ways that lead to having to, well, either spend more than anticipated—higher taxes and so forth—or just not having the assets anticipated, like if Social Security benefits receive some reduction or something along those lines. There's frailty and cognitive decline and then, potential elder abuse related to those that you don't really think of as a financial risk. But if cognitive decline causes somebody to make financial mistakes, that ultimately leads them to have to spend more, and that could be as something as simple as subscribing to the same magazine multiple times. Or, of course, it could be just there's no limit on what that type of risk could do in terms of the spend down of assets in unanticipated ways. And then, also retirement housing, and people have to think about, with the gradual decline people experience physically, having to outsource some tasks that they may have done for themselves, such as mowing the grass and so forth, at some point, would raise the expenses; needing to move for health-related reasons could raise the expenses. Those are some examples that I think that really highlight the potential range of spending shocks.

Ptak: I might have missed it, but I want to say that you cited death of a spouse as a potential risk factor. And of course, the emotional toll of losing a spouse is enormous, but we tend to hear less about the financial implications. Can you talk about that?

Pfau: That's a really important one. I didn't mention it, but it's definitely worth adding to the list. The death of a spouse is kind of inevitable at some point for every household to experience. But people might not realize the full financial impact that can have, especially if it happens earlier than anticipated. Now, when there's one person in the household instead of two, the household expenses should decline, but not necessarily by enough to account for some of the impacts of the death of a spouse, if that means losing a source of pension income, receiving less for the household from Social Security benefits. And then, on the expense side, some expenses may come down, but others won't, because it is still the same house, there's all the fixed expenses related to the house impacted by the number of people.

And then, the tax situation, I think, gets overlooked where in the next year when somebody switches to be a single filer, there's a whole new set of tax rates that they're dealing with, and a single person, even with less expenses, may still be paying more taxes than when both spouses were alive. So, it can have a heavy financial impact in ways that may not be fully appreciated all the time.

Benz: Another risk factor that you discuss is forced early retirement. And this is a two-part question. First, is this less of an issue today, given how tight the labor market is? And second, what are the implications for retirement planning if someone is forced out of the workforce earlier than they expected to be? I think we've probably all seen research that shows that people aren't great judges of when they will actually retire, that oftentimes they tend to retire earlier than they thought they might.

Pfau: People do tend to retire earlier than planned for either involuntary job loss or health decline, health-related reasons for themselves, or they leave the labor force to become an unpaid caregiver for a family member or a friend or someone along those lines. With the pandemic, a lot of people left the labor force in a quick and unexpected way. Today, unemployment is low, and people who do want to work may have more opportunities. But certainly, it's still a risk, and it can have big financial implications. Usually though, when people talk about this issue, one of the best ways to get a financial plan on track is to work a few years longer. Then you have more years to save. Your savings have more time to grow before you start spending. Your subsequent retirement horizon is shorter. You may have a higher Social Security benefit, maybe other higher pension benefits and so forth as well. And so, all that works in reverse if you retire sooner than anticipated. Less time for your money to grow, less years of savings, more years that you need to fund in retirement, less going into the calculations for your Social Security benefits and so forth. So, it is a very big risk that if I plan to work until 65 and I'm forced out of the labor force at 61, that could have big implications for my financial plan, and it may require, if work is not possible, revisiting some of the assumptions around the sustainable level of spending and so forth.

Ptak: Some of your best-known research relates to withdrawal rates. When we last interviewed you for this podcast more than two years ago, we were in the early stages of the pandemic. We spent a lot of time discussing sequencing risk because the market was down a lot at that point, and it's down again in 2022. For people who haven't yet retired, is the environment better for their retirement today than it was a year ago, given lower equity valuations and higher bond yields, or does higher inflation erase those benefits?

Pfau: There's a few issues there. There's this idea of a safe withdrawal rate paradox, and it's something I talked about with research I did 10 years ago on this idea of a safe savings rate that, yes, everything else being the same, those retiring July 1 should have better prospects for the future than those retiring Jan. 1, because since then the markets are down in the ballpark of 20%. So, whatever the "safe withdrawal rate" was on Jan. 1, it should simply be higher today than it was on Jan. 1. But at the same time, that doesn't necessarily mean that people's overall retirements are in better shape today just because they're also now dealing with lower portfolio balances. So, maybe they could use a higher withdrawal rate today than they could have used at the start of the year, but that's on a lower portfolio balance. And so, overall, it's not necessarily the case that they're any better off. And indeed, we did talk about inflation and the fact that inflation is higher now.

The markets are not really pricing in this idea of high inflation over the long term. We anticipate still inflation will get back under 3% again in the not-too-distant future. But it's high now and that certainly is creating additional pressures, and it does mean that if the market was down 20% and inflation is 10%, really in purchasing-power terms, the market is down by even more. So, certainly, that is a concern today as well.

Benz: You've been critical of the 4% guideline in the past. Is the main issue that retirees simply don't spend that way, taking fixed real withdrawals, their paydays tend to be a little lumpier? Or is it that 4% may be too high given the current environment, or maybe you're concerned about both things? Can you talk about that?

Pfau: I think both things are relevant. And really, the 4% rule style of research was really always just meant as a simplification to get around the idea of what is a sustainable level of spending. Today, it's not necessary because we have financial-planning software that will allow you to incorporate realistic spending streams that will calculate taxes and everything else, and then you can just run based on the capital market assumptions of the software, and hopefully, those capital market assumptions don't use the 4% rule assumption basing it on historical market averages, but account for the lower interest rates and so forth. But you can then run an actual financial plan.

And the 4% rule, even if they want to spend a constant inflation-adjusted amount, taxes make that impossible. The fact that there's just different cash flows. If you're delaying Social Security, you might be spending more before age 70, but then less after age 70. There's all these issues. People just might spend less as they age. The 4% rule, it's not realistic for anyone's retirement strategy; it's more just a guideline around what's sustainable and what it really speaks to is, no, I would say, if you're using software and you try to simulate the 4% rule, so you're 65, you plan to live to 95, you put in a 50% stock allocation. You have $1 million portfolio, I don't guess, in a Roth account because it ignores taxes, and then you want to spend $40,000 a year plus inflation. You can see what the probability of success is. If the software is based on historical market returns, it will probably report around a 95% success rate. But if it accounts for the fact that interest rates are lower today and therefore bond returns will be lower, if it accounts for maybe the risk premium is not going to be higher than historical, and so therefore the overall stock return might be connected to a lower bond yield and therefore be lower as well, you might start getting that the 4% rule might have a 70% success rate. And that's where if you want a higher success rate, you would need to look to a lower spending number. But at the same time there's so many issues, we don't know what is a reasonable success rate to target. If I have plenty of reliable income outside of the portfolio, maybe 70% is a reasonable target for the success rate, because it's not catastrophic if I'll spend my portfolio or if I'm flexible to cut my spending a little bit after market downturns, that can allow me to start with a higher withdrawal rate because I build in this capacity to reduce my spending to manage sequence risk.

So, we don't really need things like the 4% rule just because no one really will base their retirement strategies around something like that. It's still a useful kind of learning tool to think about what's sustainable for retirement. But again, I don't see it all that useful. And I would say, if you're strictly trying to follow all of its assumptions—30-year retirement, 50% to 75% stocks, no taxes, no ability to adjust spending if the market is down and so forth—then I would say that 4% was always going to be the safe withdrawal rate, that it wouldn't be lower than that. I think it's more reasonable as I guess about what's the most likely withdrawal rate. Could be a little bit less, could be a little bit more, somewhere in that ballpark is probably what today's retirees will experience.

Ptak: You make the very good point that it's a leap to assume that investors will even earn market returns, which would further undercut the sustainability of a 4% starting withdrawal with inflation adjustments thereafter. What are some of the factors that can erode investors' returns, things like costs, behavior or timing, tax costs? Maybe you can kind of run through what some of those factors are.

Pfau: That's another set of issues. The 4% rule assumes investors earn the indexed market returns. So, there's no investment fees—well, you can get low fees these days, or if you're otherwise assuming you need alpha to offset any sort of investment or advisory fees. The 4% rule, it's not a one-to-one trade-off. It is a simple kind of concept there—a 1% fee might reduce the safe withdrawal rate by about 0.5%. Then, indeed, the 4% rule is assuming these simple asset allocations, but that you stick to those allocations and that you always rebalance every year, whether it's 50% stocks, whether it's 75% stocks, you never panic, you never deviate from the strategy; you'll stick with it. And we do know that people struggle with that, that they may worry, they may panic after a market downturn. They may not keep the 50% stock allocation that's required. They might start toying with ideas like market-timing and so forth that academic evidence suggests are not realistic ways to improve the financial outcomes. And so, you have to consider that sort of thing.

And then, you have the taxes, the 4% rule, if it's being taken from a Roth account, you're OK. If it's taken from an IRA or a tax-deferred account, you're just paying the taxes out of the 4%. But when you talk about a taxable brokerage account, there's no 4% rule, just simply because the earnings on the portfolio are going to face this sort of ongoing taxation in a way that is going to reduce the compounding growth of that portfolio and reduce the sustainable withdrawal rate. So, all those factors can relate to as well where in a perfect world 4% maybe OK, but when you consider these real-world implications, that creates a lot more hurdles to get over to make something like that work.

Benz: Speaking of real-world implications, one important question in the realm of retirement spending is how that spending might change over the retiree's lifecycle. You alluded to that earlier. Much of the research points to retirement spending declining in the middle to later years of retirement before potentially increasing a bit later in life. But is it safe to assume that each individual's spending will trend that way, even though retirees' aggregate spending exhibits that pattern? I guess something I wrestle with is what if I'm the 95-year-old who still wants my high-spending lifestyle. How should people think about that?

Pfau: And most of the time we don't plan around the averages for retirement. That's the 4% rule is not meant to be the average; it was meant to be the worst-case scenario. But with these retirement spending patterns, like David Blanchett's spending smile was based on the average of the population, which is your spending declines until your mid-80s and then starts to pick up near the end of life to account for health expenses. So, certainly, there are going to be people who don't have that spending pattern, and that's where the inflation-adjusted spending assumed by the 4% rule, overall, it would be a pretty conservative assumption in that there's probably not going to be many people whose spending would increase even faster than inflation throughout retirement. But I don't know exactly what that breakdown might be.

The way I approach this—and it's still difficult because it's hard to budget over a 30-year retirement—but if you think you're someone who might just simply travel less when you're in your 80s and so on and so forth, which is definitely the typical situation, go ahead and plan for that sort of reduction in expenditures at later ages. And the way you can treat that is at the same time you're still budgeting for healthcare, and you can have those health expenses growing throughout retirement. And when you do something like that, what you're going to get ends up looking kind of like a spending smile anyway and you just try to calibrate that the best as you can to what you think is most reasonable, but also trying to be conservative with your assumptions for your retirement. Some categories probably will decline. Healthcare will probably go up. And how can you develop a plan that you feel comfortable with? If I can fund this plan, then I'm comfortable proceeding with my retirement.

Ptak: We touched on annuities earlier, but we wanted to dig in a bit more. Single premium immediate annuities and deferred-income annuities are intuitively appealing and also tend not to be associated with high commissions. But does high inflation make such products undesirable? As you note in your book, no one is offering CPI-linked products today. So, does that make them a nonstarter, in your opinion?

Pfau: So, you can't get inflation protection with commercial annuities today. You could buy a TIPS, say a 20-year TIPS, and then 20 years from now use that to purchase the SPIA, assuming they still exist in the future and so forth, but you don't get that inflation protection. I've had a few different research studies where this wasn't the primary focus of the study, but one of the implications was, I don't really think you need the inflation protection inside the annuity, because we're not talking about putting all of one's assets into an annuity. It's always a partial annuity-type situation. Maybe I'm going to put 20% or 30% in. Well, a fixed-income annuity that doesn't have any sort of cost of living adjustment or inflation protection will have the highest payout rate, which means, if I'm trying to meet an overall spending goal and I'm going to cover a portion of that with the annuity, I can put less into the annuity today to get that same spending amount. And though it doesn't have inflation protection, what it means is, since it has a higher payout rate, I can now use a lower withdrawal rate with what's left in my investment portfolio.

That portfolio needs to cover the inflation adjustments, so it has more pressure on it. But with this whole issue of managing sequence of returns risk, and the synergies around managing sequence of returns risk, having a lower withdrawal rate can have a huge impact on portfolio sustainability. So, what I tend to find is, if you're trying to manage inflation risk, don't worry about getting it through the annuity, put less into the annuity with a level payout, keep more in the investment portfolio, use a lower withdrawal rate from the investment portfolio, give your portfolio more chance to grow, and then, in the future, you have a better shot at if you'd like more protected income, you can ladder in additional annuity purchases by distributing from the portfolio and buying more level income annuities in the future. So, that's how I generally approach inflation with annuities. And like we were talking about before, what TIPS give you the inflation protection, I Bonds—but if you're just comparing income annuities to traditional bonds, neither one gives you the inflation protection, but the annuity gets you more protected income for a long-term financial plan, and that's why it doesn't create as much harm from the inflation perspective than traditional bonds do. So, the story is always about allocating from bonds for the annuity, not allocating from stocks to the annuity, and that's how I think you can get better long-term inflation protection with such a retirement strategy.

Benz: That's helpful. I'm curious, are you encouraged by efforts to wring high commissions out of the annuity landscape? Jeff and I recently had David Lau on the podcast, and he talked about his firm's efforts to make annuities more attractive to RIAs especially. Can you talk about that?

Pfau: There is now increasingly noncommissioned annuities that can fit better into the business models of RIAs, and I think that's a wonderful development. I would just caution, there's been this ongoing debate about the fee-only advisor not having any sort of conflict. But when you really look at it, paying 1% a year for assets under management might look cheaper in year one than paying a one-time, say, 6% or 7% commission. But when you're talking about a long-term financial plan, that gets reversed, and maybe the one-time commission can be a cheaper way to support a financial product. So, it's not obvious that the fee-only annuity is superior other than if the advisory fees will be low, there are a lot of benefits to that sort of fee-only annuity. It may not have surrender charges because it's not having to finance the commission. It can have lower mortality and expense charges, which can give you more upside potential, more opportunities for step-ups if we're talking about a deferred annuity with the living benefit and so forth. And so, indeed, it's definitely worth looking at this sort of fee-based annuity that doesn't pay commissions just because it may have that better pricing. And so, yes, I'm also excited to see that more financial advisors who traditionally only focus on assets under management and viewed it as damaging to their business, to suggest putting assets in annuity because they can't charge their fees on that asset anymore, that they're becoming more open and are able to incorporate annuities into their business practice. So, it is absolutely a positive development. I just don't want to leave the suggestion that a commission is always worse than some sort of ongoing management fee.

Ptak: Your book includes one of the most comprehensive discussions of long-term care that we've seen. It seems that this area is challenging for upper-middle income, older adults where they don't necessarily have several hundred thousand dollars to set aside for self-funding. What are the least-bad ideas for such consumers today?

Pfau: There's really four options for funding long-term care. And none of them are clearly better than the other, and it depends. But the self-funding, as you said, that would be one option. Self-funding but with Medicaid as the backstop. So, if somebody doesn't have a lot of assets and it's likely they may deplete everything and need to use Medicaid, that's not something to aspire to, and some of the ideas around Medicaid planning to try to protect assets to go on to Medicaid, people might not be happy with that decision when it comes to the services that Medicaid is able to provide versus self-pay is a consideration. But then you have insurance, and it's traditional long-term care insurance, which has really fallen out of favor due to risks with premium increases as well as people tending to lapse on their policies as they start to experience cognitive decline, which means they can't collect the benefits that they had may have been paying premiums for years for.

Shifting now toward the hybrid policies, which can be linked to annuities but are usually linked to life insurance, and there's different ways that can be structured. But having life insurance that has a long-term-care benefit attached to it in some way where the premiums can't be increased. You can still lapse on these policies, but it's generally harder, especially if you're paying a single premium so that there's not an ongoing premium need and so forth. That's where a lot of the attention has turned in terms of insurance-based approaches for long-term care.

Benz: Can you delve into the hybrid products a little bit more? Do you like them? It seems like they've really proliferated as traditional long-term care has been ebbing away. But do you think that they are potentially a good way for pre-retirees to address this risk? Or is self-funding a better option? Or does it just completely depend?

Pfau: I think it really depends on someone's situation about how they want to approach this. There can be benefits to having some sort of long-term-care insurance—these hybrids are an example of it. Because then you'll feel more comfortable spending that money. If you're self-funding, you might worry about "spending the kids' inheritance," and no one really worries about spending the insurance company's money. So, having a policy in place might help you feel more comfortable actually spending to support your long-term-care need, as well as many policies include a care coordinator as one of the benefits, which is somebody who can help facilitate finding institutional care and so forth. But then, with the hybrid life insurance policies, some listeners may have one and not even realize it, because it's common these days with permanent life insurance that there is some sort of accelerated death benefit rider, which just allows you that if you meet the same sort of criteria that would allow you to collect on long-term-care insurance, traditional insurance, you can accelerate the payment of the death benefit while you're still alive to pay for long-term care. So, that's more of a life insurance with a long-term-care kicker.

Then there is a whole other—and they are just structured under different parts of the tax code— more of a long-term-care insurance-based approach with a life insurance kicker, where it is focused more on accelerating the payment of the death benefit. But then, if you spent all the death benefit, you can then continue with additional continuation-of-care benefits beyond that. And indeed, again, like I said, a lot of people may have this accelerated death benefit rider on their life insurance and might not realize it. So, that would be something worth reviewing your policy. And otherwise, indeed, it could be worth having a look at different types of hybrid policies and seeing whether anything resonates with you as an individual about if you want to offset some of that risk to the insurance company as well as, like I said, then also have insurance, which, well, we already talked about the one issue—then you feel comfortable spending it—but it might also be easier to facilitate entering assisted living or a nursing home and so forth with a long-term-care insurance policy in place.

Ptak: We wanted to close with a big-picture question. We had a wonderful discussion with Stanford professor Laura Carstensen last summer. She noted that the notion of traditional retirement is misguided. She pointed to the growing body of research showing the benefits of staying busy and engaged later in life and how we might in fact need breaks from work throughout our careers to raise kids or switch career path. Should we be rethinking traditional retirement? And, if so, what would that entail?

Pfau: I think that's an important issue, and in some ways, we could say, retirement is really a late-20th-century phenomenon where, before that, there really was not a sense of retirement. You worked in the field and maybe the last couple years at the end of life, your family took care of you because you could no longer work. But then, we got to this stage after World War II, post-war growth, maybe you have a 10- or 15-year retirement. Now, we're at the point where if you retire in your 60s, you may have a 30- or 40-year retirement. And that is financially much more difficult to fund, and also, it gets in all these nonfinancial issues as well of what are you going to do for 30 or 40 years? You're probably going to get bored of having a 30- or 40-yearlong vacation. A lot of people like to work to have a sense of purpose or passion, even if it's not necessary for the finances.

As people are living longer and longer, you're starting to see the early development of this, is this idea of an encore career that people get to retirement and then may do something completely different. Maybe they become entrepreneurs; or maybe they just do consulting in the same field; maybe they work for a nonprofit. It's not necessarily about earning income at this point, but just trying something different. And that might evolve more where, instead of this traditional life cycle of, you get education, then you work, then you retire, people might have multiple careers throughout their lifetime. So, you get educated, you do a career for 10 or 20 years, you have a few years for retirement, you get education in a new field, you then work in that field for 10 or 15 years, then you have a break or a sabbatical or a long five-year retirement-type scenario, then you get educated for a third career, and keep that process going throughout your lifetime. I think we will see more of that in the future, and it's certainly important. Because again, when you're looking at a 30- or 40-year retirement, you're probably going to want to do something besides just relax over that kind of time horizon, and that's where a lot of that effort is being focused about how to help people find purpose and passion throughout their lifetimes.

Benz: Well, Wade, as always, this has been such a thought-provoking discussion. Thank you so much for being here to share your insights.

Pfau: Well, thank you. Thanks, Christine, and thank you, Jeff. It was a pleasure.

Ptak: Thanks so much.

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

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Benz: And @Christine_Benz.

Ptak: 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. 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.)