Economist Wade Pfau has been thinking about retirement since he was in his twenties. But not just his own retirement.
Pfau began studying Social Security for his thesis while earning his doctorate. at Princeton University in the early 2000s. At the time, Republicans wanted to divert some of the Social Security payroll tax to a 401(k)-style savings plan. Pfau concluded that it could provide sufficient retirement income for retirees, but only if the markets cooperated.
Today, Pfau is a professor of retirement income at the American College of Financial Services, a private college that trains finance professionals. His most recent book, “Retirement Planning Guidebook,” was published in September.
While many retirees are betting on a continued rise in equities to keep their portfolios growing, Pfau fears the markets will plunge and jeopardize this “overoptimistic” approach. He’s embraced often-criticized insurance products like variable annuities and whole life insurance that will hold their value even if stocks crash, and he’s done advisory work for insurers. He wrote another book, “Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement,” because these loans can also be used as “buffer assets” during market crashes.
Pfau, 44, is already having fun with spreadsheets to analyze his own retirement plan. He recently built a model to determine when it’s best to convert money from tax-deferred accounts to tax-free Roth accounts, in part because he wanted the answer for his own retirement accounts. We joined Pfau at his home north of Dallas. An edited version of our conversation follows:
Barrons: The 4% rule states that a retiree can safely withdraw this percentage each year from a portfolio, adjusted for inflation. Why don’t you think this will work?
Phew: It’s not that I don’t think it will work. I think there’s something like a 65-70% chance that the 4% rule will work for retirees today rather than being a virtual certainty.
It’s a debate. Do you just stick to historical data, or do you make the adjustment to say, “Wait a second. With low interest rates, you can’t have as high a bond yield as we’ve had historically, and maybe you can’t predict as high a stock yield as we’ve had historically either? »?
What percentage can people safely withdraw?
I think 3% would be much more realistic in terms of giving the same chance of success that we usually think of with the 4% rule.
Will people still have enough money to retire with a lower withdrawal rate?
One of the unrealistic assumptions of the 4% rule is that you have no flexibility to adjust your spending over time. Someone could start their retirement with a withdrawal rate of 4% if they are ready to reduce their expenses somewhat if we find themselves in an unfavorable market environment.
Nothing else?
People have to be smart in their Social Security claim decisions. It is acceptable to spend short-term investment assets so that you can delay Social Security benefits until age 70, at least for a high-income married couple. The boost you get from Social Security benefits in the meantime will really reduce the need to take distributions from investments after age 70.
People might also be looking for ways to use their home equity to fund retirement expenses, whether that means downsizing the home or considering getting a line of credit through of a reverse mortgage.
Isn’t that exploiting home equity to avoid selling shares that double on a losing bet?
Using a buffer-based strategy, such as home equity, accepts the idea that, over long periods of time, the stock market will behave at a reasonable level. If there is no market recovery, it will be all the more difficult to have a sustainable retirement strategy.
Why are the first years of retirement the most dangerous?
This is the idea of return sequence risk. I have estimated that if someone is planning a 30 year retirement, the market returns they experience in the first 10 years can explain 80% of the retirement outcome. If you get a market downturn early on and the markets recover later, it doesn’t help much when you spend from this portfolio because you have less left to benefit from the later market rally.
What is the solution ?
There are four ways to manage the risk associated with the sequence of returns. First, spend wisely. Second, spend flexibly. If you can reduce your expenses after a market downturn, this can manage the return streak risk because you don’t have to sell as many shares to meet the expense requirement. A third option is to be strategic about the volatility of your portfolio, even using the idea of an upward stock trajectory. The fourth option is to use buffer assets such as cash, a reverse mortgage, or a cash value whole life insurance policy.
What is an upward equity trajectory?
Start with a lower equity allocation at the start of retirement, then work your way up. Later in retirement, market volatility doesn’t impact the sustainability of your spending trajectory as much, and you can adjust by having a higher equity allocation later.
Why do annuities make sense when interest rates and annuity payments are low?
Well, because low interest rates impact all strategies. But the impact of low rates on annuities is less than the impact on a bond portfolio.
Most income annuities are not indexed to inflation.
An income annuity will not be the source of inflation protection in the retirement strategy. This will have to come from the investment side. But the annuity will allow a lower withdrawal rate from your investment portfolio early on to mitigate the sequence risk. Most retirees naturally spend less as they age, and they may not need inflation protection
Medical costs increase with age.
Okay, that’s the only compensating factor. Medical spending is rising but everything else tends to fall at a rate fast enough that overall spending continues to fall until very late in life when people may need to pay more for care at home or in a retirement home or other type of long-term care. Needs.
Is long term care insurance a good idea?
When I look at traditional long term care insurance, I struggle a bit because you typically use insurance for low probability, high cost events. And the problem with long-term care is that it’s a high-probability, high-cost event.
There are other hybrid approaches where you can combine long-term care insurance with life insurance or an annuity, and that’s where most new business is going, and it has some potential.
How is your own money invested?
At my age level, I’m still mostly into stocks.
Do you have annuities?
I’m interested in variable annuities with living benefits, but I’m still too young. Usually we don’t talk about getting annuities until you are in your mid to late 50s.
Variable annuities have a bad reputation. Do you think it’s undeserved?
For the most part undeserved. They have a bad reputation because they have high fees, and I’m thinking about retirement, not so much the trail of fees, but how much assets you need to feel comfortable in it. thought of retiring. Variable annuities mean that you think the markets will outperform, but you also don’t want to stake your entire retirement in the market, so you want a sort of safety net.
You have been a promoter of products sold by insurers, such as annuities, and you have done consulting work for insurers. How can we be sure that your search is not in conflict?
Whenever I do some kind of research paper, I completely describe the methodology to give people a complete understanding. Nothing is in a black box. The hypotheses are all listed, and if people want to try different hypotheses, they can.
If I conclude that annuities can be useful, I try to give the benefit of the doubt in my assumptions not to use annuities and I always find a strong argument in favor of annuities.
Social security is more generous than pensions. Shouldn’t people maximize it before buying an annuity?
Yes. Insurance companies have to live in the real world, so when interest rates are low, it has an impact on annuities. Indeed, if you think about annuities, the first step is that at least a high-income couple should defer Social Security until age 70. And then if you want more annuity protection beyond that, fine. It generally wouldn’t make sense to claim Social Security earlier and then buy a commercial annuity at the same time.
Does it sometimes feel strange to be focused on an event that won’t happen to you for a few decades?
For the most part, no. It only happens when someone asks me why this kid is telling me how to retire.
For me, it’s not so much retirement as tracking the ability to be financially independent. It’s always relevant for me to think about when I might be able to retire, even if I’m not necessarily ready. I have a personal interest in it.
A personal interest in what?
Playing with spreadsheets and analyzing my own retirement plan. This is what primarily prompted me to do this research on tax planning so that I could specifically incorporate loss conversion strategies into my own planning.
Thanks Wade.
Barron’s Retirement Q&A Series
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