A respected retirement researcher discusses what types of spending are correlated with a better retirement--and which are not.
Our guest on this week’s episode of The Long View podcast is nationally renowned retirement researcher Dr. Michael Finke. Michael is Professor of Wealth Management and Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services. He joined the College in June 2016 having served since 2006 as a professor and PhD coordinator in the department of personal financial planning at Texas Tech University. From 1999 through 2006, he served as the Director of Graduate Studies at the University of Missouri. Michael has published more than 50 peer review articles with a focus on the value of financial advice, financial planning regulation, investments and individual investor behavior. He was named to the 2012 Investment Advisor IA 25 list and the 2013 and 2014 Investment News Power 20. His research conducted with Wade Pfau, questioning the 4% rule was published in the Journal of Financial Planning and won the 2014 Montgomery-Warschauer award for the most influential article in the publication. He had previously won the award with Thomas Langdon in 2013. He was also selected to present his research on financial literacy and aging at the 2015 MIT Center for Finance and Policy Conference.
Michael Finke, PhD, CFP bio
2013 Investment Advisor IA 25 profile
2013 Investment news Power 20 profile
“The 4% Rule is Not Safe in a Low-Yield World” by Michael Finke, Ph.D., CFP; Wade D. Pfau Ph.D., CFP; David M. Blanchett CFP, CFA; Journal of Financial Planning; June 2013
“Determining Withdrawal Rates Using Historical Data” by William Bengen; Journal of Financial Planning; October 1994
“Low Bond Yields and Safe Portfolio Withdrawal Rates” by David Blanchett, CFP, CFA; Michael Finke, Ph.D., CFP, and Wade Pfau, Ph.D., CFP; Morningstar Investment Management; January 2013
“Reduce Retirement Costs with Deferred Income Annuities Purchased before Retirement” by Michael Finke, Ph.D., CFP and Wade Pfau, Ph.D., CFP; Journal of Financial Planning; July 2015
“Why Advisors Should Use Deferred-Income Annuities” by Michael Finke, Ph.D., CFP; Advisor Perspectives; November 2015
“Retirement Income for Life; Here’s a New Way to Get It” by Michael Finke, Ph.D., CFP; Bottom-line Personal; July 2016
“Lifetime Income Solutions as a Qualified Default Investment Alternative (QDIA) Focus on Decumulation and Rollover”; Written Testimony of Michael Finke, Chief Academic Officer, The American College of Financial Services; 2018 ERISA Advisory Council, August 2018
Health and Cognitive Decline
“Old Age and the Decline in Financial Literacy” presented by Michael Finke at the MIT Center for Finance & Policy; September 2015
“Health and Retirement Study”; National Institute on Aging, Social Security Administration; University of Michigan’s Institute for Social Research
“Managing Long-term Care Spending Risks in Retirement” by Michael Finke Ph.D., CFP and Wade Pfau Ph.D., CFP; 2017
“Old Age and the Decline in Financial Literacy” by Michael Finke, Ph.D., CFP, John Howe, Sandra Huston; Management Science; August 2011
“Wealth Shocks and Health Outcomes: Evidence from Stock Market Fluctuations” by Hannes Schwandt; American Economic Journal; October 2018>
“Spending, Relationship Quality, and Life Satisfaction in Retirement” by Michael Finke, Nhat Ho, Sandra J. Huston; 2018 Academic Research Colloquium for Financial Planning & Related Disciplines; September 2017
“Spending in Retirement: Determining the Consumption Gap” by Chris Browning, Ph.D., Tao Guo, Ph.D., Yuanshan Cheng, and Michael Finke, Ph.D., CFP; Journal of Financial Planning
“Estimating the True Cost of Retirement” by David Blanchett, CFP, CFA; Morningstar Investment Management; 2013
Asset Allocation in Retirement
“An Old Friend: The Stock Market's Shiller P/E” by Cliff Asness; AQR; November 2012
Daily Treasury U.S. Real Yield Curve Rates; U.S. Department of the Treasury
“Reducing Retirement Income Risk with a Rising Equity Glide-Path” by Wade Pfau and Michael Kitces; SSRN; September 2013
“The Effect of Advanced Age and Equity Value on Risk Preferences” by David Blanchett, Michael Finke, and Michael Guillemette; Journal of Behavioral Finance; January 2018
Equity risk premium data; website of professor Aswath Damodaran; Stern School of Business at New York University
“The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice” by Michael Finke, Ph.D., CFP, and Thomas P. Langdon, J.D., LL.M., CFP, CFA; Journal of Financial Planning; July 2012
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc. My colleague, Jeff Ptak is away. So, I'll be conducting today's interview solo. Our guest today on the podcast is nationally renowned retirement researcher Dr. Michael Finke. Michael is Professor of Wealth Management and Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services. He joined the College in June 2016, having served since 2006 as a professor and PhD coordinator in the department of personal financial planning at Texas Tech University. From 1999 through 2006, he served as the Director of Graduate Studies at the University of Missouri. Michael has published more than 50 peer review articles with a focus on the value of financial advice, financial planning regulation, investments, and individual investor behavior. He was named to the 2012 Investment Advisor IA 25 list and the 2013 and 2014 InvestmentNews Power 20. His research conducted with Wade Pfau, questioning the 4% rule, was published in the Journal of Financial Planning and won the 2014 Montgomery-Warschauer Award for the most influential article in the publication. He had previously won the award with Thomas Langdon in 2013. He was also selected to present his research on financial literacy and aging at the 2015 MIT Center for Finance and Policy Conference.
Michael, thank you so much for being here. And welcome to The Long View.
Michael Finke: Thank you, Christine.
Benz: I'd like to start with the first topic that I ever heard you speak about, the topic of spending in retirement and what retirees say about what type of spending makes them happy. Can you talk about your research in that area, the type of spending that translates into more happiness, and also the opposite, what sorts of things do people spend on that doesn't translate into a lot of additional happiness?
Finke: Well, Christine, there's an emerging literature, not just in financial planning, but in economics and sociology, that social spending is what really makes us happy. And I think that the more research we do into life satisfaction in retirement, the more obvious it is that there are, what I like to call, the three pillars of happiness in retirement. And for those who are thinking about how much they need to save for retirement, money does matter. It affects your happiness. It's a statistically significant predictor of life satisfaction.
Benz: So, not worrying about money is huge, right, in terms of…
Finke: It matters. And the more research we do, the more we see that it's not just – there are people who are unhappy, who have a lot of money, and they do the wrong things in retirement, they spend money on the wrong things. I like to give this story that so many retirees at the very beginning of retirement want to buy a vacation home, or they want to buy an RV. And they don't have a very clear idea of how that's actually going to affect their happiness in retirement.
I knew a financial advisor once who recommended to anybody who suggested that they were going to buy an RV, he said, "It was a great idea. I think you should definitely go out, see the country. But instead of buying one, why don't you rent a midsized RV. And then you can decide whether you really want to buy a small one or a big one." And he made that recommendation, because he knew that three quarters of his clients were going to come back and say I never want to do this again in my life. Because one of the things it does is it socially isolates you. And when we look at what makes people happy in retirement, some of them might be happy driving around an RV if that actually enhances opportunities for social interaction, if they go to those RV parks, and they like talking to people, then they're going to get satisfaction out of buying an RV. But if all they do is just drive around for a month, and it doesn't actually enhance their ability to interact with other human beings, then that's not going to make them happy. So, the happiest retirees are the ones who are careful about maintaining opportunities for social interaction. We know that the number-one activity of retirees other than sleep is watching television. So, this is a big problem among retirees is how do you create a structure to make sure that you're spending money on the kinds of things that actually do make you happier in retirement.
Benz: So, spending on socialization--I mean, socialization, having breakfast with friends or things like that, those aren't very costly endeavors either, right?
Finke: You know, they're not. And when we look at how much retirees actually spend, what we see is that the year after they retire, they spend almost exactly as much as they did the year before they retired. And that is the most money that they will ever spend in retirement on average. So, we are creatures of habit; we tend to live in the same house, which means we're going to pay the same property taxes; we spend money on insurance and food. You know, a lot of our basic expenses are going to be the same as they were before we retired. And for the average household that makes about $200,000 a year--they're really only spending about $90,000 of that. That's the lifestyle that they're actually going to need to replace in retirement. A lot of financial advisors will recommend that their clients try to replace maybe 70% or 80% of their gross income, which doesn't seem very realistic, especially when you consider that they no longer have to make payroll taxes that many of them were saving money for retirement anyway. And in addition to saving money in their 401(k), a lot of them were socking money away, they don't have to replace as much of a lifestyle as they may have thought. And if you look at spending between, say, households in the top 20th percentile of wealth and then in the fourth 20th percentile of wealth, what you see is that, maybe the richest Americans spend an additional $20,000 a year on average more, but it's not an enormous amount of money. I mean, really, what having a little bit extra allows you to do is it gives you access to the kind of activities, things like going on vacation or regularly going out to dinner with friends, the things that really make you happy in retirement. It's access more than anything.
Benz: So, also on the list of things that tend to be additive to happiness, types of spending, spending on things that help you maintain health status. So, that is just what, investing in a gym or what other things would tend to lend themselves to keeping your health status good?
Finke: Yeah. If you think about the three things that do make you happy in retirement--saving obviously for retirement is an investment. We're sacrificing today in order to live better in the future. Building long-lasting close friendships is an investment. It takes time, it takes effort. You may have to travel to maintain those close friendships. But the payoff is that those friendships become even more important in retirement than they were before retirement. And the third investment that you should consider making is in your health. And you should view it as an investment. In fact, economists view our health as an investment because it's a sacrifice. We are not able to eat everything that we want to eat. We have to exercise on a regular basis. We are taking time and effort--we're living a little worse today in order to be able to enjoy our resources in the future to, A: be around, and second of all, be able to be mobile in retirement. It's an investment. There's no use saving up all this money if you're not going to at the same time be able to maintain your health in retirement or have the friends--invest in the friends that you're going to lean on to provide that flow of social interaction when you're in retirement. All three are really the support investments that you need to make. And very often financial advisors just focus on money. And that can lead to perhaps disappointing outcomes for clients in retirement.
Benz: So, let's talk about the types of expenditures that actually don't translate into greater happiness in retirement.
Finke: We were surprised to see that gifts don't translate into happiness in retirement. My grandmother used to say that, it's always better to give money with a warm hand than a cold one. But the reality is that actually it doesn't have a big impact on life satisfaction.
Benz: So, getting them or receiving them?
Finke: Well, giving the money doesn't have as much as – I mean, obviously, everybody likes to receive money, but…
Benz: Giving money
Finke: …giving money does not necessarily provide the level of satisfaction. There have been studies that show that philanthropy provides this warm glow effect.
Finke: We don't see it quite as much in our studies when we compare it to other sources of satisfaction. Buying stuff does not seem to be a big source of satisfaction in retirement. There was one bit of an anomaly. And I say this when I'm giving presentations to groups of consumers--that I'm going to give you license to buy a fun car in retirement. And the reason I'm giving you a license to buy a fun car in retirement is because it's almost statistically significant. And I think that one of the reasons it's almost statistically significant is because those retirees who buy something special--they buy a classic car, or they buy a Corvette--that brings them into a new club, a group of owners, that actually enhances the social-interaction element, that's when buying something can actually make you happier. But if you're just going to buy a car, and it's going to be fun to drive around with every once in a while, you know, a fancy luxury car, it may not necessarily provide the level of satisfaction you think it's going to provide in retirement.
Benz: So, that's interesting. So, there might be other expenditures, I don't know, country club membership, or some sort of wine club or something like that, that might confer additional social activity. So, those types of things tend to be good.
Finke: That's right. It's exactly true.
Finke: And when you're planning out retirement, I think it's always a good strategy to map out expenses, not just when you're putting together an investment strategy. I think it's an essential first step to putting together a retirement-investment plan is to map out your expenses, but also, to think about what you could spend money on that's actually going to make you happier.
Benz: So, one thing that jumped out at me in looking at that spending and happiness research was the role of children, relationships with children. Let's talk about what your research demonstrates on that front.
Finke: Well, if your rationale for having kids is that they were going to make you happier in retirement, then that doesn't pan out as a hypothesis. Having kids does not necessarily make you happier. Living within 10 miles of your children makes you less happy on average. And I think what happens is, people have expectations about what that relationship is going to be like after retirement that don't necessarily match reality. You may have very positive interactions with your children on an irregular basis. But when you live near them, that completely changes the dynamic of the relationship. Also, there may be the case that both spouses don't agree that living close to a set of children is the right course of action in retirement. There's all sorts of in-law dynamics that go on. You may think that you're going to have a very fulfilling relationship, and then, you end up being a cheap babysitter, and you have all sorts of wonderful advice to provide that is not listened to. Again, it's important to be realistic. But I do think it's also important to be aware of the research. And in this case, the research says that that's probably not the best course of action.
Benz: OK. So, you hinted at this, Michael, the trajectory of retirement spending, and my colleague, David Blanchett has done some work on this topic as well. So, sort of, this whole like, go-go, slow-go, no-go spending pattern. Can you walk through what the research says about trends in retiree spending, how it may be as high early on, tapers off, and then maybe ticks up a little bit later in life?
Finke: Yeah. So, when you look at spending, we do experience cognitive and physical changes as we get older, especially in our late 70s and early 80s. And what David found in his research is that the change in spending in retirement kicks in the strongest in the mid-70s or so. We start decreasing our spending the most around in our mid-70s. I've also talked to researchers that have access to people's credit card and account data. And they say, at the very beginning of retirement, sometimes people go a little nuts, they buy the RV, or they buy the vacation home, they spend a lot of money. But generally, what happens is that spending does decline in a relatively steady linear fashion after the first year that you retire--it always goes down a little bit, then it goes down a little bit more sharply in your 70s. And then the rate of decline falls, or at least this is what David found, the rate of decline falls in your 80s when your health spending starts to pick up a bit. But by that time, you're not spending a whole lot of money on other things. And the not-so-great thing about health spending is that when you're spending a lot of money on health, you're probably not capable of spending a lot of money on vacations, for example.
Finke: So, there is that substitution effect. And generally, what we see when we follow retirees over time--we did a study a couple of years ago, where we started in 2000, and then followed retirees all the way through 2012, we found that a surprisingly large percentage of them just didn't spend anything. So, we spend all this time going a little crazy, arguing about how people should withdraw money from their retirement accounts. And at least in the late 1990s or around 2000, those retirees who were really at the tail end of the defined-benefit cohort, they didn't spend down their money at all.
Benz: So, these are people with pensions?
Finke: Very often, and especially, in those higher-wealth, higher-income groups, many of them were eligible to receive some sort of a pension at some point in their working life.
Benz: OK. So, in other words, you were controlling for income, it's not like they were spending less, because they were worried about running out? That wasn't an issue?
Finke: Yeah, that wasn't an issue. And David in his research was very careful about even looking at the people who had more than enough money, they could never spend it all in their lifetime, and still view the same patterns of spending over time.
Finke: So, the whole 4%-rule concept rests on the idea that you want to maintain inflation-adjusted spending over the course of a 30-year time horizon. And the good news, I suppose, in terms of retirement readiness is that we don't see a lot of retirees maintaining in real terms their spending over their entire life cycle.
Benz: Right. So, healthcare spending, though, later in life you noted that it does tick up often, obviously coinciding with diminished health. So, I think a lot of retirees struggle with that--how to model out what their healthcare outlays will be in retirement. Can you walk through some of the key things to think about? I assume your own health history would play a big role in how much of an additional cushion you'd want to set aside.
Finke: You know, not so much in the sense that if you are in good health, you're going to be around longer. And you may have an extended period of time where you require more advanced healthcare. You can't necessarily bank on having lower healthcare expenses, because you are in greater health. And healthcare expenses bother me a lot, because they're highly volatile in old age, and that means there are some retirees who are spending next to nothing. In fact, most retirees aren't spending very much at all. When we map out spending over a 10-year period on healthcare, what we see is that for many retirees, they're actually spending less than they did at the tail end of their working life, when you consider how much money they were spending on health insurance and copayments. Medicare, at least right now, is pretty generous. So, what you really worry about are the ones at the tail. And this is a classic example of a risk that you should insure against. But long-term-care insurance is not the market that you would hope it would be at this point. Not a lot of people buy it; it is expensive. The products that are really ideal, which will provide protection against the true tail risk against having maybe a 10-year or more period in a nursing home, those products are becoming more and more rare. And I think as a society, that's a problem we're going to have to deal with, because all of us face it. And if that's causing us to not spend money in retirement because we're worried about that big potential expense, then we're not going to live as well as we could live in retirement.
Benz: Well, really, to be honest, that's the hair-on-fire issue that I encounter when I speak to groups of retired individuals. That's the thing that they are terrified of, where maybe they haven't purchased long-term-care policies, and so they're planning to self-fund long-term care. But it really can be this catastrophic large expense later in life. And I think especially in the case of married couples, you have a person who is terrified of depleting the assets and leaving the well spouse nothing. So, you know, I guess just there's a dearth of good options. What should people do?
Finke: Well, we did do a study a couple of years ago, where we were looking at retirement satisfaction. We found that those who had long-term-care insurance, their level of life satisfaction was equivalent to somewhere in the range of having an additional $250,000 of wealth. And normally, long-term-care insurance doesn't cost $250,000. So, in terms of life satisfaction, knowing that you don't have to bear that risk, it seems to have a big significant impact on your well-being, because again, it gives you the freedom to be able to actually spend your money in retirement. I do feel like it is a financial problem that we need to solve somehow. It was originally part of Obamacare and got removed at the last minute. I know the baby boomers are going to have to struggle with this. I feel like we don't have the private market solutions that we need at the moment. So, this is an area that really bugs me about retirement planning. Because until we get this solved, no one can really be at ease about spending their money.
Benz: Right. So, I have a long list of questions about annuities. But related to long-term care, there are now these hybrid products. In fact, that seems to be most of the sales in the long-term-care marketplace relate to these hybrid life long-term-care policies or annuity long-term-care policies. What's your take on those types of products?
Finke: I think the resistance to buying long-term care is very often that the premiums are very expensive, and that creates this sort of perception that I can self-insure against long-term care. But when it's bundled with a life insurance policy, then the consumer always knows that they're going to be able to get their money back one way or the other, either in the form of a death benefit or through payments for their long-term-care expenses. And that psychological benefit I think you're clearly seeing in the marketplace. It's breaking down that barrier of people feeling like they're putting a ton of money into long-term-care insurance when they're not sure if they're going to get it back. And especially within annuity, there have been academic studies that have been done, essentially saying that the perfect type of retirement product is some sort of a combination of an annuity and a long-term-care policy, because really, the big risk of buying an annuity is that you're not going to have the liquidity available to cover an extended long-term-care event. But if you bundle the two together, you really get rid of one of the main issues that prevents people from annuitizing.
Benz: My understanding is though, that's still a pretty thin marketplace. There aren't a lot of products like that on the market currently?
Finke: It's thinner--well, I mean, the whole market for income annuities is pretty thin right now. So, a hybrid product would be relatively thin as well.
Benz: OK. So, we've been talking about spending and I want to go back to that specifically talking about portfolio-withdrawal rates. Your research with Dr. Wade Pfau and David Blanchett concluded that the 4% guideline that many people, including some advisors, used to guide retirement withdrawals, is flawed. First, walk us through some of the assumptions that underpin the 4% guideline that a lot of planners and individuals, kind of, take and run with.
Finke: Right. So, this is an argument that especially in a low-interest-rate environment, where guaranteed income started to look pretty expensive, we would very often hear advisors say, "Well, why would I incorporate some sort of partial annuitization strategy if I can get a safe 4% income inflation-adjusted from an investment portfolio over the course of my clients' retirement?" And we said, "Well, you know, that would be great if you could, but the reality that we're living in right now is not necessarily the reality that existed in the past when the Bill Bengen 4%-rule article was originally wrote. He used some assumptions. One of those assumptions was, it was safe if the money lasted over the course of 30 years. And then the question becomes is a 30-year time-horizon max a really safe assumption? And the more you look at the trends in longevity, the more you realize that especially among clients of financial advisors (longer-lived retirees), men have gained six years in longevity over a 20-year period since the 4%-rule paper was written. Women in the top decile of earnings have gained three years of longevity. So, in terms of joint longevity, the likelihood that one member of a higher-income couple is still going to be alive at the age of 95, we're now up to 43% on average of couples will have one member that lives beyond the age of 95 that are in that healthy group of retirees. And I know actuaries and some insurance companies that say, you know, among their lower-risk-class clients, it's actually up to about 57% chance that one of them is going to live beyond the age of 95. So, I often tell advisors, if they're strictly following the 4% rule, then they need to incorporate a strategy of recommending that their client buy a motorcycle on their 94th birthday and encourage them to ride it without a helmet because they've only estimated the safety of their retirement-withdrawal strategy up to the age of 95.
And the other element that bothers me is the use of historical asset returns. And in the United States, we have had a tremendously good run of asset returns. In particular, people cite things like, well, we had the Great Depression. And that's true, but during the Great Depression, we didn't have tremendously expensive stocks and bonds, like we do right now. In fact, stocks became incredibly cheap during the Great Depression. And what we've seen historically is that you just don't have these periods where bond yields are as low as they are right now and really have been for over 20 years. And we also have stock prices, which are well above the historical average, the Shiller P/E is about double the historical average. And there was a great article that was done a few years ago by Cliff Asness at AQR Capital, where he projected out subsequent 10-year returns from investing in different P/E regimes. And what he found is that when stocks are as expensive as they are right now, the average annual return over the next 10 years was one-half of 1% above the rate of inflation.
So, yes, you can use historical returns. But let's use historical returns when stocks and bonds were as expensive as they are right now. And if we do that, and then we project out to the future, we see that the same strategy that may have had a 95% chance of success using historical returns really only has something close to a 50% chance of success or less in today's low-yield environment. And those failure rates are very susceptible to changes in interest rates. If you were to build a TIPS ladder right now, which is really the safest way to create inflation-protected income in retirement and you follow the 4% rule and you are 65 years old, you would run out of money somewhere between the age of 91 and 92. And that's not assuming any asset under management fees. So, if your retirement portfolio is 60% in bonds and 40% in equities, we already know that the market says that for that 60% of your portfolio that's in safe bonds, you're going to run out of money at the age of 92. And then, the stocks have to bail you out if you want the money to last any longer. But when it comes to stocks, A: they're expensive; B: if you get unlucky, and you get a bad, what's known as, sequence of returns, at the very beginning of retirement, you could actually run out of money even earlier than the age of 92 even if your average return is OK. As long as you get the poor returns at the very beginning of retirement, you're going to run out of money early. It all sounds very depressing.
Benz: It does.
Finke: And I always warn people when I talk about retirement-income planning. But there's just nothing good about retirement-income planning at the moment. People are living longer, asset returns are probably going to be lower, that means that retirement is simply going to be more expensive.
Benz: Well, let's talk about four people who are just embarking on retirement, some practical ways to approach this. One logical thing would be to say, "OK, well, 4% seems maybe too rich, then I should pull it down to, what, 3%? Or should I employ a variable withdrawal system?" How should people approach this? Because I do think people are legitimately concerned about some of the issues that you're talking about.
Finke: Well, I mean, Wade Pfau has estimated--my colleague here at the American College--that if we start from today's asset valuations, it's probably closer to somewhere between 2.7% and 3% if we strictly follow the methodology of the 4% rule, and remember that methodology assumes that we're maintaining constant inflation-adjusted spending.
Benz: So, we're taking that 2.5% or 2.7% initially, and then we're inflation-adjusting that dollar amount thereafter?
Finke: Right. So, if you have $1 million saved for retirement, then you pull out $30,000 the first year, if inflation is 4%, then you pull out $31,200 in the next year, and so on. Your spending goes up every year. That is one strategy. I think that's overly conservative, especially since we know that retirees are probably going to decrease their real spending over time. Especially in today's relatively low-inflation environment, even maintaining something close to nominal spending every year seems to be OK as a strategy, because we know you're spending about 2% less per year, on average among retirees. So, you know, what is my preferred strategy? First of all, we haven't talked about mortality credits. And in a low-interest-rate environment, mortality credits actually become far more valuable than in a higher-interest-rate environment, because that's going to bump up the amount of money that you could safely spend every year.
Benz: So, you're talking about some type of an annuity product?
Finke: Yeah, an income annuity product, something that's going to provide a guaranteed lifetime income.
Benz: So, let's just unpack the term “mortality credit,” what that means and how that can be additive to my portfolio at that life stage.
Finke: So, one strategy an advisor could have is building what's known as a bond ladder in retirement. If you build a bond ladder in retirement, if you want to spend $100,000 a year, you're going to have to invest in zero coupon bonds that will mature every single year in retirement. So, if interest rates are 2%, then you buy a $98,000 bond today, and in one year, you can get $100,000 of income. And you may look at the mortality tables. Let's say, you have a client who is a 65-year-old single male, and that client wants to make sure they have a 95% chance that they're not going to outlive their money. So, you look at the mortality tables. You see that there's only a 5% chance that you're going to live to the age of 100; I have to build my bond ladder to the age of 100. So, you set aside a certain amount of money every year. Interest rates are pretty low; You're going to have to set aside about $30,000 today to buy $100,000 of income at the age of 96.
Now, you look around at your clients, and you actually have 10, 65-year-old male clients. They're all putting together a bond ladder, and that bond ladder is going to last all the way to age 100. Each one of them asked to set aside $30,000 today to fund $100,000 at the age of 96. And then, you look at the mortality table again, and you see male 65-year-old retirees have a 1 in 10 chance of making it to the age of 96. So, they had 1 in 20 chance of making it to the age of 100. They have a 1 in 10 chance of making it to the age of 96. So, each one of them is spending $30,000 to buy $100,000 of income at the age of 96. Why not simply create a long-life-income club among 10 of your clients? And then instead of each of them having to save $30,000, they can just pool their money together and whichever one of them is still alive at the age of 96 gets the full $100,000. And this is one of the reasons why economists all say, “Why would you not annuitize at retirement?” Because instead of having to set aside $30,000 today to fund $100,000 of spending at the age of 96, you can set aside $3,000 today, and the only cost is that you have to be part of this long-life-income club. And whoever is still alive gets that full $100,000 at the age of 96. That's the efficiency of what's known as using mortality credits.
Now, the downside is that the other nine men are subsidizing the one that lives to the age of 96. And to an economist: well, why do you carry your debt? The idea of worrying about the fact that you didn't get a really awesome rate of return on your annuity and someone else did get a much better rate of return on their annuity--that shouldn't matter at all to you because you're dead. So, you don't care if somebody else did better than you did. All you know is that every year you were alive, you got to spend more money and you felt more secure, because you knew the money was never going to run out. And that's why if you ever get a group of economists together and they talk about annuitization, you never hear any of them talk about whether or not you should annuitize; it’s just assumed that you should annuitize, especially to fund safe spending in retirement. A normal income annuity is a fixed-income annuity or single-premium immediate annuity, or a fixed deferred. It's all funded with bonds anyway. So, you consider that as being part of the bond portion of your portfolio. The purpose of bonds is to fund safe spending anyway, so why not fund more income, more safely with the bond portion of your portfolio? And the fact that so few people annuitize is really a mystery. In fact, it's known as the annuitization puzzle.
Benz: Well, I want to talk more about that about why people don't annuitize. But before we go any further, let's just talk about some of those annuity types that might be most appropriate, the ones that you like the most, because I think many consumers hear annuities and their hackles immediately go up. They think high costs; they think very low transparency. What types of annuities tend to be most beneficial in retirement in terms of ensuring that you don't run out of money?
Finke: Well, to an economist, the annuities that maximize the mortality credits are the types of annuities that are most valuable. So, you know, I joke--I was talking with someone who worked in an insurance company about who is buying deferred-income annuities, specifically deferred-income annuities that receive a tax benefit as a qualified longevity-annuity contract. And they told me the only people who are buying them were, of course, economists and actuaries and engineers, so they had sold about 20 of them. But we're all in love with it. I mean, it's the perfect type of annuity. You're maximizing your mortality credits by annuitizing later-life income and you get this tax-deferral benefit from not having to pay required minimum distributions on the amount. It is the most underused, most valuable retirement-income product that's available in the marketplace today. There's just nothing that comes close.
Benz: So, let's just walk through that, Michael. You mentioned the QLAC, the Qualified Longevity Annuity Contract, you mentioned that the amount that you steer into a QLAC is deemed to fulfil your required minimum distributions. Let's just talk about how all this works from a practical standpoint when implementing this strategy.
Finke: So, the regulations are that you can put up to $130,000 or 25%, whichever is lower, of your IRA assets into a QLAC. So, you need at least $520,000 to put $130,000 into a QLAC from your IRA--you can only buy them from your IRA. And my recommendation is always to take the income as late as you possibly can, which is the age of 85. And so, for $130,000, you can buy about $40,000 of income at the age of 85. But what happens now is that makes retirement-income planning so much easier. Because if you've done what you're supposed to do and deferred Social Security, and you're getting $30,000 a year in Social Security, you're getting an additional $40,000 a year at the age of 85. There are not a lot of 85-year-olds that are spending much more than that in retirement; in fact, very few. So, you've gotten that taken care of; 85-plus is taken care of. And then, all you have to worry about is planning for spending between, say, the ages of 65 and 85. And then you develop some sort of a strategy for pulling money out of the accounts in a very tax-efficient fashion. But the QLAC gives you the ability to deal with that problem of not knowing how long you're going to live.
Benz: OK. So, let's discuss the profiles for whom an annuity would be an exceptionally good fit. It seems like if I have a pension, for example, that's supplying most of my income needs, probably don't need to consider any sort of an annuity in addition to that, because my pension is effectively an annuity.
Finke: Well, I mean, an economist would say, "Yeah, I mean, a pension is nice, but what is the rest of the money for? And if the rest of the money is for income, then you're going to get more income more safely per dollar if you annuitize." So, it's really important to think about what is your lifestyle going to be? What is the purpose of each pot of money that you have? And then, you want to take whatever strategy is going to maximize that pot of money in its ability to fulfill that purpose. So, if your goal is to give it to your heirs, then make sure that you're engaging in whatever kind of a strategy is going to ensure that the most money goes to your heirs. And that may mean pulling as much money out of your IRAs as possible, so that you can convert them into a Roth or some other type of a strategy that's more beneficial for estate planning. But if it comes to income, yes, if you have a pension, the need for an annuity is not as great as if you don't have a pension. But what is the purpose of all that money that you saved? If the purpose of all that money that you saved is income, then why not annuitize it, because then you can get more money more safely than using an alternative strategy like a bond ladder.
Benz: People wrestle with how much of a portfolio to annuitize. Do you have any thoughts on how someone could rightsize their annuity purchase?
Finke: That's a great question. And I get this question very often. I think that an easy answer is, a QLAC is step one. Deferring Social Security is step two, if you're worried about retirement income, because Social Security is very often a less-expensive way of getting income in retirement than actually buying a private annuity. And then, you start thinking about when it makes sense to buy a private annuity. Obviously, if you're in poor health, the pricing of the annuity is going to be based on the kind of people who buy annuities who tend to be healthier. If we do end up in a situation where annuities start making their way into defined-contribution plans, which is something I really am hoping for, then we can start getting pricing that's more favorable for an average worker group-pricing on annuities. That's probably an underappreciated element of the new legislation that would make it easier for plan sponsors to incorporate annuitization into defaults. I would love to see more employees having the option to buy annuities at a more favorable price.
Benz: Well, let's talk about where we are with that right now. There's the Secure Act, which is in Congress, and it would make it easier for plans to offer an annuity option. What type of annuities are under consideration for that role? Has it been specified?
Finke: It is not. It's very broad in the current legislation. I think the plan sponsor is still going to have to pay attention to whether the annuity option is in the best interest of their employees. And if you ask an economist, what makes the most sense, and I testified on this very topic, if you think about what, say, a default investment looks like in a 401(k), you've got a percentage of stocks, and you've got a percentage of bonds. And the glide path determines the allocation, the allocation goes more towards bonds as you get older. So, more and more of people's retirement savings is being invested in bonds. I would love to see part of that bond allocation shift into guaranteed income for a number of reasons. A: it's going to give employees more clarity about how much income they can actually buy with their 401(k) savings--especially in today's low-interest rate environment, they may be surprised by how little they can buy with their savings. I mean, oftentimes you end up with these gaudy numbers in retirement, and then you find out how much income you can actually buy with those numbers, it gets a little bit depressing. I would rather know as an employee that maybe I ought to work a couple more years if my income goal is X, and my 401(k) is only going to buy me Z. Clarity, I think, is a huge benefit, and also encouraging more Americans to partially annuitize in retirement so that they're not at risk of potentially running out of money if they live too long. And many employees, especially if they're investing in default investments, they don't have the financial sophistication to be able to manage a complex investment portfolio into their 80s and 90s. I would much rather see them, especially if they're being defaulted into some kind of postretirement option, I'd much rather see them being defaulted into something that's going to preserve their lifestyle for the duration of retirement.
Benz: So, cognitive decline is another reason to like annuities in this setting, because people get sort of that paycheck equivalent. It takes the guesswork out of it.
Finke: Yeah. We find that when we get older, something like nearly a third of Americans are experiencing some serious age-related cognitive decline. The problem with cognitive decline is that we don't know what's happening. So, when we do surveys of older Americans, what we find is that we can test their financial literacy, and it's going down by 1.5 percentage points per year after about the age of 65 or 70. But at the same time, their confidence in their ability to make financial decisions is not going down. And we talked about investment risk as being a big source of risk that people could run out of money in old age, and perhaps an equal and maybe even a more serious risk is cognitive risk in old age. And annuitization is one way to actually provide insurance against that cognitive risk.
Benz: So, you mentioned this annuity puzzle, the reason why people are resistant to purchasing annuities, and why only academics and engineers like them. So, let's talk about some of those factors that are in play. I referenced one, which is that I think some consumers have heard bad things about some annuity types, the variable high-cost annuity types. What are the other factors in play here?
Finke: Well, I do think that--if you think about what an annuity is, there is a traditional income annuity, which is the way that an economist thinks about annuity. And then, there is this whole world of structured products that are labelled annuities. And some of them have options to buy guaranteed lifetime income, some of them do not. They have in the past been opaque products in some cases, and in some cases, they clearly not been constructed for the benefit of the consumer. And that's a shame. Because there are products out there that are beneficial, that do allow you to capture some of the equity-risk premium, do provide options to create guaranteed lifetime income that are really valuable. And in many cases--and I've done consumer-survey types of studies on these types of product characteristics--they are what people want. And I think the products that exist in the marketplace, in many cases, exist in the structure that we see because they are what consumers want in retirement. They want some ability to receive upside; they don't want to regret it. If the equity market increases, they want to participate into it, but not fully in the equity market. They want some sort of an option if the market doesn't do well to be able to receive a guaranteed lifetime income as a downside protection. So, these types of characteristics are what I see when I do consumer surveys. And the products are reflecting the preferences in many cases of consumers because they want to be able to receive some sort of an upside but they're afraid of the downside. And of course, the question always becomes, can you replicate that type of strategy, as is the case in any types of a structured product, using an alternative type of investment strategy.
Benz: So, getting back to how retirees should invest apart from the annuity decision, where do you come down in the glide path debate that's been raging among retirement planners, like yourself? There was some work done by Wade Pfau and Michael Kitces that argued for sort of this reverse glide path that people's equity-weighting should actually trend up as they age in retirement. Sort of the traditional glide path would be downward trending and more conservative trending. How do you think people should approach that with their investment portfolio, sort of, setting apart the annuity considerations that we just went over?
Finke: Well, I think your job as a financial advisor is to make your client happy and to give them what they want. I think there's a very serious question about whether holding a very high percentage of stocks in your portfolio in older ages is what's going to make you happy. In fact, there was just a study done in The American Economic Review last year, which found that among retirees, those who were invested in equities and had experienced the financial crisis of 2008, that actually had a significant impact on their mental health, and their physical health, and it actually reduced their longevity, which is shocking that a decline in the value of their investment portfolio had that big of an impact on them personally in retirement. And the whole point of money is to make you happier, and if your money is not making you happier, because it's stressing you out--and there's also lots of studies that have been done on how older individuals process risk and loss, that all seems to be pointing in the direction of putting together a more stable portfolio for retirees as they get older simply as a way of managing their natural response emotionally to the amount of risk and potential loss that they could experience in their investment portfolio. So, I think we have to go a little bit beyond the mathematics. And I think there are methodological issues about the mathematics of looking at glide paths when we have a fixed period of time. And just ignoring those, the whole point of investing is to make your clients happier. And it's pretty clear from the research that experiencing a bear market later on in life is not going to make you happy.
Benz: OK. So, you've done some research on common mistakes that retirees make when positioning their portfolios that lead to worse returns from the equity market. Let's discuss that research.
Finke: Sure. So older investors--and this was a study that was actually done using Morningstar data--David Blanchett and myself and Michael Guillemette at Texas Tech University looked at risk-tolerance responses among older employees. And what we find is that middle-age younger employees, when the market’s doing poorly, their risk-tolerance score is really not that much different than everybody else's is. But as you get closer to age 65, people become far more sensitive to taking risks based on recent market performance. And this is something that I've also found in subsequent consumer surveys. This is a particularly interesting characteristic of older investors--their willingness to take investment risk is more dependent on how well the stock market has done recently. And, of course, that's not a very good way to invest. Because what ends up happening is that you end up becoming more risk-averse after stocks have fallen in price, which means that you're more motivated to sell stocks when they're cheap. And then you become more risk-tolerant after stocks have increased in price, which means that you're allocating more to equities when their prices are higher, and the expected equity-risk premium then is lower. So, a good way to consistently lose money in your investment is to focus too much on recent returns. And the data would seem to suggest that older investors are more prone than younger investors to focusing too much on recent returns.
Benz: So, I'm sensing more storm clouds over the new crop of retirees because it does seem like based on what you've just said that some of them would be pretty complacent about equity risk today. We've had a pretty good market for a long time.
Finke: We've had a pretty good market for a long time. And I think when you think about equity risk, you have to be realistic about what the upside is, especially because the markets--this is a bit of an esoteric discussion--because markets tend to be mean-reverting and that valuations tend to go up and down over time, really what's that saying is that the market requires a higher premium to induce investors to participate in the equity market at some times than it does at others. So, if you think back to March of 2009, the market required a very high equity-risk premium to induce people to buy stocks, and they got it subsequently. And right now, the market does not seem to be requiring a very high equity-risk premium. So, in other words, the bang for your buck that you're getting for taking risk is not as high now as it was in 2009. Even though it may feel like the stock market is safer, because it's gone up so consistently over the last decade, the reality is, the upside from investing in stocks, the upside from taking risk is less than it has been historically. And if you are a retiree and you're planning on the type of returns that you can get from equities going forward, your expectations need to be more modest than they would be in a period where stock prices are more attractive.
Benz: So, if you were making a few recommendations about how people could have a happy and financially successful retirement, what would they be? You've talked about a couple, investing in social relationships, not buying the expensive RV. What other things should people take with them as they think about and formulate their retirements or as advisors help coach their clients on having a happy retirement?
Finke: Well, I think the more thought you can give to how you're actually going to live in retirement, the better off you will be when you construct an investment portfolio and when you think about how you're actually going to be spending your money and your time in retirement. And one aspect that we haven't talked about is where you're going to live. But this relates very much to the discussion about social interaction that if we stay in our own homes as we get older, we're prone to becoming more socially isolated as we become less mobile. Does that mean at the very beginning of retirement when we we're planning how to spend our money and our time, should we not be then planning on transitioning to a different type of living environment where we are given more opportunities for frequent social interaction than we would experience if we lived in our own home. I think many of us have had the experience of having to move one of our parents into this type of a living facility, which is always an incredibly pleasant experience. And our parents are always very grateful for having to sell off all their stuff and move them into one of these homes. But if we did that actually in our own terms, if we decided where we were going to live in advance, and if we plan for how much money it was going to cost to live in that sort of a place. And of course, it may be less expensive than we think, because that's really all we're going to be spending money on at that point in our lives. We're not going to be going on as many vacations. The more planning, I think, we do, the better off we are going to be and the easier it will be to put together an investment plan where the risk of our investments matches the amount of flexibility that we have when it comes to what we're spending money on in retirement. So, again, if we're spending money on things like housing, where we cannot be very flexible, then it makes far more sense to fund them with certain investments, like bonds, and then, if we're going to fund them with bonds, then think about whether or not to capture that mortality credit as a part of your bond portfolio.
Benz: How about your own retirement, not suggesting you are retiring imminently. I know you're not, but has your work in this area kind of changed your view of what your own retirement might look like?
Finke: It absolutely has. I'm glad you asked me that question, because it has on more than one occasion. So, about a week and a half ago, my wife and I were getting to the end of summer. She still had the summer off. She's a faculty member. I had a little bit of time off. And we were trying to map out what we were going to do for the rest of the summer. And my wife hadn't seen a friend of hers who lives in Boston in about a decade. And she thought, you know, I need to maintain that relationship now, so that I can draw from that relationship in retirement. We had just gotten done doing this research--we did this research on life satisfaction together. And we're now much more aware of the importance in investing in friendships. And sure, it's going to take money to fly to Boston, and sure, it's going to take part of our time. And we could have found a million reasons to talk ourselves out of it. But now, it's becoming far more clear that those investments are going to pay off in retirement just like money that we save in our 401(k). And it makes us far more aware of the importance of making that investment.
I also have to say that when I first went to Texas Tech University from University of Missouri, I was given the option of buying all of the years that I had put in at University of Missouri into the Texas Tech system as a part of my pension. And it was a big amount of money. It was pretty much everything that I had saved up to that point in my 403(b). And I had the option to buy an extra nine years of credit towards my pension. So, I actually had to face this experience of saving diligently, having a big number in my retirement savings account and then seeing that number go to close to zero after I bought guaranteed, a promise of guaranteed income, in the future. And I did it because I understood the mathematics of it. It was a good deal. But what I didn't fully understand is that when I bought that guaranteed income, it actually made me far more secure. Every year since I bought that income, no matter what happens in my life, I know that I'm always going to have that base of income starting at the age of 64. And that makes it easier to live. I think when it comes to buying income, especially later on in retirement, oftentimes, we don't think about how much happier we could be if we took that weight off our shoulders.
Benz: Well, Michael, I could talk to you all day. This has been a fascinating discussion. Thank you so much for taking time out of your schedule to talk to us. I think it's just been super illuminating. Thank you again.
Finke: That was a lot of fun. Thank you, Christine. My pleasure.
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. 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.
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