Jason Parker interviews Wade Pfau, Ph.D., CFA about the safe amount to spend in retirement.
Wade D. Pfau, PhD, CFA, is a Professor of Retirement Income in the new PhD program for Financial and Retirement Planning at The American College in Bryn Mawr, PA. He is a past selectee for the InvestmentNews Power 20 for people expected to shape the financial advisory industry, and is a recipient of Financial Planning magazine’s Influencer Awards. His research article on “safe savings rates” won the inaugural Journal of Financial Planning Montgomery-Warschauer Editor’s Award, and his work on evaluating the outcomes of different retirement income strategies received an Academic Thought Leadership Award from the Retirement Income Industry Association. He has also served as a past curriculum director for that organization’s Retirement Management Analyst (RMA) designation program, and he has contributed to the curriculum of The American College’s Retirement Income Certified Professional (RICP) designation. He holds a doctorate in economics from Princeton University, and he has published research on retirement planning in a wide variety of academic and practitioner research journals. He is also an active blogger on retirement research, maintains the educational Retirement Research website, and is a monthly columnist for Advisor Perspectives, a RetireMentor for MarketWatch, and an Expert Panelist for the Wall Street Journal. His research has been discussed in outlets including the print editions of The Economist, Wall Street Journal, Money Magazine, and SmartMoney.
See his Google + profile for contact information.
Below is the full transcript:
Announcer: Welcome back, America, to Sound Retirement Radio, where we bring you concepts, ideas, and strategies designed to help you achieve clarify, confidence, and freedom as you prepare for and transition through retirement. And now, here is your host, Jason Parker.
Jason Parker: America! Welcome back to another round of Sound Retirement Radio. I sure appreciate you making this your resource for expert resource advice. Today we’re going to be talking about how much money is it safe to pull out of your investment portfolio to be able to sustain you throughout retirement. We’ve got an expert guest I’m going to be bringing on to the show, so I’m excited to introduce him. Before we get started, though, I like to start with something to renew our minds. I’ve got a verse here. This comes from Matthew, Chapter 8, versus 2 and 3:
Suddenly, a man with leprosy approached him and knelt before him. “Lord,” the man said. “If you are willing, you can heal me and make me clean.” Jesus reached out and touched him. “I am willing,” he said. “Be healed,” and instantly, the leprosy disappeared.
Then, of course, we always like to have a joke that you can share with your grandkids. Did you hear the two guys that stole a calendar? They each got six months. These are bad jokes, but thank you so much for tuning in guys. We’re going to get started here with the program. We want to talk about how much money is safe for you to be pulling out of your retirement plan. This is episode 065.
Let me do a quick introduction of our guest then we’ll bring him on and pick his brain, and getting you really good information here. Wade PfauWade Pfau, Ph.D., CFA, if a Professor of Retirement Income in the Ph.D. program for financial and retirement planning at The American College in Bryn Mawr, Pennsylvanian. He also serves as a principal and director for Mclean Asset Management, helping to build retirement income solutions for clients. He holds a doctorate in economics from Princeton University and publishes frequently in a wide variety of academic and practitioner research journals on topics related to retirement income. He hosts the Retirement Researcher website, and is a monthly columnist for Advisor Perspectives, a retire mentor for Market Watch, a contributor to Forbes, and an expert panelist for the Wall Street Journal. His research has been discussed in outlets including the print editions of The Economist, The New York Times, Wall Street Journal, and Money magazine. Wade, welcome to Sound Retirement Radio.
Dr. Wade Pfau: Thanks, Jonathan. It’s a pleasure to be here.
Jason Parker: Tell us about this title of yours, Professor of Retirement Income. What exactly is does that mean?
Dr. Wade Pfau: As far as I know, it’s a unique job title, but retirement income has now really emerged as a distinct field in the area of financial planning. It’s been in the last few years that people realized that the traditional approach to saving for retirement and accumulating assets. A lot of things change when someone transitions from saving and working into retirement, and having to determine how to spend down the assets for the rest of their life. This retirement income planning is a new field, and that’s my focus at The American College.
Jason Parker: This is a really important topic. Sound Retirement Radio is all about bringing experts onto the program to help make people’s lives better, so that they have a greater sense of confidence as they’re preparing for retirement. In the research that you’ve done, Wade … There is a lot of controversy out there about how much people can safely pull out of that pile of accumulation, that pile of money that they’ve accumulated for retirement without risking running out of money in retirement. What’s your research show? What’s a safe amount?
Dr. Wade Pfau: The whole discussion about how much you can spend in retirement got started with some research by William Bengen in the 1990’s. He developed what’s been known as the 4% rule, which is that you can take out 4% of your portfolio at retirement, and adjust that amount for inflation in each subsequent year and not run out of money for 30 years. Where I’ve entered into that research area is with a concern that in the current low interest rate environment, we’re really in a unprecedented situation where that traditional 4% rule that’s based on what is the worst case scenario in the U.S. historical record so far, that somebody retiring in 1966 with a 50/50 portfolio of stocks and bonds, could only have spent sustainable at an initial 4% withdrawal rate. That’s where a lot of folks would say, “Yeah, that’s the worst case scenario in history.” It’s really hard to imagine anything worse happening in the future. What the situation now is, we have interest rates at historic lows. There was only really a couple years in the early 1940s where interest rates were at such low levels. That’s one side. At the same time, the stock market …
Robert Shiller who is a Yale University professor, talks about the cyclically adjusted price turning ratios. Research has shown that has a pretty clear link to how much you can spend sustainably in retirement because it has a link to stock turns. When stock markets are over-valued, stock returns tend to be lower in the future. And vice-versa, when the market valuations are low, stock returns tend to be higher. We are at a situation today, and really since the late 1990s, where the stock valuations are quite high, at levels only experienced in the past in the lead up to the Great Depression in 1929. It’s not to say that something like the 4% rule won’t work, but with this low interest rate environment, and the high stock market valuation environment, I do have concerns, and if pressed to state some number, I would say that 3% is much closer to being a sustainable spending rate in this current environment than a 4% withdrawal rate.
Jason Parker: Wow, 3%. That’s a significant decrease in what people might be able to sustainably withdraw, and then there’s no guarantee that that’s going to work. That’s just a hope, that is. With the CAPE ratio, the cyclically adjusted price-to- earnings, I wanted to ask you about that. I know that you’ve written some articles. I’ve read some of your articles on this. Folks, again, you can find a lot of Wade’s research at retirementresearcher.com if you’re interested in some of the topics we’re talking about. We’ll include show notes on the episode. This is episode 065 at soundretirementplanning.com.
Regarding the cyclically adjusted price-to-earnings ratio, is that still a relevant measure for determining whether fundamentally the stock market is fairly priced, given the amount of quantitative easing, and given these extreme emergency measures where the feds has pumped so much money into the market, reduced the interest rates down to zero, that people have had to move money out of banks, CD’s, and save money places, just to try to earn a better rate of return? Should we expect that the median cyclically adjusted price-to-earnings ratio of 16 should be higher going forward, just as a result of all this financial manipulation we’ve seen take place?
Dr. Wade Pfau: Yes, that’s a great question, Jason. And I apologize. I had a professor named Jonathan Parker, so I think I accidentally called you Jonathan at the beginning. I’m sorry about that.
Jason Parker: That’s all right.
Dr. Wade Pfau: Yeah. There is a lot of debate about that issue. I think the stock markets had a lot of volatility lately, but CAPE ratio has been in the neighborhood of 25-26 in recent months, 16 is on average. There is a lot of debate and discussion about whether 16 is the appropriate average to think about returning to. You give a valid reason why we could justify higher valuation level. With interest rates so low, there is a lot pressure to seek higher earning assets, and that could sustain a higher CAPE ratio than 16. There’s a lot of different types of arguments that can be made. I’ve seen discussions about how as accounting standards have changed and the way that earnings are calculated has changed, that could justify a higher CAPE ratio. As well, William Bernstein, who writes a number of books, he had a interesting idea about … He called it the Paradox of Wealth, which is as societies become wealthy the returns on their capital, the returns on their investment tend to fall. That could justify, rather than having that flat 16 average CAPE ratio. It could justifiably be trending upwards, so that we may not necessarily have to get back down to 16 to be considered average. It may be a higher number. I think however you look at that, CAPE is relatively highly valued at this point in time.
There is so much discussion about this. I don’t put too much weight on this particular point. I still think this for retirees entering into retirement it’s important to lean toward being conservative with your assumptions about future market returns. CAPE is highly valued. You definitely don’t want to be assuming we’re going to have higher than average stock market returns in the future. I think it would be wise to lean to the lower side rather than the average.
Jason Parker: When it comes to the other side of that equation, you talked about the fact that interest rates are just so darn low. I was just looking yesterday and I think the 10 year treasury was just a little over 2%. In the low interest rate environment, you’ve written an article recently that some people would argue is pretty controversial. It had to do with why retirees should not own bond funds as they prepare for retirement. You want to talk a little bit about that research and that article you wrote?
Dr. Wade Pfau: Sure. The issue there is how retirement income planning is so different from pre-retirement wealth accumulation. One of the major risks of retirement is known as longevity risk. This is just the idea that people don’t know how long they’re going to live. We know on average with statistics, what is the life expectancy of 65 year olds. For example, could have life expectancy of 20 years. But, whether they end up living 5 years, 10 years, 20 years, 30 years, or 40 years, it’s just unknowable in advance how long someone’s going to live. That’s where the issue with … my concerns about mutual funds or bonds, or bond funds in particular. I have that concern.
Alternative to think about are either just holding individual bonds to maturity, or using an income annuity, or some other type of annuity which provides that guaranteed income for life. On the annuity side in particular, the concern is you don’t know how long you’re going to live. To manage that risk on your own, which is something the 4% rule is trying to do, you have to assume you’re going to live a long time, well beyond life expectancy, so that you may plan for 30 or 40 years. If you’re trying to spend from a bond fund over 30 or 40 years, especially with low interest rates, that’s a very low level of spending.
An income annuity, though, is also basically invested in bonds, but it’s pulling that longevity rate. It’s a large number of people, so that those who end up having shorter retirements, some of their premiums will subsidize those who have longer retirements. That means they can pay out based on someone living to their life expectancy. For example, spreading those assets over 20 years rather than having to spread those assets out over 30 or 40 years. That means, in a sense, the people who live longer win at the expense of people who had shorter retirements. But, nonetheless, everyone can spend more throughout their retirement because they’re in this position where they’re spending their assets out over their life expectancy rather than over some advanced age that they may or may not live to.
That’s the basic story. Traditionally, we think of bond funds as a way to mute some of the volatility in an investment portfolio. But, it’s important for listeners to realize that bond funds can have loses. When interest rates go up, there’s capital losses on those bond funds. If you’re in retirement and are having to sell off shares of your bond funds at a loss, that’s the kind of event that triggers this additional market risk that … Investment risks amplifies for retirees because pre-retirement … When you’re putting new money and new savings, the idea of dollar-cost averaging, if the market declines, you get to buy more shares. That can be helpful in the long run. That reverses in retirement. If the market declines you have to sell more share to get the same income. That can really sink a hole for the portfolio.
Bond funds are exposed to that type of risk as well. That market risk is avoided if you hold individual bonds to maturity. If you go even beyond that and look at income annuity, you’re also avoiding that market risk as well as the longevity risk.
Jason Parker: Wade, I want to ask you. When it comes to portfolio construction, it seems like there’s a lot of information out there. A lot of people have opinions about this, but you still see today, a lot of people take what I would call more of a traditional approach to portfolio construction where they retire and they say, “Okay, we want 60% of our portfolio in bonds and 40% in stocks.” Maybe it’s vice-versa. Maybe it’s 60% stocks and 40% bonds. Some kind of ratio like that. Given the interest rate environment that we’re in, this zero interest rate environment, and a really high historical evaluation for the stock market, is that still the smartest way to construct a portfolio for most retirees?
Dr. Wade Pfau: Yes. If we’re talking specifically about retirees, I have concerns about that. Especially, we think of bonds as providing that reduction in the volatility, but when interest rates are low … If interest rates just always stay at the same level, then the return on those bond funds is going to be the same as today’s interest rates. If interest rates end up increasing, which I’m not predicting that will necessarily happen, although it does seem more likely to have future interest rates increases than decreases at this point in time. If that happens then there’s those loses, so you’re still getting losses with the bond funds.
I’ve not done a lot of research on the specific portfolio construction for retirees other than some work that I did with Michael Kitces who works for a financial firm in Maryland. It indicated that retirees should be thinking about in these lower interest rate environments, holding shorter term bonds rather than longer term bonds, because shorter term bonds are less exposed to the risks if interest rates increase. You have smaller loses on the shorter term bonds. When you’re talking about this, it’s not a sequence of return risks, but that’s what amplifies the investment risks for retirees. It’s not just the average investment return over a period of time, but the order that those returns happen. If you get poor returns early in retirement … That’s what I was describing before, where you’re in the position, you have to sell a bigger share. You have to sell more shares of your funds to fund the same income. Longer term bonds amplify that sort of risk as well. A better retiree with a traditional 60/40 stock/bond portfolio, or 40/60 stock/bond portfolio … They’re getting the volatility from their stocks, and with longer term bonds … especially they’re getting that volatility from their bonds as well.
Of course, this more of a theoretical abstraction that, at a purely theoretical level there is really no use for a bond fund in a retirement income portfolio.
Jason Parker: Okay.
Dr. Wade Pfau: Of course, on a practical level, people will want to include some bond funds, and that’s fine. I think that’s going to those pre-determined types of asset allocations. That’s not something that retirees should be using as a starting point. That’s important to think about how the risk for retirees differ from the pre-retirement period. That would tend to suggest or consider moving away from the same kind of bond funds that people generally use pre-retirement.
Jason Parker: I want to talk to you about annuities next, because that seems like a really controversial subject. It also seems like a tide has changed, maybe because of demographics and more people are transitioning into retirement and they want more safety, and more guarantees. Maybe it’s because of the low interest rate in the bond world. You see, there’s some people out there that write … You’ll see their advertisement that say, “I hate annuities and you should, too.” Help our listeners understand why an annuity can make sense for people as they’re preparing for and transitioning into retirement.
Dr. Wade Pfau: Those “I had annuity ads” show up in pretty much every magazine, especially magazines aimed towards retirees. Part of the issue there … There’s a lot of different kinds of annuities. What I’m talking about more specifically are income annuities which are the simplest kinds. The kind that has very small commissions built in. A lot of investment managers tend to dislike annuities in part because they tend to charge their clients based on the amount of assets they manage. Any asset that get annuitized leaves the investment portfolio, and reduce the fees available to that advisor.
The income annuity story … Academics love income annuities because you basically have two ways to manage this risk that you don’t know how long you’re going to live. With an investment portfolio, the way to manage that risk is to spend very conservatively. To plan a 65 year old maybe living to age 95 or 100, or to 105, there’s a low chance that that will happen. But nonetheless, you don’t want to outlive your assets, so you have to end up being very conservative. That’s not really an efficient way to approach the retirement income problem. It’s much more efficient to pull that risk together with a large group of individuals. I already explained the mechanism of how this works earlier. It’s just that no one knows how long they’re going to live, but if you’re willing to, in the unfortunate circumstance that your retirement is shorter, you’re willing to subsidize those who end up having those longer retirements. Then, everybody gets to spend like they’ll live to their life expectancy, rather than having to spend like they’ll live to age 100 or beyond. That’s a simple story about how an income annuity can really allow retirees to feel more comfortable spending more, and being less afraid to outliving their assets in retirement.
Jason Parker: Wade, should people be concerned? Because you said, “When you buy an annuity, the insurance companies are essentially buying bonds and they’re also pulling mortality risks.” In a rising interest rates environment, should people be concerned about the financial strength of insurance companies, given that they’re out there buying bonds?
Dr. Wade Pfau: Right. It’s very important to consider the financial strength of the insurance company. That’s the starting point. This is an area where you don’t necessarily want to just buy whatever annuity is offering the most income. You want to really investigate how strong is that company. At the same time, this is getting back to the issue of the difference between individual bonds and holding a bond fund. Those insurance companies are generally holding their bonds to their maturity dates, so they’re less exposed to having to sell bonds at a loss if interest rates increase. That makes a big difference in the matter. If a bond fund everyday has to value the underline bonds in it’s fund, because people may want to sell that bond fund on a particular date. If you’re holding an individual bond to maturity, it’s true that if interest rates go up, you have a capital loss on paper. If you didn’t sell the bond, you’d have to sell it at a loss. But, if you hold it to maturity, that loss will dissipate. As you get closer to maturity, you’ll get back the face value at the maturity date if you’re expecting. That’s generally what insurance companies are doing. That they’re less exposed to interest rate volatility, because they’re holding the bonds to maturity dates, and they’re not selling them at a loss when interest rates increase.
Jason Parker: Okay. I saw an article recently that talked about how mortality tables are going to be updated for annuity contracts in the near future. Some companies have already started to do this. Meaning, in the past they were using tables that were based in the year 2000 mortality rates. Now, people are living longer. Have you read any of this and what are your thoughts? Is now a good time to buy an annuity? Are they going to become more expensive in the future for people that are looking for guaranteed income?
Dr. Wade Pfau: Yeah. There are basically two important factors for determining how much income you get from annuity. What are the current interest rates, and then how long will that income be paid? There’s been this general trend throughout human history that people live longer and longer. As you are pointing out, the Society of Actuaries creates life tables that are commonly used by insurance companies to price their annuities. They did an update … They had a table in 2000, and did a major update in 2014, where they were showing the 65 year olds were living an additional 2 years. That would mean annuity payout rates should decrease, but because people are going to live longer. They have to spread those assets over a longer period of time now. They have to pay less at that point.
The insurance companies do tend to be a bit slow in updating the tables they use. This may be in part because these income annuities I’m talking about are a very part of the business for insurance companies. A couple years ago, the most recently … I can find these numbers. Income annuities are only about 4% of total annuity sales, in terms of the amount sold. Not the number of contracts, but the monetary value. They don’t necessarily … I’ve talked to a lot of actuaries at insurance companies. I heard one story that they basically assign the project of pricing their income annuities to an intern. It’s just a very small part of their business, and not a big deal, so they’ve been slow in updating. The implication of that would be …
Jason Parker: Wade, I just realized … I hate to cut you off, but we’re out of time. I just want to thank you for being a guest on Sound Retirement Radio here today.
Dr. Wade Pfau: Okay, my pleasure.
Jason Parker: For those of you tuning in, you’re listening to episode 065, Wade file. You can get the show notes at soundretirementplanning. Until next week, this is Jason Parker tuning out.
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Jason Parker: Wade, we’re back on for our Podcast listeners. It’s kind of an added bonus. Thank you again, for taking the time out of your busy schedule to be a guest here. You were just talking about … Help our listeners understand mortality credits. Is there a finite pool of mortality credits? As people buy annuities, does that diminish or does that increase the value of an annuity contract?
Dr. Wade Pfau: The more people that buy into it, that should help, because then you can … With a larger number of people you can better match to the overall statically table we have about life expectancy. More risk should help. There has been some discussion about … There’s two kinds of longevity risks. There’s what’s known as systematic longevity risks, and that’s about changes in life expectancy for the whole population. For example, if a cure for cancer is found, and then suddenly everybody is trending towards living longer than expected. That’s one kind of longevity risk. That’s the risk that the insurance companies still have to take.
The other kind of longevity risk that individuals are really able to get rid of effectively is what’s known as idiosyncratic longevity risk. It’s the individuals, even though we know what the overall … Ignoring the systematic longevity risk, we know what the statistical table say life expediencies are and how long different groups live, to what ages and so forth. That particular individual does know where they’re going to end up on that distribution. The insurance companies pull the idiosyncratic longevity risks. They’re still exposed to the systematic longevity risk, but they can offset that with their life insurance business.
Jason Parker: Wow.
Dr. Wade Pfau: Suddenly, if people are living longer, they have fewer payouts on the life insurance side, but more payouts on the annuity side. Some of that gets balanced, but that balance can fall away. If they have a lot more annuity sales and their life insurance sales are declining, then there is some loss of that potential to balance those two against each other.
Jason Parker: As you look out into the future, because right now, annuity contracts are generally not medically underwritten. The insurance companies are relying on this data set of average mortality for people. If somebody knows, they have their grandmother live to a 102, their parents are alive at 100, they’re in excellent health and 65 years old, couldn’t somebody kind of game the system a little bit here and say, “Hey, I know that unless I get hit by a bus, that my changes for longevity are pretty good based on my family history and my current health.” Do you think there’s going to become a time in the future when insurance companies require people to be medically underwritten for an annuity contract?
Dr. Wade Pfau: Yeah, I’ve heard discussion that could be something coming down the road at some point. It’s probably not that people would be denied the annuity contract, but they might get a lower price if their longevity looks a lot better. Already, occasionally you hear about an insurance company underwriting a contract for somebody who does have some sort of medical problem, and who can really expect that they’re not going to live as long as the average person. The insurance company might be willing to offer them a better than usual payout rate. In the other direction, this problem is called adverse selection by economists. The insurance company, of course, would like to sell annuities to people who would have shorter than the average life span. But, the actual customers they get are the people that live longer than average life spans, so they’re always working to make adjustments for that. That’s where the Society of Actuaries steps in. The longevity tables that they prepare are based on people who actually buy the annuities, which are different from the overall population. Their tables do assume that people are living longer than the average American would live, for the reason that you mentioned.
Jason Parker: Not only do you do a lot of research, and you teach on the subject, but you are out there in the real world, too, as principal and director for Mclean Asset Management. You’re helping real people solve this retirement, cash flow dilemma, this retirement income dilemma. What’s the most important thing that you wold want our listeners to take away from this program as they’re trying to construct this plan and plan for retirement themselves? What’s the most important thing you want them to take away from our time together today?
Dr. Wade Pfau: I think the most important thing is to just recognize that the nature of risk changes in retirement, but basic issue is that when someone’s retired, they have less risk capacity. Which means, they’re more vulnerable that if there’s a market decline, there’s a bigger chance that it’s going to impact their standard of living once they’re in retirement compared to pre-retirement. When they’re still working, when they still have labor income, they still have a chance to make some minor adjustments. They’re not as exposed to that amplified investment risk created by having to spend down from a declining portfolio, getting their power from a declining portfolio. It’s really the matter that, in retirement, people are more vulnerable to risks. That really calls for a different way of thinking about it.
A lot of the opposition to annuities and that sort of things that really stems from the wealth accumulation world where, over a long periods of time, stocks tend to outperform bonds. Most people would be better off investing more in stocks. In retirement, the sequence of returns risks means it’s not … If you have a 30 year retirement it’s not the market returns you get over the full 30 years that are going to make a difference. That next 5 or 10 years, the early part of retirement, will really either set you on a course to a very successful retirement or that could completely derail your retirement. You’re more exposed to risk in retirement, so think differently about it and look beyond. Don’t follow the same advice that you would follow when you’re saving for retirement, when you’ve actually entered into retirement.
Jason Parker: That’s great. Again, I really appreciate you taking time out of your busy schedule to be a guest on Sound Retirement Radio. Any parting thoughts to our listeners before we let you get back to work there?
Dr. Wade Pfau: No. It’s been a pleasure talking to you. A lot of great questions, to thanks for the good discussion.
Jason Parker: Great, thank you. Keep up the great work, Wade. We appreciate what you’re doing.
Dr. Wade Pfau: Thank you.
Jason Parker: Take care.