Jason interviews Wade Pfau.
Wade D. Pfau, Ph.D., CFA, is a Professor of Retirement Income in the Ph.D. program for Financial and Retirement Planning at The American College in Bryn Mawr, PA. He also serves as a Principal and Director for McLean Asset Management. 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 RetireMentor for MarketWatch, a contributor to Forbes, and an Expert Panelist for the Wall Street Journal. He recently authored his first book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement, which is available from Amazon.
Below is the full transcript:
Announcer: Welcome back, America, to Sound Retirement Radio, where we bring you content, ideas and strategies designed to help you achieve clarity, confidence and freedom as you prepare for and transition through retirement. Now, here is your host, Jason Parker.
Jason: Hey, America. Welcome back to another round of Sound Retirement Radio. I’m just sitting here before you guys tuned in, looking at the different jokes that I could select from the day. I’ve got one here for you. The first one is why do dragons sleep during the day? So they can fight nights. Nights. Anyways, I’m glad to have you back here at another round of Sounds Retirement Radio. This is episode 133. I have an amazing guest, Wade Pfau. We’re going to be bringing him on in just a minute, but as you know, I like to get the morning started right by renewing our mind. I have a verse here I’d like to share with you. This comes to us from I John 4:18 and it says, “There is no fear in love, but perfect love drives out fear, because fear has to do with punishment. The one who fears is not made perfect in love.”
I’m so grateful for being able to share those, because I think they speak to me oftentimes and they just seem very timely and important. Okay, so for our guest today, this episode 133, is retirement research, Wade Pfau. He was one of our past guests. He’s been one of the most downloaded episodes that we’ve done. Wade Pfau is a PhD, CFA. He’s a professor of retirement income in the PhD program for financial and retirement planning at The American College. He also serves as a principal and director for Mclean Asset Management.
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, retire mentor and market watch, a contributor to Forbes and an expert panelist for the Wall Street Journal. He recently authored his first book, Reverse Mortgages: how to use reverse mortgages to secure your retirement, which is available from Amazon. Wade, welcome back to Sound Retirement Radio.
Wade: Thanks, thanks. It’s a pleasure to be here.
Jason: I am really glad to have you back on. Like I say, the last interview that you and I did has been one of our most downloaded episodes, so kudo to you.
Wade: Oh, wow.
Jason: Yeah, that’s pretty cool. I want to actually start out talking about your new book. You do all this investigation, all this research into retirement and the first book that you write is about reverse mortgages, which can be a controversial topic, so will you just take a minute and explain to our listeners why you wrote a book about reverse mortgages and maybe tell us are you favor of them? Are you opposed to them? What are your thoughts on them?
Wade: Sure, well, I started looking at reverse mortgages about three years ago as just one of the tools in the toolkit for retirement income planning. With that job title I have [inaudible 00:03:10] professor of retirement income. I feel like I should know about all the different options out there. I probably shared this negative view that’s common, but a lot’s changed in the world of reverse mortgages. I was really at first writing about reverse mortgages to be a chapter in a longer book about retirement income planning. As I kept writing and writing and writing, I thought, “Well, this actually could be a book in and of itself.”
Basically, with the research about reverse mortgages, it’s going back to 2012, what’s been shown is that not to think about reverse mortgages as a last resort option when all else has failed, but really think about setting up the line of credit, the growing line of credit from a reverse mortgage early in retirement and having that as an additional resource to be used as part of a responsible retirement income plan that if used wisely and effectively can create better outcomes for retirees. It’s all part of a responsible retirement income plan and it’s a tool. We can talk about all the different uses, but there’s a lot of different ways to think about how fitting home equity into the retirement plan can make a better outcome.
Jason: Two thoughts there: number one is is it because that most or a lot of retirees today, most of their wealth is tied up in their home? Is that a reason that more people need to be considering the reverse mortgage?
Wade: Well, that’s absolutely an important factor. For the average American, it’s about a ratio of their network will be able 2/3 in home equity and then 1/3 in their financial portfolio, so it is indeed the case that home equity is a huge asset for household retirees. Just thinking about how to use that, other than preserving it as the last resort option at the end …
Jason: I had another thought about-
Wade: Even for those-
Jason: I think it’s very fascinating, Wade. I really appreciate you bringing it up, because I think it is an interesting way to create some tax free cash flow for people. I wanted to ask you about the line of credit, because I know that that line of credit can grow over time. If you don’t need it, but you take out the reverse mortgage early, you’ve got this line of credit that’s growing until you do need it. The question I had for you on that: would you advocate then paying the fees for the loan upfront or would you just roll those into the cost of the loan?
Wade: Oh, that’s a good question. Usually, when I do the research about it, I’ll assume that the fees are paid out of pocket, not rolled into the loan so that you just … Because the idea usually is to keep that line of credit growing. The line of credit’s really the magical aspect of the reverse mortgage that if you don’t understand why that grows, it seems too good to be true and it’s basically just there’s this idea of a principle limit that consists of the line of credit and the loan balance. They all grow at the same rate and so I’d like to keep that loan balance smaller so that more of that growth is occurring for the line of credit instead of the loan balance. That’s why usually I think about not rolling the fees into the loan balance, although that’s certainly an option. In that regard, fees can vary a lot and there are now cases where reverse mortgage lenders are able to credit a lot of the fees and it may only be a couple hundred dollars to set up a reverse mortgage. Although, certainly it requires comparison shopping, because there are [cylinders 00:06:37] that will charge much higher upfront costs.
Jason: That’s good to know. What about the optimal age? I think you have to be 62 to qualify for the reverse mortgage, correct? Is that when people should think about start taking one out?
Wade: Mm-hmm (affirmative). Yeah, age 62 is one of the requirements to be eligible and if you have a couple where one spouse is older than 62, the other is younger, there are now provisions to protect the non-borrowing spouse, younger than age 62. But indeed, for the uses related to opening the reverse mortgage and letting the line of credit grow, the earlier, the better, and so right. As part of one of the things you do when you turn 62, if you’re planning to stay in the home, is to just open a reverse mortgage at that time.
Jason: Pay the fees upfront and then have that line of credit ready for you when you need it. Okay, thanks. As we move on, this is where you spend all your time and you obviously enjoy researching the topic. You have become a go-to expert on the topic of retirement income planning. If you could boil it all down, distill it all down into just maybe your top three pieces of advices for somebody that’s just getting ready for retirement today, what would those three things … What would you say to somebody getting ready to retire today?
Wade: I’d say first you have to recognize that the retirement income problem is different from the pre-retirement wealth accumulation problem, that the nature of the longevity risk, not knowing how long you will live as well as the market risk and the further impact of market risk [with 00:08:09] when you start spending from your investments, you become more vulnerable to market volatility. That really requires thinking about retirement in a different way and so how do you think about it? The second point would then be to think about it’s not just an investment portfolio for retirement. There can be other ways to help manage retirement risks that can be more effective. With the idea of things like risk pooling, that’s a simple income annuity that pays an income for life, helps to manage the investment risk and the longevity risk.
That’s where this whole reverse mortgage discussion fits in as well is having these assets available to the retiree that are not part of the investment portfolio can be another way to manage these sorts of combined risks in retirement. Then the third point would just to maintain flexibility, the idea of the 4% rule that’s out there has a really rigid spending rules where you always adjust your spending for inflation, no matter what happens to your portfolio. But if you’re just flexible and have the ability to make some adjustments, that can go a long way to helping with retirement sustainability as well.
Jason: Awesome. I want to ask you, because from my experience, most of people’s money is in stocks, bonds, mutual funds, ETFs, some kind of equity investment. Is there a proper amount or is it possible to be overly dependent on stocks and bonds in a retirement portfolio?
Wade: I do think so. It’s just a matter of that may not be the most efficient way to manage the retirement risks, to only use the investment portfolio, because what tends to happen and this … Well, there’s a concept called longevity risk aversion and that’s how careful are you about outliving your assets. There’s a lot of Americans out there who are wholly dependent upon their stock and bond investment portfolio. They were so worried about outliving their assets that they just don’t spend any money. They’re worried about living to age 100 or beyond or they’re worried about getting the next 2008 in the next couple of years and that just can lead to paralysis and not taking action, not enjoying retirement or spending to the degree that they might be able to do. If that’s someone’s situation, certainly there are more effective ways to manage these risks than to rely on just an investment portfolio.
Jason: The flip side to that question would be in terms of guaranteed income, so people think of social security as a guaranteed income source for them, assuming the rules don’t change and there’s not a cut in social security like the trustees reports says there could be in the year 2032. Is there a percentage, a target percentage that people should have allocated towards secure income? I think the social security statement says that you should plan on social security replacing about 40% of your working year wages. Is that enough guaranteed income for people to be able to feel comfortable just with social security or do you think that target percent should be higher than 40%?
Wade: I think that can vary on a case by case basis, but should probably generally be a bit higher than that. I think in practical terms, the best way to consider that is to just think about your budget and retirement and what expenses within that budget do you really not want to have to reduce, either because they’re fixed and you can’t easily reduce them or just it’s really an important part of your lifestyle. Then you can apply reliable income sources to that budget. Social security’s one reliable income source and the other are defined benefit pensions, any individual bonds being held to maturity and so forth. Beyond that, if there’s still a gap there, that gap is what I would look at filling in with an income annuity or some other form of guaranteed income to make sure that that aspect of the budget’s not vulnerable to a downturn in the financial markets or to other risks of that nature.
Jason: I want to ask you about annuities in just a minute but before I do, I want to ask you about budgeting, because really, retirement is … And this is something that I say all the time. Retirement’s all about cash flow. It’s your income that determines your lifestyle in retirement. If you don’t have income, you don’t have a retirement. Is there any keys or tips, things that you’ve learned about budgeting that’s important for people that are making that transition into retirement?
Wade: Well, there’s always a question about how will spending evolve in retirement and what is an appropriate replacement rate and so there are rules of thumbs out there that … The common rule of thumb is that in retirement you’ll need to replace about 80% of your pre-retirement income. It’s important, I guess, the tip would be to … That could be a starting point perhaps when you’re so far away from retirement. As you get closer to retirement, to try to really sit down and think about how your budget might change in retirement. Will you spend less and or because you’ve been working all these years and haven’t enjoyed as much leisure, you want to enjoy more leisure in retirement, travel more and that sort of thing, will your expenditures go up in early retirement? Then as well, what might happen in later retirement? Is it likely that you will travel less, go out less and perhaps be able to anticipate spending less at [inaudible 00:13:46] 70’s going into the 80’s and beyond, spending less at that point in time. There are rules of thumb about it, but it is important to try to track down for your personal situation what might happen with these types of expenses.
Jason: I see that. We see that all time where spending is not smooth in retirement. One of the challenges with a budget is you can’t … For most people, just putting together a plan that says, “Well, I need $5,000 a month or $6,000 a month,” really isn’t doing them justice because what we see is that they have one off expenses like property taxes come due once per year or their long term care insurance premiums come due once per year. Because spending isn’t smooth and then because it changes over time, so you’ve got people in their 80’s that a lot of people just aren’t traveling. They’re not as active in their mid-80’s as they were in their early 60’s. Is there a period of time or do you know what the rule of thumb might be, Wade, for saying, “Okay, at X date, I’m going to start reducing my income projections by a certain dollar amount.” It seems kind of foolish to assume that you’re always going to be increasing your spending by 4% per year no matter what when life probably just won’t support that kind of increase, unless it’s for additional medical expenses.
Wade: The rules of thumb about that are not all that clear cut at this point. There has been a lot of discussion about the idea of dividing retirement into the go-go, slow-go and no-go years so that 65 to 75 will be the go-go years where you’ll be spending a lot more. 75 to 85 you start slowing down and then 85 and beyond, your spending may drop quite a bit. Now, how much it drops, I don’t think we have good rules of thumbs at this point, but I don’t think it would be out of the range of possibility to say you might be looking at a 10% to 15% drop to expenditures in that second part of retirement and then another 10% to 15% drop in that latter part of retirement with the only caveat being about healthcare expenses and often late in life, healthcare expenses may go up and may offset some of that reduction and other expenditure categories.
Jason: Yeah, that’s not a fun way to spend money.
Jason: We want people to have a good time. My goodness, you’ve saved all this money not so you could give it to your doctor or your nursing home at the end of your life. That’s no fun.
Jason: One of the questions, and I do want to come back to this thing on annuities, but one of the questions we hear frequently from people is they say, “How can I know if I’ve saved enough?” How do you answer that question?
Wade: Yeah, how to know if you’ve saved enough for retirement. The general way that historically we’ve looked at that sort of question is to figure out how much you want to spend and retirement and divide that amount by what you view as a reasonable spending rate and then seeing if you’ve reached that wealth target. In practice, that can be difficult to do, at least for things like … There’s this idea of 4% rule out there that if I want to spend what $40,000 for example, adjusting for inflation, then I would divide that by the 4% rule and I would need $1 million to support $40,000 of expenditures in retirement. That’s a common way to approach that sort of thing. I’ve had questions about how effective that is just due to the amount of volatility we experience near retirement so that it’s hard to know five or 10 years away from your retirement date whether you’re really on track with meeting your retirement goals or not. It is the most common way to think about that.
Jason: One of the things I was thinking about this morning, using that 4% rule and the division that you just talked about, so if you needed $10,000 additional income, you would need an additional $250,000. The question becomes is it easier to save an additional $250,000 if you’re just rounding the corner for retirement or is it easier to be able to cut $10,000 out of your budget? Neither one seems very easy, but I just wonder from a budgeting standpoint if there’s more wiggle room on that side than there is on trying to accumulate $250,000 all of the sudden.
Wade: That could be and also just delaying the retirement date is the most powerful way to help improve a retirement portfolio for a number of reasons just more years to accumulate assets, less time in retirement, so needing less for retirement. It’s a lot also allowing to delay social security and so forth. It may not be that you’d stay at the same job, but even having part time work in early retirement could also help a lot to reduce the need to take distributions from the investment portfolio. Right, it’s four [levers 00:18:44]. You can either spend less, save more, work longer or assume a higher investment return. That last one is a dangerous avenue [crosstalk 00:18:54].
Jason: Hey, 10% per year, that’s what everybody expects. Getting to this idea of longevity risk aversion and using an annuity to pool life expectancy risk, if somebody’s going to go out and purchase an annuity, what should they be looking for, what should they be on the lookout for to avoid, both positives and negatives with annuities?
Wade: Well, they want to look for a very highly regulated [I guess salary 00:19:27], a good credit rating, a company with a good credit rating. Then think about as well maybe diversifying between different companies so that they don’t have too much with an annuity at any one particular company and then academics are usually talking about annuities in the context of simple income annuities. These are single premium immediate annuities or deferred income annuities. They only represent about 4% or 5% of total annuity sales, so it’s a really small part of the market, but the more commonly sold annuities are the more complex types of variable and indexed annuities. If someone’s looking at those, the complexity can be so great that it’s really hard to analyze them carefully.
You may want to just talk to an advisor about how does this really work and the only way to really analyze them is to calculate an internal rate of return from their cash flows, but otherwise, there’s too many physiological tricks built in. There’s the whole idea of a lot of these annuities will have some sort of guaranteed roll up rate on the guaranteed income that it’s too easy to misinterpret that as a guaranteed rate of return on my investment, which is absolutely not what it is, but that’s how people view it. For any of these complex annuities, really talking about someone who can look at it objectively is going to be really important or to think about just using a more simple income annuity as opposed to one of the more complex version.
Jason: If somebody’s looking at the simpler types of annuities, the income annuity, the single premium immediate annuity or the deferred income annuity, they don’t like the lifetime option because they don’t like the idea of they start an annuity and two weeks later, they die and now the insurance company gets all their money. What do you say to somebody that has that concern with purchasing an annuity?
Wade: Right, that’s another area where academics love the life only versions, because you get the most mortality credits out of them. The idea that the insurance company wins at your expense if you … The classic case if you sign the contract, leave the office and get hit by a bus and never received a single payment, but it’s not the insurance company that benefits in that case. It’s the risk pool. The reason you’re getting the income annuity is because everyone then gets a payment, like they’re all going to live to their life expectancy, because what the insurance company is able to do by pooling that risk across a large number of people, those who don’t live as long subsidizes those who live longer. It’s not the insurance company that wins at your expense. It’s the long lived. That’s obviously a good deal for those who do end up living long. Since we don’t know which we’ll fall into in advance, it can still be a good outcome for those who don’t live as long either, even though they’re subsidizing those who live longer. Because the confidence it provides you that you will not run out of money no matter what happens in the market, no matter how long you might live, you can actually enjoy those retirement years to a higher degree than you would have otherwise …
Wade: … been comfortable with.
Jason: And potentially I guess take on more market risk too. If you have a large percentage of your income on a guaranteed basis and you’re not depending on market conditions, you don’t have to try to play this tiptoe, be ultra conservative in the market. That brings me to we’ve got ultra-low interest rates, they’re just now starting up. We’ve got very high stock market evaluations. How should that play into people’s thoughts as they’re preparing for retirement?
Wade: It means that people retiring today should anticipate lower market returns in the future than we’ve experienced historically. Just the fact that interest rates are low, there’s a very clear mathematical relationship that will imply that bond returns will be low as well. Today’s interest rates are the best predictors of future bond returns and that relationship’s very strong. On the stock market side, there’s more debate about what it means that we have this high valuation level, but definitely historically, higher valuation levels like what we’re experiencing now have led to lower stock market returns in the future. What all that together means is just lower spending rates for retirement.
Jason: Well that, Dr. Pfau, we are out of time. The retirement researcher folks is where you can find Wade’s work. Wade, thank you for being a guest on Sound Retirement Radio.
Wade: Oh, it’s my pleasure. Thank you.
Jason: All right, thank you. Take care, bye bye.
Wade: Bye bye.
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