The retirement researcher weighs in on in-retirement asset allocation and the best ways to address sequence risk and shares his favorite retirement-spending system and longevity calculator.
Our guest on the podcast today is retirement researcher Wade Pfau. Wade is the founder of Retirement Researcher, an educational resource on retirement planning for individuals and financial advisors. He’s co-founder of the Retirement Income Style Awareness Tool and a co-host of the Retire With Style podcast. He’s a professor of practice at the American College of Financial Services and a research fellow with the Limra Retirement Income Institute. And he’s also a principal and director of retirement research for McLean Asset Management. Wade has written several books, including his most recent, a third edition of his Retirement Planning Guidebook. He holds a doctorate in economics and a master’s degree from Princeton University and Bachelor of Arts and Bachelor of Science degrees from the University of Iowa. He’s also a chartered financial analyst.
00:00:00 Updates to the Retirement Planning Guidebook
00:00:29 Do Retirees Today Have a Stronger Starting Spending Rate?
00:04:03 Asset Allocation, Annuities, and Target-Date Funds
00:08:11 Retirement Income Styles
00:15:07 Non-US Safe Withdrawal Rates and Flexible Spending Strategies
00:23:55 Probability of Success and Estimating Longevity
00:27:47 Underspending, Organic Income, and Mortgage Payoff
00:35:46 Exploring the Retirement Risk Zone
00:39:20 Equity Glide Paths, Sequence Risk, and Delaying Social Security
00:46:43 Annuities: Private Equity Concerns and Due Diligence
Exploring the Retirement Risk Zone
Reducing Retirement Risk with a Rising Equity Glide Path
What’s Your Retirement Income Style?
8 Reasons You Might Need to Tweak Your Portfolio
Wade Pfau: The Risks of Retirement Today
If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com.
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(Please stay tuned for important disclosure information at the conclusion of this episode.)
Christine Benz: Hi, and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning at Morningstar.
Amy Arnott: And I’m Amy Arnott, portfolio strategist for Morningstar.
Benz: Our guest on the podcast today is retirement researcher Wade Pfau. Wade is the founder of Retirement Researcher, an educational resource on retirement planning for individuals and financial advisors. He’s co-founder of the Retirement Income Style Awareness Tool and a co-host of the Retire With Style podcast. He’s a professor of practice at the American College of Financial Services and a research fellow with the Limra Retirement Income Institute. And he’s also a principal and director of retirement research for McLean Asset Management. Wade has written several books, including his most recent, a third edition of his Retirement Planning Guidebook. He holds a doctorate in economics and a master’s degree from Princeton University and Bachelor of Arts and Bachelor of Science degrees from the University of Iowa. He’s also a chartered financial analyst.
Wade, welcome back to The Long View.
Wade Pfau: Thanks, Christine. It’s a pleasure to be here.
Benz: Well, it’s great to have you here. Your Retirement Planning Guidebook is, I would say, the definitive guide for anyone who’s serious about retirement planning. It’s always a fixture on my desk, and it’s now in its third edition. So I’m wondering if you can talk about the key sections that you wanted to update with this most recently released edition.
Pfau: Well, thank you. And yeah, really, the two big changes with the third edition—one is I really tried to simplify the writing. So it’s actually a hundred pages shorter than the second edition. I didn’t remove any substantive content, but I really focused on … I would get criticisms that I was too wordy. I repeat myself too much. So really focusing on making it simpler to read and also just getting right to the point. And then in terms of content, there were a lot of changes with taxes with the legislation passed last July. So the tax-planning chapter, which is the longest chapter in the book, I really had to do a pretty thorough rewrite of the chapter to just deal with, now we have permanent tax rates instead of tax rates that are originally going to change back to their 2017 levels in 2026. And then all the other, there’s new below the line deductions that phase out with income. There is a lot to really consider in the tax-planning chapters. So those are the major changes.
Arnott: It was back in 2022 when we last had you on the podcast solo, and it was a very different environment. Yields were ultralow. Inflation was starting to tick up, and we talked about some of the risks for new retirees. Now that bond yields are higher and inflation seems to be moderating, would you say that starting conditions are better for people who are just beginning retirement today?
Pfau: Yeah, absolutely. That is something I’ve always thought that where interest rates are is the really important starting point for understanding the bond returns are really linked to today’s interest rates. And then if you think about adding a risk premium for the stock market, you add that to current interest rates. And so right now, if you were to build a 30-year bond ladder using TIPS, or Treasury Inflation-Protected Securities, the real yield before inflation coming out of that is around 2.4%. That supports a sustainable withdrawal rate of 4.6%. Now that’s different from the 4% rule because the 4% rule assumes a diversified investment portfolio. But if you can get 4.6% inflation adjusted over 30 years with bonds, I think that’s a much stronger starting point for talking about with retirement spending strategies compared to a few years back when interest rates, the 30-year TIPS yield at one point was negative. And so that really makes it hard to sustain a high level of spending throughout retirement.
Benz: Well, I wanted to ask you about that, Wade, because in talking to preretirees and retirees, many of them hold portfolios that are really equity-heavy. They do not like bonds. And certainly the 2022 experience when interest rates went up and kind of crunched bond prices, that didn’t help bonds’ case for them, but I’m wondering if you encounter many retirees who are sort of that mindset that they should be mostly equities, and how do you talk to them about having portfolios that are more or less balanced and include more safe securities?
Pfau: Probably, I don’t necessarily talk to a lot of people who are staying with a very high equity allocation in retirement, but for me, really the asset-allocation conversation in retirement, that’s one of the last steps because you really need to get an assessment of how much reliable income do you have in place before you have to worry about what your investment portfolio is doing. And with research I’ve done going way back to, I think, 2012 was the first article I wrote in this area about this idea that, with retirement, when you’re trying to meet a spending goal over an unknown length of time, the efficient frontier for retirement is stocks and annuities with lifetime income protections instead of stocks and bonds. And then if you really follow the math behind that, it suggests, once you have a floor in place where, if you have your basics covered and not exposed to market volatility, you can invest pretty aggressively with the rest. At the extreme mathematical case, you don’t even need bonds.
Now you might want bonds for other purposes such as liquidity and so forth, but when it comes just to meeting a known spending goal over an unknown length of time, the investment side can be pretty aggressive once you have reliable income in place. Now that might explain some folks who have the more aggressive allocations, but if they’re more of a pure total-returns type investor who’s not worried about reliable income and is just maintaining a very aggressive stock allocation in retirement, they need to be flexible with their spending. If they’re willing to cut spending based on what the markets are doing, and if markets go down to cut spending, increase spending of markets go up, have a flexible spending strategy, that could still justify investing aggressively, but if they don’t have reliable income and they don’t have a lot of flexibility for their spending, that’s where you really need to have a deep conversation about whether having too high of equity allocation is putting too much risk onto the retirement plan.
Arnott: I wanted to follow up on the role of annuities, and both BlackRock and Vanguard have introduced versions of their target-date lineups that allow retirement plan participants to buy into a target-date fund that includes an annuity. Does that sound like a good option for you?
Pfau: I think it’s very important to move in that direction because right now most retirement plans, they’re really focused only on having investment options, and so they can help with accumulating for retirement, but it’s pretty unclear what they’re supposed to do in the postretirement phase. And so having income options is definitely a plus with that BlackRock approach.
We did a study with them about our idea of retirement-income styles, and they have an interesting approach where it’s, you have a bond fund that tracks the price of the annuity so that you know, if you decide to convert over to an annuity, you can kind of track how much income you’ll be able to get with it, but you’re not required to make that switch. You have the flexibility. And we found that just having that option available was attractive to individuals with a variety of retirement-income styles.
It would be interesting. It seems like maybe a lot of people might ultimately not make the decision to convert into that annuity, the lifetime income stream, but having bonds that are tracking the annuity price, kind of tracking or locking in how much income you could get from the annuity, giving you the flexibility to decide whether or not to do that, that’s definitely an interesting way to incorporate aspects of lifetime income into a retirement plan.
Benz: You referenced that retirement-income style analysis, awareness. Can you talk about that? I know that you and I have talked about it previously on this podcast, but just so that people understand what you mean when you talk about retirement-income styles. Can you do some stage setting there?
Pfau: Sure, sure. And so this was based on a research project to understand there are different viable retirement-income strategies out there that people can choose from. We call those the retirement styles. And when you start to look online about retirement, there’s just very deep debates about which approach is best. And ultimately, you have options. Different approaches are better for different people based on your preferences.
So whether you’re more of a total-return investor, you’re just going to focus on taking distributions from your investment portfolio, you use a diversified portfolio, the same manner as preretirement. We call that total returns. That’s one of the styles. You’ve got what we call time segmentation. It’s also known as bucketing. That’s where you invest differently. You have different buckets for different points in time. Bonds are more for your upcoming short-term expenses. Stocks are more for your long-term expenses. That’s a viable retirement style. You’ve got what we call income protection, which is the classic idea of, before I start investing for growth, I want to build a floor of reliable lifetime income, and that can include a role for annuities if you don’t otherwise have enough Social Security, pensions, other income sources to meet your reliable income needs, then you might look to an annuity to fill that gap, and then invest on top of that for more-discretionary goals.
And then risk wrap—so the time segmentation, that’s a behavioral version of investing. It’s a different way to frame the investment portfolio to have a mental accounting for what different assets are for—risk wrap is really a mental accounting version of income protection, where you want to commit to having protections in place for your income, but you also don’t want to sacrifice potential liquidity for those assets and so forth. And so that can explain the development of things like deferred annuities with lifetime income benefits that could play that role of supporting reliable income while still affording some growth and liquidity for those assets. And then it’s still the same idea. That gives you more flexibility on top of that to invest for other goals.
And so you’ve got these options. How do you pick an approach for your retirement? Alex Murguia and I, he has his Ph.D. in psychology, we really looked on, could we develop an assessment tool to help people? And what we found are there’s these two primary factors that explain how people think about retirement. You’ve got the probability-based, safety-first idea. If you’re probability-based—and there’s no right answer—but if you’re probability-based, you’re more comfortable relying on market growth to fund your retirement spending. If you’re safety-first, you really want to have contractual protections backing assets to meet your essential expenses, whether that’s holding individual bonds to maturity or using annuities, which are contracts with insurance companies.
And then the other factor we found: optionality versus commitment. If you’re optionality-oriented, you really value having flexibility for all your assets. You want to be able to make changes and respond to new situations. If instead you have a commitment orientation, it suggests, if you can find something that solves your problem, you’re comfortable committing to that on a lifetime basis. And also we see that people who are worried about cognitive decline or about helping other family members, that might lead them more toward a commitment orientation, where they want to commit to a strategy.
And then the really fascinating part was how the combinations of those preferences explain the four retirement-income styles, so that the total-return investor: They’re probability-based, they’re comfortable relying on market growth, and they want to maximize optionality for all their assets. The income protection, the person who might think more about annuities: They’re safety-first, they want contractual protections, and they’re comfortable committing to strategies that solve for their lifetime needs. And then the time-segmentation and the risk wrap are different combinations of those preferences, but really it all … we can go into greater depth on it, but that’s probably a good overview of just the idea of, based on your preferences for these two key retirement-income factors, you can get a starting point for which of the different retirement-income strategies that are out there might be a good starting point for how you want to think building the best retirement plan for your own situation.
Arnott: Is it fair to say that the four retirement-income strategies you just talked about are equally valid depending on your individual preferences?
Pfau: Yeah, they’re all viable, valid approaches. And so I would say they’re all equally valid. Now, there’s some natural correlations at work where if you’re probability-based, you’re more likely to be optionality-oriented, and if you’re safety-first, you’re more likely to be commitment-oriented. There’s exceptions, but we do see there’s more people who are either total returns or income-protection, and then there’s fewer people in the time-segmentation and risk-wrap quadrants. But yeah, they’re all equally valid approaches. It’s really just about finding something that you’re most comfortable with for developing a retirement strategy that lets you meet your goals and feel comfortable about your plan, so that you’ll have a better chance to stick to your plan and not panic during periods of market volatility and so forth.
Arnott: You mentioned that there are fewer people who end up in the risk-wrap mental accounting quadrant. Are there other patterns you’ve seen as far as a distribution of results across the four quadrants?
Pfau: Yes. We looked at a lot of different socioeconomic type characteristics. And for the most part, if you look at someone, you can’t really guess what their retirement-income style will be. So it’s not based on things like education or income and so forth, but the two factors we did find: gender and net worth. With gender, there is a tilting. And so by tilting, with the aggregate population, a little more than a third of the population tends to be total returns, and a little more than a third tends to be income-protection. But with that tilting, men do tend to tilt more toward, closer to 50% are total returns. For women, it’s closer to 50% are income-protection. And then net worth, the individuals of the higher net worth do also tend to tilt more toward that total-returns style, and then individuals with a lower net worth tend to tilt more toward the income-protection style. And again, that’s getting closer to 50% at higher-net-worth levels tend to be total returns.
Benz: You’ve done a lot of work on safe withdrawal rates over your career. And I was interested to read in the book a reference to some research that you did on international safe withdrawal rates, so non-US safe withdrawal rates. And it jumped out at me that the 4% guideline, which many people kind of use to guide their withdrawals in retirement, that it really wasn’t safe in a lot of markets, which I think raises the question of whether it would be safe going forward in the US. I’m wondering if you can talk about that because I think it’s so widely accepted as conservative here in the US, but if you look at the experience of other countries, it suggests that maybe we shouldn’t be so sure.
Pfau: Yeah. And it was the very first study I did in the financial-planning space. I had learned about the 4% rule from Bill Bengen, and he had focused on US market data, US stock returns and bond returns. Now, since then, he has looked at more international diversification, but I simply had a dataset, and actually, at the time it was administered through Morningstar, the global returns dataset, 20 different developed-market countries, looking at local stock and bond returns for each of the 20 countries going back to 1900. And I was just curious, Did the 4% rule work with other countries’ data? Well, we know it works in the US. Turns out it also worked with Canadian financial market data, but that’s the end of the list. In the other 18 countries, the 4% rule did not work, and results vary, but globally, like if you just take all the different countries’ data and looked at the success of the 4% rule, it only worked about two-thirds of the time internationally, and the withdrawal rate had to go all the way down to 2.8% to have a 90% success rate around the world with all the different local market data.
And so I found that compelling to just suggest the 20th-century US market performance, when the data used for the 4% rule, that’s a pretty unique point in world history where the US rose to become the world’s leading superpower. It went from, I think, about 20% of the stock market capitalization of the globe in 1900 to closer to 50% by 2000. It was a pretty remarkable century. And so just understanding what could happen with different sequences of market returns, I thought was valuable to just get a better understanding about market volatility. Now, inflation also plays a big role in all of that where you could have very low withdrawal rates if you’re a country that experienced a hyperinflation, but that’s not the full story. There’s plenty of cases like Australia and so forth, where, during that stagnation we saw in the 1960s and 1970s, 3% to 3.5% might have been all that could have worked rather than, still, the US was able to eke out with the 4% having always worked historically.
Arnott: That’s interesting. So, in addition to the 4% rule, there are a lot of other, more flexible approaches to figuring out how much you can withdraw from a portfolio. There are systems like the guardrails approach, the probability-based guardrails method that is in the Income Lab software. Do you have a favorite flexible spending method?
Pfau: Yeah. So in Chapter 4 of Retirement Planning Guidebook, I spend a lot of time talking about how different variable spending strategies work. Now the guardrails approaches, ultimately for me, they don’t really test all that well. They lead to very odd-looking retirement spending patterns. So I’m not a big fan of the guardrails, and the probability-based guardrails seems like it’s just putting a hat on a hat.
Like with all the different variable spending strategies out there, the one, if I had to pick a favorite, it’s actually one that Bill Bengen had introduced in some of his follow-up articles from the 1990s. It was the Bengen floor-and-ceiling rule, where you have a hard dollar ceiling on how high your spending can go. And it turns out the ceiling doesn’t matter all that much. What’s really important is you have a hard dollar floor on how low the spending can go, but then you use a constant percentage strategy when you’re in between the floor and the ceiling, which is, instead of using constant inflation-adjusted spending, you take a percentage of what’s left every year. And as long as that leads to a dollar amount in between your floor and ceiling, that’s what you spend. If that percentage led to a dollar amount that either exceeds the ceiling or falls below the floor, then you would just use the ceiling or the floor. And that’s a powerful way to help manage sequence-of-returns risk and so it can allow for higher average spending throughout retirement than if you just followed a strict constant inflation-adjusted spending strategy, which is what the 4% rule is, that you never adjust your spending based on how the markets are doing. No matter what’s happening to your portfolio, you always just adjust your spending for the previous year’s inflation rate. Because that creates more risk of portfolio depletion, it forces you into using a lower withdrawal rate than otherwise possible with a flexible or variable spending strategy. So the Bengen floor-and-ceiling rule became my favorite when I looked at all the different options out there.
Other possibilities, too, it depends on what kind of spending pattern you’re looking for. There’s the inflation rule, which comes out of … it’s one of the rules from Jonathan Guyton’s research, where you just, if markets are doing fine, as defined by the decision rule, you take your inflation adjustment, but if markets are not doing well compared to your decision rule, you skip the inflation adjustment. That leads to more of a pattern of decreasing real spending over time. But that can be another powerful way to increase the spending throughout retirement on average. And then also, I do like its modified required minimum distribution rules, which are just, as you get older, you can spend an increasing percentage of what’s left because your time horizon gets shorter and it’s still percentage, so it reduces the sequence-of-returns risk. That approach is also interesting, especially for more discretionary types of expenses, but absolutely the idea of you do want to have some sort of variable spending strategy, the 4% rule, it’s a research simplification that assumes you never adjust your spending based on how the market’s doing, and that just creates an unnecessary amount of risk. Being able to fluctuate your spending over time can help set you on a better course and have a higher average spending throughout retirement.
Benz: I wanted to ask a follow-up on that, Wade, which is when you look at the data, you see that retirees do tend to spend less in real terms as they age. How should that factor into the retirement spending plan, or should it?
Pfau: Oh yeah, that’s a really important aspect. Most people spending will decrease with age. David Blanchett has the retirement spending smile idea, which is that, late in life, healthcare expenses start to pick up, and so, overall spending, not health or long-term-care related, tends to decline throughout retirement, but you might see a smile where late in life health expenses start to reverse that trend. But that means you can plan to spend less as you age. And so that makes another aspect of the 4% rule idea—that your spending always adjusts for inflation—that can be overly conservative because your spending may not always need to keep up with inflation fully. You may have expenses that grow with inflation, but overall, you’re making cuts—just as you have the go-go years, the slow-go years, and the no-go years, you just tend to spend less with age.
And I ran that David Blanchett’s spending smile through the same kind of analysis that Bill Bengen used with the historical data and with 4% was about 4.03% was what worked historically with constant inflation-adjusted spending, but you could get that up over 4.7% by applying a spending pattern that allowed for decreasing spending over time, increasing spending later on but never really catching up to the same levels as if you had assumed constant inflation-adjusted spending throughout retirement. So that lets you use a higher withdrawal rate or otherwise retire with less assets. In the Retirement Planning Guidebook, I go through all the assumptions of the 4% rule and talk about how changing those assumptions, for some reasons, the 4% rule might be too high, for other reasons, it might be too low, but this issue of real world spending patterns definitely falls on the list of the 4% rule might be too low if you apply a more realistic spending pattern in your retirement.
Arnott: Another important assumption for all of this retirement spending research is the probability of success, and a lot of people, including the research that Christine and I have worked on for Morningstar, use a 90% probability of success in our testing. Is that too low, too high, or do you think that’s reasonable?
Pfau: Yeah, that’s an important question. There’s not going to just be one guideline for that. It could be reasonable for some folks that … An article I wrote with Michael Finke way back in the day was about spending flexibility and safe withdrawal rates that really talked about the idea. If you have a lot of reliable income outside the portfolio and/or you’re flexible with your spending, you’re willing to adjust your spending up or down based on how your portfolio’s performing, both of those are factors that can allow you to be more aggressive in retirement. And in retirement, there’s two ways to be more aggressive: You can invest more aggressively, higher stock allocation, or you could spend more aggressively, which means really you’re accepting a lower probability of success because the higher your spending rate, the lower the probability that would work. But the idea is if you’re willing to make cuts and you have plenty of reliable income so that it’s not catastrophic if you deplete your investments, you could potentially target probability of success rates more in like the 70% or 80% range.
But if you’re someone who doesn’t have a lot of reliable income outside the portfolio and you don’t have a lot of flexibility for your expenses, that means you do need an approach that’s more conservative, more likely to work. And in those situations, 90% is a pretty reasonable success rate target to use. So it really depends on the situation. I’d say really anywhere from say 70% to 90%, and it really just depends how much flexibility you have to make adjustments so that a market downturn does not disrail or disrupt or completely destroy your retirement plan.
Benz: Sticking with questions about assumptions that underpin these various withdrawal rate systems: Another one is what sort of longevity you want to assume. I think the 30-year spending horizon is kind of the standard, but I’m wondering if you have any calculators or other tools for estimating longevity that you like. I was recently fiddling with some of them, and one that was well-regarded required me to enter a lot of stuff about my health, family health history, and then give them my email address, which just seemed like not something I … didn’t seem wise to do. But I’m wondering if you have any guidance on that.
Pfau: Yeah. The resource I talk about in Retirement Planning Guidebook, it’s through the Society of Actuaries and the American Academy of Actuaries. It’s Longevity Illustrator. So it’s just all one word on the URL. It’s https://longevityillustrator.org. It doesn’t have a detailed questionnaire. You simply, for one or two people, you put age, gender, do you smoke or not? And then you self-assess your health as good, average, or poor. And then it will give you distributions of longevity, like what’s the life expectancy, but what’s the age if you think you want to plan to the 25th percentile or 75th percentile of your longevity age is for the 90th percentile of your longevity, and it doesn’t ask a lot of questions, and it actually gives you the results. It doesn’t ask for an email address. So that’s what I usually suggest people to use: a quick and dirty but effective way to get a pretty good idea about the distribution of your longevity based on the four questions—age, gender, smoking status, and basic health status, good, average, or poor.
Arnott: Another topic that’s been getting more discussion recently is underspending. And it seems like even for people with relatively high asset levels, if people have been good, consistent savers throughout their careers, they often have a hard time making that switch from saving to spending. What do you think is the best way to get people over that hurdle and feeling better about spending from their portfolios?
Pfau: Yeah. Yeah. There’s a couple things with that. The first is just there’s this old analogy or the parable of the ants and the grasshoppers where if you’re that ant who’s always been saving, it can be really hard to flip the switch and just spend more. And you may not really get that much more enjoyment out of spending anyway. So at some level, maybe that’s, you don’t have to fret too much about the underspending. This is what makes you happy and comfortable, and maybe you get more value from ensuring that your portfolio balance is not declining over time, but that certainly won’t describe everyone.
For folks who are looking to spend more, a couple ideas there: Something with the retirement-income styles research that we did, we found that the two primary concerns people have for their retirement finances, the one is just outliving their money. And that actually plays less of a role with what I’m going to talk about, but the other one is having liquidity to plan for unexpected expenses. And what we tend to see is the default in the consumer media is total returns, that you’ve been investing to save for retirement. You just keep that same investment portfolio postretirement, and you spend from it to meet your expenses.
But with that liquidity concern, I think people, they just see this big pot of assets, and they have trouble earmarking, “Well, how much of this can I spend? How much of this do I have to set aside for long-term care or other contingencies?” And so that just causes paralysis where they simply don’t feel comfortable spending it. A way to help with that is really, well, with the retirement-income styles, it’s not just what’s your retirement-income style? Are you someone who is more concerned about liquidity? But then working through a funded ratio about positioning your assets and matching your assets to different expenses so that it becomes easier to frame. “OK, this is my reliable income. I’ve got my essentials covered. Now with my diversified portfolio, I’ve got plenty of assets there. I’m going to be able to meet those discretionary expenses. I can actually earmark a portion of that as reserve assets and still be fine. Still be comfortable to meet my expenses in retirement.” And by being able to mentally say these assets are reserves for unexpected contingencies, I think that can help a lot of people to feel more comfortable spending the other assets because now they’ve really earmarked different assets for different purposes rather than having to think about just having one big pot of assets to draw from for whatever comes up.
And that’s having a true liquidity mindset fits into that where even though a brokerage account is liquid, it’s not truly liquid if you have to earmark it to meet your future spending goal. And so just helping people to work through which assets are earmarked for other goals and which assets are available for other needs. I think that’s one of the biggest ways you could help people to feel more comfortable with their spending. And it might just suggest they’re using a total-return style, but maybe there is a different style that was more appropriate for them.
Benz: When it comes to spending portfolio income, we’ve definitely noticed that retirees tend to favor spending organically generated income. They love dividends, and they don’t want to sell their winners to raise cash. That seems unappealing to a lot of self-directed investors who I’ve encountered. So is it reasonable for advisors to build portfolios that do tilt a little bit more toward income production? Especially now, as you said at the outset of the conversation, that certainly fixed-income yields are a lot higher than they were five or so years ago.
Pfau: Well, if you can live off the income from a globally diversified total-returns portfolio, that fits into the total-returns approach. The question is just more, if I hold a globally diversified portfolio and it’s not generating enough income, do I then want to tilt more toward higher-yielding sectors of the bond market and/or higher dividend-yielding sectors of the stock market to generate more income sources? We don’t strictly view that as one of the viable retirement-income strategies because it’s just a matter of it’s less tax-efficient, and it’s potentially riskier whenever you’re tilting away from the global market portfolio into certain higher-yielding sectors of the marketplace. So it’s not one of the broad retirement-income styles. But that being said, this does become more of a behavioral type of argument where, I know it’s popular in the broader public, like if you look in online discussion boards and things, people will say, “This 4% rule is ridiculous because I can build a portfolio of dividend-paying stocks that are paying out yields at six or 7%.” Again, that may not outperform a total-return investing approach, but behaviorally, if that makes you comfortable, I don’t have any objection against people doing something like that. It’s just you got to be clear that it’s not a better way to invest than a total-returns investing approach, but if it helps you sleep at night and you’re willing to accept potential underperformance, I don’t have a big objection to people investing for income in that way.
Arnott: Another perennial question that comes up as people are starting to think about retirement is whether to pay off a mortgage. And if you are fortunate enough to have a relatively low interest rate on your mortgage, it may not necessarily be beneficial from strictly a math perspective to pay off your mortgage early, but it seems like a lot of people do derive a lot of peace of mind by heading into retirement without that debt overhang. How would you think about a question like that?
Pfau: Yeah, this is definitely another kind of behavioral type of question where if you feel a lot better having the mortgage paid off, even though strictly mathematically speaking, you could invest at a higher yield than the mortgage rate, go ahead and do what makes you feel comfortable. And I know these days, some people may still, if they got the mortgage timed at the right point from the past 10 or so years, they may have mortgage rates less than 3%. And these days it’s almost easy to find like Treasury bills and things that’ll yield more than that. So you might have that spread by keeping the mortgage and just investing in safe assets, but that’s going to be where it’s harder. If it’s that easy to outperform the mortgage yield, it’s tougher to pay off the mortgage, although this may be small dollars in the grand schemes of things. And ultimately, I don’t have any issue. Certainly, in terms of my own behavioral type situation, I felt a lot more comfortable not having a mortgage. And even though I probably could have earned more on the investments than what the mortgage rate was, I felt more comfortable just having that mortgage paid off. And so I can understand, especially going into retirement, we’re not wanting to have those fixed mortgage payments as an ongoing obligation. People can feel a lot more comfortable just not having the mortgage there. So absolutely—it mathematically may not be the best option, but behaviorally it might help people feel a lot more satisfied with their plan.
Benz: You recently co-authored a paper with Michael Finke and David Blanchett, both of whom we’ve mentioned throughout this conversation about what you call the retirement risk zone. And it sounds like it’s the 10 years surrounding someone’s retirement date—before retirement and then just after retirement. Can you talk about why that is such a dangerous time, and what preretirees can do to defend against it?
Pfau: Yeah. So it’s lifetime sequence-of-returns risks. The sequence-of-returns risk idea comes up in the retirement context with the idea that, if you’re trying to meet a fixed spending goal in retirement, if there’s a market downturn early in retirement, that can dig a hole for your portfolio in a way that a market downturn later in retirement may have very little impact because you’ve already kind of figured out by that point whether you can spend a lot or a little. And that exists preretirement as well. So when people are saving for retirement, there is sequence risk. If I just invest money in year one and leave it alone for the next 30 to 60 years, there’s no sequence risk. I’d always have the same balance at the end.
But whenever there’s cash flows, there is sequence risk. So if I’m saving a percentage of my salary for the next 30 years, market returns early on have very little impact because I haven’t saved anything yet, but by those final years before retirement, those market returns impact all my years of contributions. And so the market returns in the years just before I retire matter quite a bit and, arguably, depending on how you frame the problem, just as much or more than the market returns in those early years after retirement. So you get this zone where, in the years before retirement and the years after retirement, if you experience a market downturn at that point, that can really disrupt your retirement plan. If you just think about the logic of like, well, if you assume a 7% rate of return every 10 years, your wealth doubles, well, that means when you’re 10 years before retirement, if you’re assuming that, you’re only halfway to your retirement goal and you’re really vulnerable to what specifically is going to happen in those 10 years leading up to retirement.
So you do get that sort of sequence-of-returns risk, both in the preretirement phase and the postretirement phase. And so in terms of what people can do about that, well, part of that is just the whole idea of target-date funds, the idea that you start to take some of that risk off the table as you get closer to the target date, that can help manage the risk. And then in the context of retirement-income styles, part of the idea, too, is in the five to 10 years before you retire, if you have a different retirement-income style, so if you’re time-segmentation, it’s, instead of continuing to invest in bond funds, I’m going to start layering in, say, 10 years before retirement, I’ll buy a 10-year bond, then one year later, I’ll buy another 10-year bond, and then I’ll get to retirement with the next 10 years of income in place, that can be a powerful way to manage the risk.
And then if you’re instead more of a income-protection or risk-wrap style, it’s allocating some of those bonds to annuities with lifetime-income protections to take that risk off the table for those assets. It’s about transitioning, really, your bond holdings into something better designed for your retirement-income portfolio in those years leading up to retirement. I think that’s the most powerful way to manage the sequence risk, to take risk off the table when you’re the most vulnerable to market volatility having a negative impact on your financial plan.
Arnott: You’ve also done a lot of research on an equity glide path that actually increases during retirement after you’re out of that danger zone five years after retirement. How would a system like that work in practice?
Pfau: Yeah. That rising equity glide path idea, that was research I did with Michael Kitces, and with that, that could be a total-return implementation of the idea of taking some of the risk off the table. So with target-date funds, you become less aggressive as you get closer to retirement. And the issue with target-date funds is: It would be rare to find a target-date fund that’s at least 50% stocks at the target date, but there’s a whole parallel research with the work Bill Bengen did on the 4% rule. His 1994 original article said retirees should be as close to 75% stocks as possible and in no circumstances less than 50% stocks. And that result holds up whenever you look at data either in Monte Carlo simulations or historical data, it usually calls for aggressive asset allocations, but that exists in a separate world from what target-date funds are doing. And with target-date funds, it’s usually you get a low stock allocation at retirement and then you either keep it low or you continue to make it even lower.
And so what Michael Kitces and I were looking at was, just as a risk management technique, really what you can be doing post target date is working your way back up. And so as a case study in our research, we looked at, well, instead of holding a 60/40 portfolio throughout retirement, using that kind of logic of the 4% rule idea, what if you started at 30% stocks, but then worked your way back up to 60% stocks over time? And that worked as a risk management technique that helped reduce the vulnerability to what’s really the worst … Well, the true worst-case scenario in retirement is you get bad market returns for like the next 30 years. You can’t really plan for that. The more practical worst-case scenario in retirement is you get a market downturn in the early retirement years but eventually markets recover, and so using a rising equity glide path helps manage the risk around a market downturn early retirement with then subsequently markets recover.
And so we hear from folks, it resonates with some people, but it doesn’t resonate with others. I don’t really push it as this is something anyone in particular should be using, but if it resonates with you, yeah, the evidence is in favor of, it works as a risk management strategy in retirement, and it’s something for the total-returns investor who’s actually changing the stock allocation in their portfolio every year. But the original genesis of this was naturally if you have like Social Security or if you have annuities or if you have a pension, if you look at the present value of those assets as part of your bond holdings, then as you age, the present value of your pension or annuity sources or Social Security declines with age and, therefore, from a total household perspective, you might have a rising equity glide path even if you’re not changing the stock allocation of your investment portfolio. If you treat the present value of your fixed-income payments as part of your bond holdings, you naturally get a rising equity glide path in retirement.
So in that regard, a lot of people, anyone who has Social Security and keeps a fixed stock allocation in their portfolio in retirement, as long as their portfolio is not declining too quickly, which is rare for people using conservative spending strategies, you might have a rising equity glide path without even really recognizing it. The issue is you specifically want to use a rising equity glide path by changing your stock allocation every year, and that’s where, yeah, it can work as a risk management strategy, but if that sounds like a terrible idea, don’t do it. It’s not necessary. It’s just an option out there to help manage sequence-of-returns risk in retirement.
Benz: Yeah. Sticking with sequence-of-returns risk, I wanted to ask about people who have taken to heart the advice to delay Social Security in order to enlarge their eventual benefit. Can you talk about the risks for them? If a bad market environment happens to materialize and they haven’t purchased any other guaranteed income, they haven’t sunk money into an annuity, and so they’re taking larger withdrawals from their portfolio in those early years of retirement, and that portfolio is simultaneously declining. Can you talk about the risk for people who are thinking about a strategy like that?
Pfau: Yeah. I walked through a case study about this in the Retirement Planning Guidebook, the chapter on social security, because it is a really important point. If you’re 62 and retired and you decide to delay Social Security to 70, you have to take a bigger distribution for the next eight years with the idea that you can then take a smaller distribution after that. And if you’re taking that distribution from your total-return investing portfolio, that absolutely increases your sequence-of-returns risk.
But this is not an argument against delaying Social Security. This is where you need to use a Social Security delay bridge. You need to build something so that you can replace that missing Social Security benefit with some sort of resource that’s not exposed to the market volatility, so that you don’t increase your sequence-of-returns risk. And I walked through a case study about, you could carve out an eight-year TIPS ladder where you have inflation-protected bonds to cover your missing age 70 Social Security benefit for the next eight years, carve that out of your portfolio entirely and, because the delay credits from Social Security are so powerful, you now have 77% more inflation-adjusted spending from your TIPS ladder and Social Security and, to meet your additional expenses on top of that, you can use a lower withdrawal rate from the remaining investment portfolio outside of what you carved out. You actually can lower the withdrawal rate, and with the whole discussion about safe withdrawal rates in retirement, being able to meet your spending goal with more reliable inflation-adjusted lifetime income and with using a lower withdrawal rate for the discretionary piece, that reduces risk for the financial plan. That puts you on a course for a stronger, either more legacy at the end of retirement, or you could spend more throughout retirement, or you just have a lower risk of depleting your asset base in retirement with more reliable income if you do deplete your asset base in retirement. So you build a Social Security delay bridge if you’re delaying Social Security, you don’t leave that exposed to the market. I talked about carving out a TIPS slider to do that.
There are other options, too. Just if you are doing part-time work, that could be an option. Reverse mortgages is an interesting potential way to build a Social Security delay bridge through the value of your housing wealth. You could get a period-certain annuity that just pays for those eight years if you’re delaying from 62 to 70. There’s a lot of different options out there, but it is very important that you build a Social Security delay bridge if you’re retired already and are delaying your Social Security benefits.
Benz: I did want to ask a few more questions about annuities, and one comes from Kerry Pechter at Retirement Income Journal. He’s been doing some great pieces on the role of private credit as an underlying investment in some fixed index annuities. It gets pretty complicated pretty quickly, but the main point I think is that the risks may be looming in some of these annuity portfolios. Wondering if that’s an issue that you’ve looked at.
Pfau: Well, I’ve not looked at that in-depth, but that’s definitely a concern, and Kerry Pechter is doing some great work in that area. It does make me nervous. There has been this trend toward like private equity firms purchasing insurance companies. And, yeah, that makes me nervous. There’s still a lot of great mutual companies out there that have been around for the past 150 years and that still, as a mutual company, they’re owned by their policyholders. They’re not owned by external shareholders or, in some of these cases, now private equity firms. And so I would put more emphasis on looking at the mutual companies that are out there. Sometimes with these fixed annuities, they are meant as more of a short-term play rather than using them for lifetime income, the multiyear guaranteed annuities or the fixed index annuities. Then maybe you can get away with some of these privately held firms. But if you’re thinking about for lifetime income, yeah, it would make me especially nervous going down the route of working with a company that was moving too far in the direction of having this kind of private equity backing.
Benz: A question about due diligence comes up a lot, like how do you research properly these various annuity products, especially the more opaque, complicated types? I think it’s an issue for advisors and certainly for DIY-type individual investors. Are there any resources that you would recommend? It sometimes strikes me that the people who are best versed in the features of these products are the ones selling them, which is unfortunate for consumers.
Pfau: I wish there was something I could suggest in terms of having an external third-party source that evaluates the different annuities. I’m not aware of anything like that. I explain how the different annuities work in my books, but yeah, every contract’s different. And unfortunately, it’s almost like the marketing departments of insurance companies are working on designing new features to make things more complicated. And then it’s not always clear exactly how the annuity works. So if you’re trying to do due diligence, a lot of these deferred annuities with living benefits are going to put an emphasis on growth opportunities and upside potential.
And before you even start thinking about that, just understand: What does the annuity do if there’s never market growth, so that if you’re not seeing step-ups to higher lifetime income and so forth, and compare the annuities based on what they do in kind of the worst-case market scenario. And then once you’ve done that, you can try to assess the upside growth potential of the annuity, but that’s where it may get really complicated, especially as all these proprietary indices are being created or just different features that it’s really unclear how everything interacts. It’s definitely a challenge, and at the end of the day, it could be hard to make really in-depth comparisons. I guess another thing, too, is focusing more on the annuities that are using broad market indices. The S&P 500, at this point, because there’s so much competition with that index, there should be more potential value to the end user versus a proprietary index that only one company may offer and it becomes really opaque about what exactly that index is doing. So, sticking to the broader market indices, understanding what the annuity does in the worst-case scenario, and trying to make comparisons more along those lines would be really just where I would suggest starting with the due diligence.
Benz: You obviously have several/many years until retirement, but I’m sure being so steeped in research on retirement planning has influenced your own views, maybe changed your views about how you’ll approach retirement. Can you share how your thinking has changed and evolved about your own retirement plan as you’ve delved into this area?
Pfau: From that perspective, I got into retirement planning just with my interest, personally, how to do all of these things. And I did come more from the investment side of the world with … I actually got into learning about all this when I was studying for the CFA examination. And so just developing, I’d say the biggest change for me was just developing a broader appreciation that risk changes in retirement with that longevity risk, with the sequence-of-returns risk, with the different spending shocks. It really requires thinking about retirement differently than how you think about the preretirement phase. And therefore, tools that in isolation can look expensive, when you fit them into a broader retirement plan can potentially add value, whether that’s like a reverse mortgage or an annuity. So I think I’ve really just become more open about … There’s a lot of different ways you could get it right, and that means being open to different types of financial products that you wouldn’t necessarily really think about in a purely accumulation mindset, but that can really aid in a distribution framework. And so that’s probably the biggest change for me, is being more open to a different variety of retirement-income tools.
Benz: Well, Wade, I hope you continue to delve into this area for many years to come. I think Amy and I could talk to you all day about these topics. Thank you so much for taking time out of your schedule to be with us.
Pfau: Oh, absolutely. Yeah. Thanks for having me on the show.
Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts. You can follow me on social media at Christine Benz on LinkedIn or at @christine_benz on X.
Arnott: And at Amy Arnott on LinkedIn.
Benz: George Castady is our engineer for the podcast. Jessica Bebel produces the show notes each week, and Jennifer Gierat copyedits our transcripts. 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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