Bogleheads on Investing-Episode 024 transcript

Wade Pfau

Wade D. Pfau, Ph.D., CFA, RICP, is the program director of the Retirement Income Certified Professional designation and a Professor of Retirement Income at The American College of Financial Services in King of Prussia, PA. As well, he is a Principal and Director for McLean Asset Management. He holds a doctorate in economics from Princeton University and has published more than sixty peer-reviewed research articles in a wide variety of academic and practitioner journals.

Dr. Pfau hosts the Retirement Researcher website and is a contributor to ForbesAdvisor PerspectivesJournal of Financial Planning, and an Expert Panelist for the Wall Street Journal.  He is the author of the books, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free RetirementHow Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Income Strategies, and Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement.

Episode 024- guest Dr. Wade Phau

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Rick Ferri, July 31, 2020

Rick Ferri: Welcome to Bogleheads on Investing podcast number 24. Today our special guest is Dr. Wade Phau, a professor of retirement income at the American College of Financial Services. Dr. Phau is the author of three books and over 60 articles on how you can get the most out of your retirement savings.

My name is Rick FerrI and I’m the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy a 501c3 non-profit organization and can be found at boglecenter.net. Today our special guest is Dr Wade Phau. Dr. Phau is the program director of the retirement income certified professional designation and a professor of retirement income at the American College of Financial Services. He held a doctorate degree in economics from Princeton University and has published more than 60 peer-reviewed research reports. He is an expert panelist for the Wall Street Journal. He has written three books. In his latest book Safety First Retirement: An Integrated Approach to a Worry-Free Retirement is the subject of our talk today. So with no further ado let me introduce Dr Wade Phau. Welcome doctor.

Wade Pfau: Thanks, and feel free to call me Wade, and it’s great to be on the podcast.

Rick Ferri: Well thank you so much for joining us today. The bogleheads are extremely interested in the work that you’re doing and I think it’s fascinating. I’ve read all your books and we’ve got a lot to talk about, a lot to get through today. But before we get there, let me start by having you tell us a little bit of something about yourself. How you decided to go into this field and what was your motivation.

Wade Pfau: Sure. Going back to the early days, I grew up in Michigan and Iowa, went to majored in economics, went to grad school for economics, and then from there just slowly started stumbling into personal financial planning. My dissertation was about the Bush Commission proposal to create personal retirement accounts by carving out part of Social Security. I was just exploring how that might work out in practice, and that really became the foundation for what I’m doing today in terms of simulating retirement outcomes based on different strategies.

I did spend 10 years in Japan as an economics professor. That was my first job out of grad school, focusing more on the pension systems in developing and emerging market countries, but in wanting to move to the US and find something more marketable here, started looking at, was studying for the CFA curriculum and so forth.

And I came across this four percent rule of thumb about how much you could spend from a retirement portfolio. So from that I had another data set that– the four percent rule is just based on US historical data, but I had the global returns data for 20 developed market countries and I  was curious. Did the four percent rule work with other countries’ data?  And that really became my introduction into the world of retirement income.

Rick Ferri: When you started researching safe retirement rates using basically what you call the probability based system which is a stock and bond and cash portfolio you discovered that there were risks to that and basically you came up with three risks: longevity risk, a sequence of return risk and also spending shocks.  And those three things together gave you the idea that maybe that’s not the most optimal way to build a portfolio for retirement. Could you explain those risks and why it may not be the most optimal way?

Wade Pfau: Right. I mean the four percent rule, this idea that if I had a million dollars I could pick up 40,000 in the first year and and then every year just spend that same amount with inflation adjustments. That’s the fundamental way the investments world thinks about retirement income. Of course there’s a lot of variations on it, but that’s a fundamental idea and the way it seeks to manage these three types of retirement risks may not be the most efficient way.

It’s with longevity risk. This is the idea that you might live longer than anticipated. The four percent rule is meant to be conservative in the sense that it plans for longer than life expectancy. In 1994 the article was written, which now is 26 years ago. The idea was a 65 year old couple, it’s pretty unlikely that either of them would live past 95 so if you build a plan that worked for 30 years you should be in good shape. Now there’s no protection there. You might live longer than 30 years, but at least you’re trying to be conservative in that regard.

It’s with longevity risk. This is the idea that you might live longer than anticipated. The four percent rule is meant to be conservative in the sense that it plans for longer than life expectancy. In 1994 the article was written, which now is 26 years ago. The idea was a 65 year old couple, it’s pretty unlikely that either of them would live past 95 so if you build a plan that worked for 30 years you should be in good shape. Now there’s no protection there. You might live longer than 30 years, but at least you’re trying to be conservative in that regard.

And then the spending shocks. So these are, well I’ve got my baseline retirement budget. I want to spend the $40,000 a year but I may have surprises along the way, with long-term care, big health care bills, different types of events that can happen, and the four percent rule strictly speaking doesn’t help manage spending shocks because it does anticipate just spending your budget. You’re going to end up with zero after 30 years but that’s only supposed to happen in the worst case scenario, so if you’re in any other sort of scenario you don’t necessarily end up at zero and so you would have some excess funds available to provide a source of spending for spending shocks. And that’s how the four percent rule manages those types of retirement risks.

Now it’s not necessarily the most efficient way to manage these risks because it really just means I’m going to be extra conservative to try to not run out of money. I may not be conservative enough — there could be a new worst case scenario, but most of the time I  would just end up  underspending and then have a bigger legacy at the end than I otherwise had anticipated. 

Rick Ferri: But you also wrote in your latest book Safety First Retirement Planning, which is a whole different way of doing this, that, and I’ll quote, “there is no such thing as a safe withdrawal rate. A safe withdrawal rate is unknown and unknowable.” So your research has shown that even if you said well let’s make it a three percent rate instead of a four percent rate that even then it might not work.

Wade Pfau: Yeah that’s just kind of the academic concept behind, well if you are trying to spend a fixed amount from a volatile investment portfolio that there really is no such thing as a quote-unquote safe withdrawal rate, anything could fail. That’s the inherent issue of volatility with fixed spending, and so if you wanted to have fixed spending you probably shouldn’t have the volatility in the portfolio or if you want the volatility in the portfolio your spending should also be flexible or volatile or adjust for the portfolio performance.

The four percent rule of thumb does assume you use 50 to 75 percent stocks at retirement and that inherently creates the most sequence risk because it leaves you the most exposed to being forced to sell assets at a loss in a market downturn. Right now if I wanted the 30 years of inflation adjusted spending with where TIPS yields are, at this point we’re getting close to about a three percent safe withdrawal rate, and that would insure you run out of money at the end of 30 years because you build a ladder of Treasury Inflation Protected Securities. And if I’m trying to spend more than that I’m investing more aggressively. I’m hoping and anticipating that the upside from the stock market will allow for a higher spending rate. But if I get a poor sequence of market returns early on, I end up having to sell principal and digging a hole for my portfolio. And so the portfolio may not recover with the overall market, and so that’s really the risk created by that sort of probability based approach in the purest form with how the four percent rule is structured.

Rick Ferri: And your solution to this is what’s called the Safety First Retirement Approach, which would also feed in basically annuities and life insurance and perhaps reverse mortgages, and other types of assets into the portfolio to try to mitigate the longevity risk. So in a broad sense could you talk about the safety first retirement planning approach?

Wade Pfau: So and to just be clear I know some Bogleheads take issue with which are can be expensive assets to use.  Annuities, we know life insurance, reverse mortgages all can have significant costs attached to them, but what really kind of the reason I find that these things can help in retirement is because of this sequence of returns risk, and how small changes to this need to take distributions from a portfolio at a loss can really disrupt the retirement plan, and how just being able to cut back a little bit on that can have such a huge positive net impact on the retirement plan.

That’s kind of the avenue where these different types of tools can help. It goes back to just looking at what’s the efficient frontier for retirement income, with an article I wrote now about eight years ago, and just finding that stock/ bond allocations are really the least efficient way to try to meet a spending goal with downside market risk while also preserving an average like the highest average legacy at the end as well. That if you basically shift from bonds to income annuities. So that I mean an income annuity is effectively a bond portfolio held by the insurance company but rather than paying coupons for a fixed number of years they pay for the lifetime. If they hedge your longevity risk, if you end up living to 110 they pay you until you’re 110. 

Now if you end up only living the 70s they don’t pay you until you’re 70. But by pooling that risk you can have your retirement outcome based more on an average experience rather than if you have this worry about outliving your money and therefore spend less, just try to stretch those assets out for longer. That’s where the stock/income annuity mix can work better for retirement than a stock/ bond mix, and that’s the basic idea that safety first is. It’s based on more academic type models going back at least to the 1920s, which is, if you have a basic spending floor where

you really don’t want your spending to have to drop below a particular level, the most efficient approach is you lock in that level with lifetime protections through risk pooling. And then you can invest the rest more aggressively and spend more aggressively at a variable rate. So something like just following RMD rules on here’s how much I’m going to spend from my discretionary investment portfolio. That increasing spending rate as I age from an aggressive portfolio mixed with an income floor, that’s a more efficient way to build a retirement income strategy than something like using the four percent rule from a total return like 60/40 style investment portfolio.

Rick Ferri: This sounds an awful lot like a replacement almost for defined benefit plans which fifty years ago a lot of workers had to fund benefit plans, which were this annuity based on risk pooling, and so people had this money coming in for the rest of their life. Now that defined benefit plans have gone away, it sounds like what you’re advocating for, in a basic sense, is to replace that. 

Wade Pfau: Yeah, yeah. And Moshe Milevski even calls it “pensionize your nest egg.” That’s the idea with Social Security and with traditional defined benefit pensions, we do get risk pooling. And with a defined benefit pension the longevity risk is pooled.  Some workers don’t live as long as others, and some live longer. And also market risk is pooled because the insurer, assuming they select the correct average–they based outcomes on an average rate of return– that some people would have been better off on their own with their own sequence of returns; others would have been worse off.  But that market risk over time gets pooled. And so a defined benefit pension, it pays your pension based on an average market performance and based on a formula linked to your work history versus in a defined contribution pension where if you’re investing that in a market portfolio you’re now fully taking on the market risk of your specific sequence of returns. And if you’re going to do systematic distributions and not use any sort of annuity, you’re then also taking on that longevity risk. So indeed annuities just provide a way to create that pension with that risk pooling. That if you had a defined benefit pension you would have been getting that way before.

Rick Ferri: We’re not talking about everybody here. I think that the target market for what you’re talking about are people who ordinarily would have had, say, a defined benefit plan. We’re not talking about people who have 10 million dollars and only spend 150,000 a year correct.

Wade Pfau: Well I  mean to some extent correct. But at the end of the day it’s still the same sort of idea that anyone, now they’re not going to run out of money clearly, but to the extent that you take some of your bonds or if somebody in that situation might have a big pile of cash sitting on the sidelines, if you took some of that and put that into that lifetime income annuity and then you feel all the more comfortable investing what’s left more aggressively you’re still– though you’re not going to run out of money anyway, you’re creating a better foundation that you’re at least if you live past life expectancy, you’re going to be able to leave behind a larger legacy than if you still just spent your $150,000 a year from a 60/40 allocation on a 10 million dollar portfolio. It’s just this mathematical outcome that doesn’t depend on the spending rate.

Now if you are more constrained you can see a more noticeable increase in your probability of success. It’s not that you’re going to see the success rate increase there, it’s if you’ve got 10 million dollars and you’re spending $150,000 a year your probability of success is probably 99  no matter what you do, but still in terms of legacy it’s what’s the most efficient way to build the retirement strategy. And in that regard using bonds to fund the retirement budget is really the least efficient way you can approach things.

Rick Ferri: I did a little math to take a look at if my wife and I decided to take a million dollars and annuitize it at age 62. I am 62 and she’s 60. I went to the website that you recommended which is, what’s the website?

Wade Pfau: immediateannuities.com

Rick Ferri: immediateannuities.com, okay not a plug for immediate annuities. We are non-commercial, but I went there and I plug in some numbers and I see what I could get right now at 62 and my wife is 60,  if we put a million dollars into this, and it came out to forty six thousand dollars a year. I believe it was with four point six percent. And I said “What if I never spent that money? What if I just took that money and I invested it in treasury bonds,” so as the money came in I invested in today’s treasury bond rates. You know at what point would I actually make more money, than if I just took that million dollars and invested it in treasury bonds, and quite frankly doing that gave me a much higher legacy rate of return, as long as we one of us lived until we were, I  think, was one of us had to live until our 80s, and if one of us lived until our 80s, by taking the higher return from the annuity and just taking the income from that and investing it in the same treasury bond that we would have bought we ended up having a higher legacy. So the return, if you live long enough, the return from the annuity is higher, and if you could explain why that is. It’s not just interest rates that drive the return on an annuity correct. It’s the pool of investors that you’re in, right.

Wade Pfau: I mean the income annuity, it’s you really want to think about it as the cash flows because there is an underlying interest rate but it’s not reported. It’s part of the payout rate that you get quoted and that’s what you see, it’s the payout rate. If I put in a million dollars how much will I get on a monthly and annual basis for the rest of my life. And so naturally the longer you live the more cash flows you’re getting back on your initial investment. Now with a pure life only income annuity the return is going to be negative until you get your full premium back as payments, and then you’d have an internal rate of return of zero percent and then as you live beyond life expectancy your return gets higher and higher. And if you live into your 90s, yeah you’re, even, to beat bonds probably more like your mid to late 80s.

Rick Ferri: Depending what the interest rate was on the bond. It came out to 87 or so, one of us had to live till we were 87, and then if I would have just invested 100 percent in the treasury bond versus investing in the annuity, taking the money and put that into a treasury bond, that’s when I started making money in the annuity.

Wade Pfau: Yeah, and if you’re both in average health, at least, not even good health, but just average health for a couple, the joint longevity is going to be higher than 87 especially if you’re non-smokers. That you’ll have a 50 chance that at least one of you is still alive in the early 90s, so the probabilities are in your favor of living long enough where you can beat out bonds with an income annuity.

Rick Ferri: You’re right as far as a legacy asset and what I’m going to leave to my children even if I’m not going to be needing the income from an annuity, it’s actually a sometimes a good investment.

Wade Pfau: Right, if you’re comparing just annuities versus bonds, and not– because then you can add in the stock market as well– but with annuities versus bonds you’re going to be lagging on the legacy for a while because bonds you still have the full liquidity for that. But yeah, once you’re past life expectancy and then with the bonds eventually you’re going to deplete that entirely.

And then you could talk about whether there’s a reverse legacy, like if I was just going to fund my retirement with bonds and I outlived the age that I anticipated, I’ll need someone to take care of me at that point. But with the annuity, though you may be giving up legacy in the early years, and we’re talking about like a partial annuity strategy, in reality no one’s going to put all their money in the income annuity, so legacies may lag for a while, but if somebody ends up having a short retirement, their heirs are going to be getting a lot anyway. It’s really with the long term where you still can have a reasonable legacy with a partial annuity strategy versus with the bonds eventually they run out and you don’t have any spending source at that point.

So it’s changing the dynamics of what the legacy will be over time. The annuity strategy will have a lower legacy before life expectancies, but a bigger legacy after life expectancies and that’s because of that risk pooling, where as you live longer, more and more of your spending is coming through the subsidies of these mortality credits that investments just simply don’t provide. It’s the premiums from the short-lived helping to pay to the long-lived, raising that standard of living for everyone in that risk pool

Rick Ferri: And that’s what they’re called, they’re called mortality credits. In other words I’m kind of making a bet that I’m going to live longer than you and we’re all in the same pool together. But I think my genes are better than your genes, and my wife’s genes are better than everybody else’s genes in the pool too. So if we get in this pool and if we actually win, we only have to be on the top 50 percent as far as our longevity, if you will, we come out ahead.

Wade Pfau: Right, and you can think of it that way but often behaviorally it’s not necessarily good to think about annuities as bets or investments because you can frame any sort of insurance that way. Like if I buy homeowners insurance I’m making a bet that my house will burn down and if it does I’ll get this big payout. And with the annuity it’s a little bit different, it’s to protect a good outcome in a scenario where I live a long time and therefore my retirement becomes more expensive and I don’t have the resources to fund that sort of longevity. So it’s insurance against outliving my assets more than it’s a bet that will pay off if I beat the rest of the risk pool. I mean you can think about it either way think about the insurance side as well.

Rick Ferri: when you’re looking at your retirement plan, you say there were basically four priorities and you start from the bottom and work your way up. And at the bottom is your basic needs. In other words, the how much you need to live on and this is where the annuities could help, along with Social Security. And then the next thing you have is called the contingency fund. Now a lot of people think of that as an emergency fund, but you know I I think the word contingency fund is actually probably a better word. Your house could need a new roof, that’s not an emergency, but it is a contingency. The next level is discretionary and legacy. So I like the way that you prioritize that.

Then you basically looked at this and said this is how you have to think about your retirement and you have to fill your basic needs bucket first with known income, and then you have to have a contingency fund, and then you can have your discretionary fund, which might be filled more with equity, and a legacy which might be filled with equity and fixed income or real estate or something. Am I getting that correct?

Wade Pfau: Yeah, that’s the idea, and right, the contingency fund, it’s really for any of these spending shocks. So in retirement there can be a lot more health related or long-term care and so forth. So yeah, right, it’s more than an emergency fund, but that’s the basic order of prioritizing and working your way up through your financial goals.

Rick Ferri: In your book you talked about those liabilities of your basic needs, and contingency and discretionary and legacy. And you sort of matched them up against your assets so you did liability matching. These assets would be used to match up against these liabilities.

Wade Pfau:  Yeah, and that’s an important part of the safety first approach. It’s an asset/ liability matching problem. The liabilities are just the expenses associated with your goals, which you are describing. I use the term four L’s as well the longevity, lifestyle, liquidity and legacy are your four L’s. Longevity about your core expenses. Lifestyle about discretionary. Liquidity for the contingencies and then legacy for legacy. Of course those are the liabilities associated with your goals and then positioning your assets to match those goals with reliable income assets.

So things like Social Security, individual bonds, traditional pensions, and then annuities as well potentially, and the diversified portfolio, and then reserve assets and so is it with this asset liability matching that’s another thing where you can’t double count assets. So reserve assets are just what you have that’s not already earmarked for something else. And that’s important in the context of retirement income because if I believe in the four percent rule and I’m looking to spend forty thousand dollars and I have a million dollars, so I put it in a brokerage account and put it in like 50/ 50 stock/ bond mix, do I have any liquidity? Technically the answer is yes, my brokerage account’s liquid, but in the meaningful sense of this retirement income problem the answer is no. The entire million dollars is earmarked for that $40,000 spending goal and even though I could spend it on something else, doing so directly jeopardizes that future spending goal. And so the reserve assets are just what you still have available for contingencies that are not earmarked for one of your other three L’s, your lifestyle, longevity or legacy goals.

Rick Ferri: Okay. Well now we’re going to dig into all these different insurance products because they are, they can be very simple or they can be very complicated. And in your book you go through them all. And some of them, believe me, could when I especially, when I got to the variable annuity, it got to be extremely complicated. And I don’t know how anybody could keep this in their head. Difficult, but let’s go ahead and move on to the different types of annuities because you talk about them all in the book. And there’s the basic immediate annuity, deferred annuity, getting into a whole life policy. If you could go through the, you know, the pluses and minuses of each one of these types of annuities that would be great.

Wade Pfau: Yeah so on the annuity side the spectrum would be the simple income annuity– so single premium immediate annuity or deferred income annuity– those would be, those are fixed annuities, they’re on one side of the spectrum in terms of the most guaranteed income but the least, or no liquidity, and least or no upside exposure. And then as you move along the spectrum from that end towards the other end, it’s going to be the fixed index annuity and then the variable annuity.

So the fixed index annuities in the middle where it is a fixed annuity but it’s deferred you haven’t locked up your money with it in the sense that you still have access to the funds, and they’re generally based on some sort of like a financial derivative strategy that’s where you can read about how people can create their own fixed index annuity return structures– they can’t create the mortality credits if you have a guaranteed living withdrawal benefit– but it’s generally you have principal protection because the insurance company buys enough bonds to protect your principal and then with what’s left over they buy some call options to give you some exposure to the upside. It’s like the very basic level of how they work, so downside protection with some upside exposure, and with a guaranteed living withdrawal benefit can provide the lifetime income, and especially with the tax deferral, their returns could be competitive with a bond portfolio after taxes.

And then you’ve got moving along the variable annuity at the other end, which would generally then have the least downside protection. You can have the guaranteed lifetime income, but it would generally be lower than what an income annuity or a fixed index annuity would provide, but the most upside potential, with the ability to invest in an underlying asset allocation and subaccounts, that are not the same as mutual funds but they’re the annuity equivalent of mutual funds. And then also the liquidity as well where you because it’s a deferred annuity you still can tap into and get access to those funds if you wanted to get them back and take them out of the annuity.

So that’s the spectrum, income annuity, fixed index annuity, variable annuity and where you end up on that spectrum really just depends on that trade-off between the most income in the worst case scenario, versus maybe less income in the worst case scenario, but the most potential for a higher income if markets end up doing well.

Rick Ferri: You recommend that if people are going to buy an immediate annuity that they should first not take Social Security– delay Social Security.

Wade Pfau: Oh yeah. Yeah that’s an important point because step one of thinking about annuities is delay Social Security because delaying– especially for the higher earner in the couple, the spouse might start sooner– delaying Social Security age 70 that the delay credits that you get from doing that were based on the situation in 1983 when people were not living as long, when the assumed real interest rate was 2.9 percent instead of the negative territory that it is now, and so the implied benefit of delaying Social Security if you think of, if I delay Social Security the benefits I give up become a premium for at least the difference in benefits. The benefit increase I get at 70, that’s a really high assumed payout rate, much higher than any commercial annuity could provide. And so it’d be really inefficient to start Social Security at age 62 and then also buy an annuity.

First delay social security to 70, then figure out what’s going to be your income gap at that point. And then think about the annuity from there.

Rick Ferri: I kind of think of it in many ways as if you’re going to go buy an immediate annuity that you are trying to beat the pool, you know, you’re trying to be in the 50 percent that outlives the rest of the pool, that you have other people in the pool who are thinking the same thing. They’re healthy and they think their longevity is going to beat the pool. So everybody who’s in that pool is, I think, probably more healthier than, say the average person out there. But that’s not the case with Social Security. I mean everybody’s in the pool so if you’re healthier delaying seems to me to be the best option.

Wade Pfau: Oh yeah, yeah absolutely right. With annuities there’s adverse selection, that those who have a feeling they’re more likely to live longer are more likely to buy the annuity. But right, Social Security is based on the aggregate US population and so to the extent– there’s all these factors that are correlated with longevity some people, because they have more of a long-term focus and this is going to be a lot of Bogleheads, they’re just higher education, higher income levels, saving and accumulating more wealth, that ultimately they’re going to have a longer average lifetime than the average American. So that’s even speaking stronger to the idea of delaying Social Security, because your likelihood of living beyond the break-even ages is all the more greater than the average person. And generally it’s once you get past age 80 you benefit from delaying Social Security and 80 is well below life expectancies for almost anyone who’s going to be listening to a podcast about retirement income. But I mean there’s going to be accidents or illnesses that happen randomly on occasion but the average person listening to this type of podcast will live dramatically longer than the average American and that’s even a stronger case for delaying Social Security and for annuities.

Rick Ferri: You also talk about another type of insurance, which is called whole life. Normally, you know, out there in the world to stay away from whole life, but what you’re saying, you’re making the argument that this could actually be a good option for people.

Wade Pfau: Yeah that’s what I found in doing my simulations, and just to be clear, so I’m still a little bit young to be buying the annuities. I anticipate doing that but still in my early 40s. But after doing this work on whole life insurance and I am at the right age, so I found it so compelling I did get myself a big whole life policy. I know Bogleheads generally don’t like it, but it’s not about whole life versus the stock market, this is about as a replacement for bonds. If you just think about the cash value as an alternative for taxable bond investments it can be competitive in that regard. 

The simulations I do, they start at somebody who’s still either 35 or 40 years old and they decide they need life insurance pre-retirement. Then they think about do they buy term and invest the difference or do they buy whole life insurance, which is going to have a much higher premium and is going to reduce the amount they have in their investment accounts, but then lays the foundation for them having different strategies for retirement income. And comparing well what sort of approach where I’m going to have a limited amount of savings each year and I can allocate that between investments, term insurance, and whole life insurance. What can lay me the best foundation to get the most spending and legacy in retirement and finding there were a number of different ways that whole life insurance can fit into that puzzle to support more income and/or more legacy in retirement. And I found it compelling enough to actually kind of begin implementing this for myself. It’s, we just had the discussion about the annuity, that the simple income annuity often has the most downside income and that’s true. Like a single life only, single premium immediate annuity would have the highest payout rate, and then if you have two spouses, with annuities the way you protect the spouse would be you get a joint life or you get a cash refund, or you keep the liquidity for the underlying contract value and so forth. And then that’s your life insurance in that case, you get a lower guaranteed payout rate because you’re building in more protection through the annuity and I compare that to well what if I just had the death benefit to back up the annuity premium. So in retirement you could get a single life, life only income annuity backed by the life insurance. And I found that that sort of approach could work much better than buy term and invest the difference, and then doing systematic distributions, or even buy term and invest a difference and then buy a joint life income annuity at retirement.

And then the other approach, it’s really about the sequence of returns risk, and it’s this buffer asset which I first really learned about on the reverse mortgage side, but cash value life insurance is the other major example of a buffer asset. Its this idea you have something outside your investment portfolio that’s not correlated with the portfolio that can be a temporary spending resource to help avoid having to sell assets when they’re at a loss or in trouble or the role that I found work best is whenever your remaining investment assets are less than the amount they were at the start of retirement, in nominal terms, draw from the buffer asset if you have it. And that can really help manage sequence of returns risk and help to preserve the portfolio in a way that the gains in the portfolio can more than offset the fees associated with the buffer asset, whether that’s the expense of reverse mortgage or whether that’s the life insurance that has of course the insurance fees but you’re getting the death benefit for that, but also just anything else related to the complexity of the contract and how that can lead to commissions or fees that are otherwise hard to tease out what exactly they are.

But looking at real policies, finding that you can support more spending and or more legacy at the end of retirement as well with these more integrated strategies. But it’s the same idea again– it’s not that you’re selling stocks to buy the insurance, it’s you’re selling bonds to buy the insurance. Try to keep the same amount of stocks, but you just position bonds so that they’re not all held in bond funds. They’re also held in income annuities or in whole life insurance. And I just found the results to be really compelling, and tested many different variations on it. I agree it’s counterintuitive and surprising because I do come from the investments only world, but I found it compelling enough to actually implement for myself.

Rick Ferri: So just a couple of clarifications when you’re talking about your buffer assets. You’re talking about if you have a downturn in the market and you don’t want to have to sell stock in order to take the money to live on. That you go to one of these buffer assets like the cash value in a whole life policy, or like a reverse mortgage, and that’s where you get the money from in the year or two in which the markets are down. And then when the markets come back up then you can go back to selling stock. And this is the concept of a buffer asset.

Wade Pfau: Yeah. Yeah that’s the idea and that because sequence of returns risk works in such odd ways, the synergies of being able to avoid having to sell at a downturn or at a loss are really compelling, and really then lead to a much better outcome for the portfolio. In both cases, with the reverse mortgage or the cash value you’re treating it as a loan, the reverse mortgage you’re borrowing from the home equity and the the cash value, you structure it as a loan from the policy, so there’s going to be a loan balance that grows with interest but the benefits to protecting the portfolio can more than offset the costs of the growing loan balance associated with the buffer asset. So yeah, that’s the idea.

Rick Ferri: We’re going to talk about reverse mortgages. But I think that before we do that we need to kind of clear up a couple of things. And that is I live in a retirement community, in an over 55 community, and I get these invitations to go to dinners where they’re put on by retirement specialists talking about giving me guaranteed retirement income for life. So I went to one of these free chicken dinners. You know, I tell you it was the biggest farce I’ve ever been to in my life. The guy used all kinds of emotional things to try to get, particularly targeted the woman in the audience, to say you’re never going to see your grandchildren again if your husband dies, unless you come and see me and I’m going to make sure you get the income that you get. I mean it was a real sleaze, and this is sort of the impression that people get about, you know, insurance and insurance sales people. So all of this stuff gets lumped under, don’t do it, don’t go there. It’s just high commission garbage.

Wade Pfau: Yeah. And I mean as a starting point default assumption that’s probably a good rule to live by because as annuities get more complicated, they’re not transparent. So that can allow costs to be internalized in ways that are not at all obvious. I mean so the the starting point is the simple income annuity, and just the reason all these more complicated annuities developed was because the simple income annuity is you pay the premium and then that asset disappears from your balance sheet, but you now have this protected monthly paycheck for the rest of your lifetime.

People were not comfortable giving up that liquidity. And then also they were not comfortable with giving up upside for that asset. Once you have the income annuity you can’t strike it big in the stock market and so forth. And so that’s where these other types of annuities developed. And these are deferred variable annuities, or fixed index annuities and I think a lot of those chicken dinner type events are going to be for the fixed index annuities where they might even portray them as “get the returns of the stock market without the risk.” And that to be clear is also not how they work, but it’s easy to get misled about that.

But at a basic level, and so the idea is there can be good competitively priced versions of those. That’s not necessarily what you’re getting at one of the chicken dinner events, but it’s a way to still have the liquidity. You don’t have to annuitize the contract so you can still get your money back. Now there could be surrender charges and things, but you still have access to the funds and then you still have some degree of upside exposure, and the variable annuity usually would provide more upside exposure than a fixed index annuity. But you have the underlying contract value, you have the upside exposure, and then you have this optional rider that really was developed just in the 1990s, initially this guaranteed living withdrawal benefit that will provide you that guaranteed lifetime income and you’re spending your own money as long as there’s money left in the contract, but the idea is if the contract depletes that’s when the rider kicks in and you’ll continue to receive that guaranteed income for the rest of your life. So it works as a source of guaranteed lifetime income.

But the companies have just made these things so complex, and every company uses different terminology and, especially with the variable annuities, they have the guaranteed roll-up rates that people misconfuse misunderstand to mean a guaranteed rate of return.  And so the point of those two chapters in the Safety First book was to just try to step back and describe how the annuities work so that if somebody’s thinking about them they at least know the basic underlying structure, and know what questions to ask, and know what they need to understand to determine if that’s the right type of product for their situation. But yeah, I mean, otherwise the default is you do want to be quite cautious.

Rick Ferri: You know to me the transparency of say an index mutual fund, here’s the fee, here’s what you get, here’s the performance of the index, here’s the performance of the fund it’s very clear. Even if you’re doing, you know, treasury bond, here’s the interest, this is what you’re going to get, you know here’s the bond. If you go to a bank and you buy a CD, this is the annual percentage rate that you’re going to get, this is for how long, if you turn it in early there’s a penalty. And it’s all very simple and very clear and a lot of people can figure it out on their own. And they’ll end up buying index funds and CDs and you know, keep keeping it simple. But when it comes to insurance, boy things can get really messy. I mean how do you know you’re working with an agent who actually cares about you. 

Wade Pfau: Well that’s a good question, and since I’m not actually involved in selling insurance these kinds of more practical issues–it’s a good question that I don’t necessarily have a good answer for– because you can’t just go by on who has the nicest personality or who’s a member of your church and so forth because those– a lot of people can use these types of civic organizations to gain trust in inappropriate ways. So yeah, I mean I don’t have a good answer but I think you probably want to just do more, especially like Bogleheads who are more involved in this process, do the research about the actual annuity products themselves. Figure out what annuity’s right for you and then just as necessary, use an agent to get what you want rather than having to rely on that agent to give you the proposals about what they want to sell you, I guess would be the real starting point with that.

Rick Ferri: But do you see why there’s a kind of an aversion to doing the whole concept of the safety first, not that it wouldn’t work, it all sounds good and I’m sure that there are good companies out there to do it. It’s a question of how does an individual actually go out and decipher which are the good people to work with, and whoever’s out there selling chicken dinners trying to capture a ten percent commission and on to the next person. It makes it very difficult to say adopt your strategy, which probably should be adopted by more people. So the question is the process of how you actually ferret out all this stuff out there and actually come up with what is the way in which you do this.

 Wade Pfau: Yeah, and probably like staying away from those chicken dinners is another sound bit of advice. But increasingly the annuities are now being offered on a fee only basis where they don’t pay commissions and so the traditional financial advisors who don’t accept commissions and who just charge a fee from their clients to provide the advice are able to offer annuities to their clients as well.  And with the fee-only version, since it doesn’t bake in a commission it can have lower fees and also even perhaps not have surrender charges, or at least have dramatically lowered surrender charges as well. But yeah your point’s valid that it’s hard to know who you can trust in the world of annuity purchasing.

Rick Ferri : Let’s talk about another buffer asset that you mentioned a few times, now called a reverse mortgage, which you wrote a book about. In fact it was your first book. You wrote it in 2016. Some of the rules and regulations have changed since the book has come out so could you go over reverse mortgages and how reverse mortgages could work into this whole retirement plan.

Wade Pfau: Right. So it’s another tool that you can have as part of the toolkit, and indeed as people were starting to really figure out the value of reverse mortgages, and it was possible to set one up for 125 dollars in some circumstances. In August 2017 there was a rule change introduced that got implemented October 1st 2017 that effectively, by increasing the initial mortgage insurance premiums, raised the initial cost of setting up a reverse mortgage quite dramatically. I wasn’t planning to do it, but I had to like to write a second edition of my book to redo all the analysis under the new rules. Found the new rules did weaken the case for a reverse mortgage but didn’t completely overturn it. So the second edition of my book accounts for today’s rules.

And it’s the same idea, if you can be strategic and you open the reverse mortgage and then use it strategically alongside the investment portfolio in any number of ways it can help lay a foundation for a better retirement outcome in terms of either supporting more spending and /or the same spending but having more legacy at the end of retirement as well, where legacy in that case would be what’s left in your investments plus the value of your home minus the loan balance due on the reverse mortgage. Where it’s the buffer asset, same as we were just talking about with life insurance, that you have the reverse mortgage line of credit and it’s growing over time and it can’t be cancelled or frozen and then rather than having to sell from your portfolio at a loss in a troubling time you could tap into the reverse mortgage as a source of funds. Again it’s proceeds from a loan so it’s not taxable income. It doesn’t show up as part of your adjusted gross income and it can provide that bridge for spending. You could also just set it up as a contingency fund, as a way to have liquid contingency assets for any sort of spending shock. So there’s a lot of ways reverse mortgages can be used.

Rick Ferri:  Wade, a lot of these ideas seem to make sense. What stops people from doing it?

Wade Pfau: In terms of annuities there’s this whole academic literature about the annuity puzzle, just trying to explain why people are not comfortable with annuities and that we’ve talked already about the lack of liquidity and upside potential in a traditional income annuity. Another thing is just people, they view it as the gamble, like we discussed that if I buy the annuity and then I die early, the insurance company wins at my expense, and people aren’t always comfortable with that. That’s not strictly how the annuity works. It’s so long lived in the risk pool that win at your expense rather than the insurance company but that can certainly be an impediment.  And so there are things as well, like charitable gift annuities where you can– usually the payout rate would be less with a charitable gift annuity because it’s trying to build in something for the charity,  but in that case you can frame it more as well the charity would win at my expense rather than the insurance company. So that can be a potential solution to that annuity puzzle.

Rick Ferri: Could you explain what a charitable gift annuity is?

Wade Pfau: It’s a way for charities to receive charitable contributions from individuals but to link that as well to a lifetime income. Now charities have different approaches. The safest approach for the charity is they take your gift and they purchase from a commercial insurer an annuity for you to pay you. But because they’re offering a lower payout rate than a commercial annuity they’re able to then keep part of that as a gift. The riskier way for a charity to manage that would be to actually become an insurer themselves, so to speak, and to pay out the annuities through the collections that they receive, but either way the idea is they’re paying below market rates as annuities, and therefore on average, are able to receive a charitable contribution so that people can make that gift sooner but still receive a lifetime income connected to it. So that they can also be thinking of it as it’s like a way to mix their retirement spending and their charitable giving together into one overall strategy rather than keeping them separate. 

Rick Ferri: How do the taxes work on that. In other words you give a gift to charity and they buy you an annuity. I mean how much of a deduction do you get on the gift and how much do you have to pay in taxes on the income that you get from the annuity?

Wade Pfau: Well you’re not going to necessarily get the full tax deduction right away. You probably do want to indeed talk to a CPA to make sure that you’re getting all those specifics right because indeed part of a charitable gift annuity payment can be taxable income.

And as we talk as well about this annuity puzzle and kind of why don’t people seem to like annuities another idea that’s been offered is it’s been called the Scrooge McDuck effect from the old cartoons. He loved to jump into his money bin and swim through his money and it was like people want to see their money. They may not have a money bin like Scrooge McDuck but when they look at their portfolio statement, if they see a lot of funds they feel wealthier, and if you purchase an income annuity you can lose that phenomenon. The annuity has a present value of its lifetime future payments and that can be substantial, but that’s not usually reported anywhere and so people may feel poorer after purchasing an income annuity because instead of having this pot of assets to look at they do have a valuable asset, they just don’t get to see it and they don’t appreciate it as much for that reason. 

Rick Ferri: Let’s jump into one topic that you talk about a lot that is not insurance related and that is using TIPS in a portfolio.

Wade Pfau: Well, so interest rates are very low now but that’s true across the board. If you’re going to hold individual or if you’re going to hold bonds in retirement,  I think yeah the case for TIPS would be much stronger than for traditional treasuries. But at the end of the day I don’t just simply know how many different types of bond holdings a retiree needs. I would lean more towards using that income annuity approach instead. But if you want inflation protection, TIPS and I Bonds are the bonds that can provide that to you.

Rick Ferri: Let’s end with what you call the retirement research manifesto where you have eight points. You put this in the beginning of all your books, and I just want to go through them with you and you comment quickly on each one. The first one is play the long game. 

Wade Pfau: You occasionally hear somebody say, “Oh I don’t need a retirement plan. I’m going to be dead by seventy.” And that’s not really the way to think about retirement planning. You’ve got to assume you’re going to live a long time. That’s the foundation of how we mostly think about retirement, but it’s just important to have that reminder. 

Rick Ferri: Number two, don’t leave money on the table.

Wade Pfau: The idea there is to just be efficient with your planning and there’s so many parts of retirement income where a small short-term expense can lead to a big long-term benefit and that’s what I mean about not leaving money on the table in that regard.

Rick Ferri: Use reasonable expectations for portfolio returns.

Wade Pfau: I think that one’s really important. A lot of financial planning software just plugging in historical averages for everything, assuming bonds are going to average five or six percent returns when we see interest rates in the neighborhood of one percent. You’ve got to be realistic and especially with sequence risk.

Rick Ferri: Which leads into number four, be careful about plans that only work with high market returns.

Wade Pfau: So much of the simple stuff you’ll see online is assume an eight percent rate of return and this or that happens and sure it’s easy to fund retirement with eight percent returns but the probability of getting those is not necessarily all that high. You’ve got to make sure you have a plan that can work even if you don’t get eight percent returns.

Rick Ferri: And that leads us to what we talked about today. Number five, build an integrated strategy to manage various retirement risks.

Wade Pfau: Bonds are a starting point, and the way to try to spend more than just a simple bond portfolio, you have the diversified stock portfolio, aggressive portfolio, and get a risk premium from the stock market. Or you use an insurance approach and get risk pooling. And either way you have the potential to spend more and they can manage these different risks, the longevity, the market risk, and the spending shocks in different ways. So integrating tools together is important. 

Rick Ferri: And number six is the reason I wanted you on the call today because of what’s going on in the financial markets, with very low historic low interest rates, negative interest rates all over the world. Approach retirement income tools with an agnostic view.

Wade Pfau: Yeah, that’s the important one because if you come from a particular area you think that’s the solution for everything, whether it’s investments, whether it’s insurance, even people who think that reverse mortgages are the solutions for everything. And at the end of the day just keep an open mind about any sort of tool. Think about how it can contribute to your plan and think about things that way, don’t just exclude things without a deeper investigation.

Rick Ferri: Number seven, start by assessing all retirement assets and liabilities.

Wade Pfau: The retirement balance sheet, it’s about asset liability matching and so you figure out your goals. They lead to your liabilities, their expenses, and then you map your assets to those goals and you try to match up the risk characteristics. So you don’t want a lot of stock market investments for your basic expenses, that sort of thing, but you need to think about the whole picture about matching assets to liabilities.

Rick Ferri: And finally, distinguish between technical liquidity and true liquidity.

Wade Pfau: An investment portfolio can be technically liquid but with asset liability matching, if I believe in the four percent rule and I have a million dollars and I want to fund $40,000, that money though technically liquid is not true liquidity. It’s earmarked to meet my future spending. True liquidity is when you have assets that are not earmarked for something else and then they become the source of reserves that can fund your contingencies in retirement.

Rick Ferri: Wade, thank you so much for being on Bogleheads on Investing. You gave us a lot to think about, and I very much appreciate you being on the show today.

Wade Pfau: Well thanks it’s been a pleasure.

Rick Ferri: This concludes Bogleheads on Investing podcast number 24. I’m your host, Rick Ferri. Join us each month to hear a new special guest. In the meantime visit boglelheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening.

Investment adviser, analyst, author and industry consultant

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