David Blanchett, PhD, CFA, CFP®, is Managing Director and Head of Retirement Research for PGIM DC Solutions. PGIM is the global investment management business of Prudential Financial, Inc. He is also currently an Adjunct Professor of Wealth Management at The American College of Financial Services and Research Fellow for the Alliance for Lifetime Income. David has published over 100 papers in a variety of industry and academic journals. When David isn’t working, he’s probably out for a jog, playing with his four kids, or rooting for the Kentucky Wildcats.
Michael Finke, Ph.D. is a Professor of wealth management and Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services. He received a doctorate in consumer economics from the Ohio State University in 1998 and in finance from the University of Missouri in 2011. He leads the O. Alfred Granum Center for Financial Security at the American College and is a Research Fellow at the Retirement Income Institute, a member of the Defined Contribution Institutional Investment Association Academic Advisory Council, and serves as a Trustee on the Pension Reserve Trust of Puerto Rico. He is a nationally known researcher in the areas of retirement income planning, retirement spending, life satisfaction, and cognitive aging. He is a frequent speaker at financial planning conferences and was named one of the 25 most influential people in the field of investment advising in 2020 and 2021 by Investment Advisor Magazine.
Wade D. Pfau, PhD, CFA, RICP® is the founder of Retirement Researcher, an educational resource for individuals and financial advisors on topics related to retirement income planning. He is a co-founder of the Retirement Income Style Awareness tool and a co-host of the Retire with Style podcast. He also serves as a principal and the director of retirement research for McLean Asset Management. He also serves as a Research Fellow with the Alliance for Lifetime Income and Retirement Income Institute. He is a professor of practice at the American College of Financial Services and past director of the Retirement Income Certified Professional® (RICP®) designation program.
Does the 4% rule still work? In this episode, we welcome three esteemed experts to counter a recent controversial claim made on the Dave Ramsey Show regarding the validity of the 4% rule in retirement planning. Joining us is David Blanchett; the Managing Director and Head of Retirement Research for PGIM DC Solutions, Michael Finke; a distinguished professor of wealth management at the American College of Financial Services, and Wade Pfau; Director of Retirement Research at McLean Asset Management. In our conversation, these experts shed light on the intricate world of retirement income planning, dispelling misconceptions and advocating for a more nuanced approach. Discover the flaws in Ramsey's assertion and explore the dynamics of sequence of return risk in retirement planning. Unpack the complexities of investing in bonds for retirees and the evolving risk profiles of stocks over varying investment horizons. We also uncover the significance of variable spending rates, debunk the fallacies behind aggressive withdrawal suggestions, a safety-first approach in retirement finance, and much more. Tune in for an enlightening journey through retirement planning and equip yourself with expert insights to pave a secure path for your financial future!
(0:07:26) The motivation for addressing Dave Ramsey’s 8% retirement spending rate claim.
(0:09:48) Unpack the holes in Dave Ramsey’s 8% claim.
(0:15:08) How important sequence of return risk is for retirement planning.
(0:17:57) Discover if investing in bonds is risky for a retiree.
(0:21:55) Learn how the risk of holding stocks changes for longer versus shorter investment horizons.
(0:24:04) Subjective risk tolerance and how it is influenced by market fluctuations.
(0:30:10) Going all-in on stocks compared to strategies that involve both bonds and stocks in your investment portfolio.
(0:35:23) They share their thoughts on Dave Ramsey’s notion that the 4% rule is depressing.
(0:37:28) Overview of the issues and misconceptions surrounding the 4% rule.
(0:40:06) Alternative approaches to spending money from a riskier investment portfolio.
(0:43:01) Dynamic spending strategies to improve the initial withdrawal rate from investments.
(0:50:05) Explore other financial products, like annuities, for retirement planning.
(0:58:46) Mindset hurdles and adjusting expectations for financial planning.
(1:02:24) Dissect the concept of delaying government pensions and its impact on investors.
(1:07:52) Insights into the pros and cons of delaying social security for higher-earning women.
(1:09:30) Final words of wisdom the guests have for listeners.
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, and Cameron Passmore, Portfolio Managers at PWL Capital.
Cameron Passmore: Welcome to episode 289. And this week, Ben, we have a fantastic episode where we invited and we're super grateful to welcome three experts to give a counterargument to an episode of the Dave Ramsey show that was aired on November 2nd, which really took a run at the 4% rule safe withdrawal rate. We thought, "Well, let's get the three gentlemen who wrote an article as a counterargument to that opinion." And they all agreed to join us.
So, joining us today will be Michael Finke, Wade Pfau and Dave Blanchett. Dave's been on the show twice. Wade's been with us once. And this is the first time visit for Michael. With that, Ben, before we do a bit of their bios, why don't you set up the episode that happened on the Dave Ramsey show?
Ben Felix: I mean, I made a video responding to this too. I think a lot of people made content. You'll hear these guys explain why. It was just a great opportunity to educate people on why Dave was wrong because he was so wrong about so many different things. He basically just said that retirees could safely withdraw 8% from their portfolio each year on the assumption that you're going to earn 12% per year, which is incorrect for a whole bunch of reasons that you'll hear these guys talk about in a minute. And then there's going to be 4% inflation. So, you're going to earn 12%. You're going to lose 4% to inflation, which leaves 8% that you can safely spend. Now that's ridiculous for a whole bunch of reasons I won't explain why right now because you're going to hear the best people in the world quite literally give the explanation in a minute.
Cameron Passmore: Yes.
Ben Felix: Yeah. That was a big problem. But then the other thing was he was very vitriolic and very pointed toward people who do financial planning research.
Cameron Passmore: The goobers.
Ben Felix: The goobers. Yeah. The super nerds. Whatever you want to call them. Lots of mean stuff. But you'll hear how thoughtful these guys are in a minute. I don't know how many published papers they have between the three of them, but it's got to be in the hundreds. Each one of them has published a huge number of papers on this, on retirement income planning. They've done a ton of co-authored as well. They must all be buddies. That was it.
Dave came across as so abrasive on this topic that he was clearly so wrong about that it made a lot of people want to respond. And these guys wrote an article for ThinkAdvisor where they said super nerds unite against Dave Ramsey's 8% safe withdrawal rate guidance. And they basically went through all of the reasons why this doesn't make sense. And, yeah, it was a funny, funny scenario overall because Dave's word choice was comically aggressive.
Anyway, you and I talked about it. Should we invite these guys on? Because we know David and Wade. So, you reached out. And they were willing to come on, which is awesome. But this is like the brain trust of retirement income planning globally. It doesn't get better than these guys.
Cameron Passmore: Let me give a brief bio of each of them because their backgrounds are incredible. Dave Blanchett is the Managing Director and Head of Retirement Research for PGIM DC Solutions. He's the adjunct professor of wealth management of the American College of Financial Services. All three of our guests are research fellows for the Alliance for Lifetime Income. And Dave is also the co-host of the Wealth, Managed podcast with our other guest, Michael Finke. Michael is a first-time guest on the podcast. He's a professor of wealth management for the American College of Financial Services. And their Frank M. Engle Distinguished Chair in Economic Security.
And Wade Pfau, a second-time guest. He is the co-creator of the Retirement Income Style Awareness Tool and the Director of Retirement Research at McLean Asset Management. Professor of practice at the American College of Financial Services and also co-host of a podcast called Retire With Style with co-host Alex Murguia.
Ben Felix: Yep. It's good introduction.
Cameron Passmore: Three great communicators. Three great guys. And this is one fantastic conversation. I just love this topic.
Ben Felix: Yeah, you do love it.
Cameron Passmore: I love the nuance about the value of having variable spending rates in retirement. It's so fascinating the impact it can have. And we asked him that question. How big an impact? I mean, you'll be blown away by how important it is to understand this.
Ben Felix: But it's also such a complex topic. Because you could spend a career going down that variable spending pathway, and how to optimize it, and how people should be doing it and all that kind of stuff. But as you hear Wade talk about, that's not the best way to do this mathematically. And more subjectively, it's not the best way to do it for most people based on their research. They find that two-thirds of people prefer somewhat of a safety-first approach with the alternative being variable spending from a portfolio of risky assets.
I do want to mention at the top here just in case people miss it at the very end, Wade has a tool to help people assess their retirement income style. That's the RISA tool. And he is giving us a URL that we'll post in the show notes where people can access the RISA profiler and figure out what their retirement income style is, which is pretty cool.
Cameron Passmore: Love it. Okay, Ben. With that, let's go to our conversation with three experts; David Blanchett, Michael Finke and Wade Pfau.
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Cameron Passmore: David Blanchett, Michael Finke and Wade Pfau, welcome to the Rational Reminder podcast.
Wade Pfau: Thank you.
Michael Finke: Great to be here.
David Blanchett: Great to be here.
Cameron Passmore: It's great to have you, guys. I know, David, you've been on twice. Wade, you've been on once. And Michael, it's great to have you on.
Michael Finke: It's good to be here.
Cameron Passmore: Okay. Let's kick it off with a very technical question. Do any of you guys actually live in your mother's basement?
David Blanchett: I don't, but I used to live with my grandmom if that's close enough. I lived with her for about a year. But not my mom's basement.
Wade Pfau: Yeah. And where I'm at in Texas, we don't even have basements.
Michael Finke: That's right. Yeah, I'm in Texas too. The basements don't even exist here.
Wade Pfau: I never realized there were houses without basements.
Cameron Passmore: That's like the perfect response, Wade. That's too funny.
Ben Felix: And what's your favourite type of calculator? Each of you?
David Blanchett: I use Excel. I'm an Excel guy. A huge Excel junkie. I mean, it used to be like the TI BA II + back in the day. But I've evolved into just a full Excel junkie.
Wade Pfau: Yeah. For me back in high school, it was all about those graphing calculators that you could convert into game playing machines and all kinds of – I think it was the PI 85 I think that was the popular one back in the day.
Cameron Passmore: Wow.
Michael Finke: Don't you miss the 12C though? Don't you have a certain amount of reverence for the 12C? It's so 80s. It's like 80s finance person. It's this brick. It's backwards. All the logic of it doesn't make any sense. Only a few people really understand how to use it. It's indestructible. I mean, the 12C, there's nothing better.
Cameron Passmore: I remember the reverse logic. That was something.
Michael Finke: It was. Yeah.
Cameron Passmore: Okay. Let's kick it off on a little more serious note. Why did you guys decide to respond to Dave Ramsey's claim that 8% is a safe retirement spending rate?
Wade Pfau: Well, that's not a new claim from him. And I think we probably have all responded to it before. We've really had the foundation at this point to know for at least 30 years that that's not really a statement that makes any sense. I suppose it was just a matter of he's calling out all the researchers out there who are saying that you have to look at more conservative numbers. And, “8% should be fine” I think it's something that needs to be responded to because he does have so many listeners.
Cameron Passmore: I think you meant goobers, not researchers, Wade. Just for the record.
Wade Pfau: That's right.
Michael Finke: I think for me what got me was his like aggressive negativity. And it sounded – I forget the gentleman's name that's actually done research on his website talking about like 4% or 5% percent.
Wade Pfau: They said George, I think.
David Blanchett: Yeah, George.
Michael Finke: Yeah. Just going – how wrong, though. And I think his daughter was about to correct him but didn't. I think there's chances in there where he kept saying things that were so wrong that it was like a new level, to Wade's point. He's been saying this for like a decade, but that was kind of like next-level hate on good advice.
Cameron Passmore: He was really aggressive against like you guys as a group. Not you specifically, but researchers in the space as a group.
Michael Finke: And I think that one of the great opportunities is when someone says something like this that is so over-the-top wrong, that it's a great opportunity to then go back to why it's wrong and to be able to remind people that there is such a thing as a sequence of returns. That you don't get 12% return per year on stocks. And that has some implications on what happens to your portfolio. If you get some bad years and you don't adjust your spending, then you're spending a lot of money. But your portfolio is smaller even if you get a higher return. It's not going to bail you out. All of these concepts, I think we all know them intuitively. And a lot of advisers have heard stuff like sequence of return risk, but they don't really know how to visualize it in a very simple way.
And so, I thought well this is an opportunity to just explain some of these fundamental concepts that most of us who do retirement income research, we talk about them all the time, but we don't really explain the basics. And because he was so wrong, it was just such a wonderful opportunity to explain the basics of retirement income planning.
Ben Felix: Can we keep going in that direction? What specifically does Dave Ramsey get wrong about retirement math to justify the 8% spending claim?
Michael Finke: What does he get right? I mean, yeah, ask that question two ways. I'll let Wade take it from here.
Wade Pfau: Well, yeah. I mean, he's just doing a really basic calculation. He's saying the stock market historically averages 12%, which first issue there is that's in a single year. But if you look at growth over time, it's going to be less than that. But even saying the market grows 12%, he's assuming you get 12% every year. And so, you just build a simple spreadsheet.
And the idea is he says you take out 8%, there's 4% to account for the inflation. Every year, your portfolio is going to grow 12%. You're taking out like an 8% real amount from that. And you just continue to increase your spending for inflation throughout retirement. And in that regard, you never even dip into your principle because there's no volatility. Every year, your market portfolio grows 12% and you consistently spend and enjoy and never face any sort of issues or risks or anything else in your retirement plan.
That's the calculation he's doing in his mind. And what's wrong about it is just the reality that markets are volatile. People do have to pay investment fees. Market volatility reduces the growth rate of assets compared to just a simple calculation of what's the average historical return. You can't really spend as much. And it assumes people are holding 100% stocks throughout retirement, which is not going to be a common occurrence as well. That's the basic idea of what he gets wrong.
Michael Finke: This is such a great opportunity to talk about the way that economists think about taking investment risk. Because to an economist, risk means dispersion. There's a range of potential outcomes. You can get unlucky. You can get lucky. You have to live with the consequences of getting either unlucky or lucky. And he's just assuming that there is no risk. And there would be no reward for investing in stocks if there was no risk.
But because there's risk, there is an expected reward. Not necessarily a guaranteed reward. But we expect that on average you're going to get a higher return. But part of that bargain is that you have to accept a wider range of outcomes. And if it just so happens that you get bad, unlucky outcomes at the beginning of retirement, that screws everything up with the math.
Cameron Passmore: We know that he likes American funds, some of which have done very well for a long time. Would an 8% withdrawal rate work for investors who happen to have owned those exposed successful funds?
David Blanchett: I mean, it would have some of the time. I mean, Wade might have looked at this for over a decade. I mean, some investors get really lucky. I mean, if you retire, the markets go up 10%, 20% a year, you'll be in great shape. The problem is it doesn't always do that.
And so, the short answer is sure. It's worked some of the time. It's not going to work all the time. And while American funds, those funds have done pretty well, things – and Wade did this over a decade ago. Things look very different if you use other country's historical returns. Sure, sometimes it's worked. But I think an expectation that is an incredibly unrealistic withdrawal from a portfolio.
Wade Pfau: And another aspect too is when you look at the historical data, starting in 1982, markets did very well. So, an 8% withdrawal rate would have worked fine for a retiree in 1982. But if you look at what it took to get to 1982, they struggled with market returns, a very high inflation, volatile, low returning type environment throughout the 70s and the early 80s there. They wouldn't have had as much wealth.
And so, even though they do get to enjoy, in the case of 1982, maybe even close to a 10% with all rate, it's not that they have such a dramatically better retirement than anyone else when you consider the lower starting base. And, yeah, sometimes the 8% spending rate will work. It's just not going to be a common occurrence. And it's going to have a high likelihood of depleting the portfolio if you really insist on spending that amount every year.
Michael Finke: There's this kind of annoying tendency to look backward and try to project something unusual happening in the future or an added amount of safety if you just would have followed this strategy. In retirement income planning, I've seen some articles where people say, "Well, if you just would have been more value stock heavy. Or if you just would have taken advantage of some of these factors that historically had outperformed, you could have withdrawn more money from your portfolio."
Well, all you have to do is look backwards and figure out what did better? For example, if there was a family of funds that outperformed historically, you can say, "Well, if you just invested in those smart things, those good funds, then you could have withdrawn more." And of course, if back when a lot of this research was really popular, you had moved into small-cap value and thought that that would have been the key to allowing you to spend more every year more safely and then you went through a period like the last five years, I mean, you would have just gotten slapped by the higher performance of growth.
Essentially, if you're just looking in the rearview mirror, then you can always come up with a rationale for how people could have spent more money. But oftentimes, that rationale doesn't really play out in the future. You can't really count on magic fairy dust to save you or to give you some amazing ability to be able to spend more than you otherwise could in an efficient market.
Ben Felix: Can you guys talk about how important sequence of return risk is to how investors fund the retirement consumption?
Wade Pfau: Sure. It's kind of one of the key ingredients of what makes retirement different from pre-retirement. When you think about wealth management or wealth accumulation, you as a saver can benefit from a market downturn. Because if you're saving, you get to buy more shares and a better overall position. It reverses in retirement when you're taking distributions. If there's a market downturn and you're having to sell shares to fund expenses, you're having to sell more shares to meet a particular spending need. Those shares are gone. And then even if the overall market recovers, your portfolio doesn't get to enjoy the full recovery. The market returns in the early retirement years have a really disproportionate impact.
And what it does is it amplifies investment volatility. Because where the 4% per rule idea comes from, it was based on you could hold a 50-50 portfolio of stocks and bonds. In the US data starting in 1966 through 1995, the average return over that 30-year period wasn't all that terrible. But it was the sequence of returns. You had high inflation and downturns in the financial markets in the late 1960s and then the big downturn in '73 and '74.
I already mentioned 1982. The best-case scenario in history begins halfway through the worst-case scenario in history. You could have used almost a 10% withdrawal rate starting in 1982. That's halfway through the 1966 hypothetical retirement. But by that point, it was too late for that 1966 retiree. They were on the trajectory to the worst-case scenario because they were spending from their portfolio. And so, they don't get to enjoy the market recovery that happens after 1982. Their portfolios already on track. It's headed toward zero. And, well, the best case is when history begins halfway through the worst case in history. That's really sequence of returns risk in a nutshell.
David Blanchett: I think sequence of return risk makes retirement very unfair where you could have the same exact geometric return over the 30-year time horizon but be able to spend two or three times more. And so, for better or for worse, we all only have one retirement path. Well, you can run a thousand Monte Carlo at 100,000, how many every number you want to choose. But everyone's path is different. And the returns you experience when you first retire radically affect that outcome.
As you move through your retirement, you move towards the certainty of an outcome. But if you're lucky enough to retire when the market goes up, you're probably going to be in great shape. A lot of folks aren't that lucky. And I think that's where this idea that you should be invested 100% in equities when you retire, it's just a really bad idea. There's very few people that would suggest retirees should be invested all in stocks given how much risk that places on that particular path of that retiree.
Cameron Passmore: Do you think there's a point where people can have too much in bonds and that becomes actually risky for a retiree?
Wade Pfau: Yeah. With bonds, you have to take a look at the yield curve and see, well, how much can I support? I could build a bond ladder and not have to worry about the short-term volatility if I hold these bonds to maturity. You can calculate exactly how much you're able to spend. And as soon as you try to spend more than that, bonds are going to ensure failure. And so, the trade-off becomes do I want to invest in stocks with the hope of growth to spend at a higher level than bonds can support?
But certainly, yeah, in the historical data, the 4% rule in Bill Bengen's initial article, he said always hold at least 50% stocks. Later when you break it down a little more, you could go as low as 35% stocks. But below that, the 4% rule limits you much lower withdrawal rate as you get to lower and lower stock allocations.
And even in the international data, I did a study about sustainable spending with 20 different countries' financial market data back to 1900. In 18 of the 20 countries, the safe max, the highest spending rate you could have done in the worst-case scenario occurred with at least 50% stocks. In 18 of the 20 countries, it was only Sweden and Switzerland where a lower stock allocation would have worked better than a higher stock allocation. Yes, you can definitely go too low with bonds if you want to spend more than bonds can support.
Michael Finke: I'm going to get a little geeky here. Because that's what we do. The answer to that question depends a lot on the bonus that investors are getting for taking investment risk. And that bonus that investors are getting for taking investment risk, it's not guaranteed. And it seems to be higher and lower in different eras.
For example, if stocks are priced at a level that suggests less growth in the future, then the tradeoff of a higher bond allocation is going to be less significant. And it seems like a good indicator is how much are people paying for a dollar of average profit that the company made over the last 10 years. Or in the S&P 500, how much are people paying for a dollar of profit? That's actually very predictive of the performance that you're going to get in the future from stocks.
And stocks are expensive right now. Stocks are more than twice as expensive per dollar of historical profit as they have been historically in the United States. You wouldn't expect that stocks are necessarily going to provide that same benefit over bonds that they have in the United States. It's almost impossible for them to do what they've done historically when they're priced as they are today for today's retirees. That's going to influence the tradeoffs of having a higher bond allocation in a marketplace like the one that exists right now where bond yields are relatively high and stocks are pretty expensive. It's very possible that, in the future, safe withdrawal rates are going to be pretty similar between a higher stock allocation and a lower stock allocation. David, would you agree with that? You've also done a lot of research in this area.
David Blanchett: I think it's very time-dependent right now. You've got real yields on tips at 2%. They were negative three years ago. I think that there is this kind of time dependence. I think that the future returns on the stock market is a lot more uncertain. I think there's going to be winners and losers. I think that the role that bonds can play in a portfolio, it really does vary over time. I think that right now you can make a much better case for them than you could maybe two or three years ago. But look at what happened in 2020. Everything was down over 10%. It requires this constant evaluation.
But I do believe that, for most retirees, it's important to be somewhere in the middle. You shouldn't be all in fixed income. You shouldn't be all in equities. I don't know what the band is for that sweet spot. But there really are I think risks on both ends of that spectrum.
Ben Felix: Can you guys talk about how the risk of being in stocks changes at longer investment horizons versus shorter ones?
David Blanchett: I would love to. I'm actually doing some – we did a paper on this about a decade ago. It was actually part of my PhD dissertation. And there's this kind of assumption that exists that returns are independent over time, right? That returns follow a random walk. And the thing is, is that hasn't been the case. A lot of advisers talk about time diversification.
The risk of every asset out there increases over longer investment time horizons. Risk does not go down. Risk goes up. But the risk goes up at different rates. And we've seen historically across multiple countries is that the risk of equities changes at a different rate than the risk of fixed income. And that equities can become increasingly attractive, especially for investors who are concerned about inflation the longer you hold them, right?
Nominal bonds aren't necessarily a great longer-term inflation hedge. Some of the structural drivers of equity returns really are a decent way to hedge long-term inflation. I think the key is to look at the data historically. Returns don't evolve non-randomly and that there has been a pronounced benefit across most countries over most time periods where if you're going to be a longer-term investor, it does benefit you to be a bit more aggressive.
Wade Pfau: There's another little subtle detail with retirement income and long-term horizons that, usually with a longer time horizon, it points to a higher stock allocation even in retirement even though there's sequence of return risk. But what happens is the longer the time horizon, you have to look at a lower withdrawal rate to be sustainable over the longer time horizon. And as you lower the withdrawal rate to help the money to last for longer, that reduces the sequence of returns risk. And so, that makes it easier for a higher stock allocation to weather any storms and support that longer time horizon. But it's because the withdrawal rate is lower, it's really behind the scenes what's driving that sort of outcome as well.
Ben Felix: Oh, man. That's interesting. A longer time horizon requires a lower safe withdrawal rate, which allows for a higher equity allocation.
Wade Pfau: Right. Exactly.
Ben Felix: That's very cool. We can say stocks maybe get a little bit less risky at longer horizons. What about subjective risk tolerance? How does subjective risk tolerance change with fluctuations in the market?
Michael Finke: Well, Michael, I mean everyone's rational, right? People don't vary their expectations over time, right? Yeah. There is this what I like to call the inverse law of demand rule with stakes. And that is that as prices go up, people want more. And as prices go down, people want less. And in fact, that's what shows up when you look at consumer risk tolerance surveys. We've looked at it from investors that work with a financial advisor. We've looked at participants in retirement plans. And we see the same thing, which is that when the market has gone down and stocks are cheaper, people are more risk-averse. And when the market has gone up and stocks are more expensive, people are more risk-tolerant. They want to take more investment risk.
That actually leads to consistent underperformance. There have been mutual fund studies that find that the average investor loses about 1.4% per year compared to someone that just doesn't make any changes at all in response to changes in the market. And the biggest mistake is to sell stocks after they've fallen in value. That's where people lose the most money.
Now, consequently, we also spent a lot of time doing research on investor behaviour in retirement plans. And what we see is that target date fund investors who tend to be the least financially sophisticated investors, the lower income, less education, they actually outperform everybody else because they're not doing anything.
In some cases, being blissfully ignorant is actually in your best interest as an individual investor because you're not tempted to make these changes that result in lower performance over time.
David Blanchett: I think a really important point about this notion of time-varied risk aversion is who exhibits it the most. I think that if I were to ask you, “Hey, who do you think is out there actively trading,” and the markets go, “You're wrong,” you would say, “Oh, it's probably younger people because they haven't done this before. They haven't been through ups and downs.” That is unequivocally false, right? Our research shows that it's older investors, participants, et cetera that exhibit this effect. We don't know why. But if I had to guess what is it that drives this variation and risk tolerance and trading activity, it's like the salience of retirement.
I mean, I think retirement is like a mirage when you're 35 years old. It's going to happen at some point in the future. No big deal. But I think as individuals kind of move toward their retirement, they're increasingly concerned about, “Oh, my God. If my portfolio goes down by 20%, I can no longer go on vacation. So I've got a sell to kind of lock this in.” I think that's a really important point about this.
Some people like Dave Ramsey say, “Hey. Oh, stocks go up more than bonds. You should be heavily invested.” He's somehow assuming that investors that have all this wealth will stay invested. I just question that assumption a lot for older individuals, those who are retired and don't want to go back to work. So I think that this idea that people can stay in for the long term but doesn't jive with reality, especially among retirees, older investors that don't want to go back and work and are more kind of subject to market down terms.
Ben Felix: David, do you think it's the percentage on that amount? Or is it the dollar value? A bigger portfolio of 20% is a much bigger absolute number. Is that what's really driving it do you think?
David Blanchett: I just think it's just age. I think it's just the implications on lifestyle because the problem with the balance is a half a million dollars could mean a lot more to me than your 500 balance based upon our lifestyles, our goals, our preferences, our guaranteed lifetime income amounts, all these different things. I mean, again, I totally could be wrong. I think what happens with this age factor is it just becomes very real. People who are 25 don't spend a lot of time thinking about how much they're going to have when they retire. What are the implications of a drop?
Anyone that's a few years away like my in-laws, every day, they're checking their balance. One day, they called me up. There's like a dividend imposed, and they’re like, “Call Fidelity.” They're actively concerned. They're like hyperfocused. That hyperfocus, I think, actually hurts them versus, as Michael said, folks that buy targeted funds that aren't as sophisticated because they just don't worry about it.
Ben Felix: So you're saying older investors just by age, that's the variable we're looking at. Their subjective risk tolerance becomes more sensitive to market fluctuations.
Michael Finke: The more equities they have, the more sensitive they become. That's really the big risk of encouraging older investors to take excessive investment risk is that they may not capture the benefit from taking all that risk. So in other words, they may get all the volatility and none of that bonus that you expect to get above bond returns for accepting investment risk because the more risk you take, the more sensitive you tend to get.
Wade Pfau: This counters a little bit. There was a whole line of research maybe 10 or 15 years ago that talked about the portfolio size effect, which was saying that like target-date funds got it all wrong. They had higher stock allocations when you were younger and didn't really save much yet. So there was really nothing at stake. If the market doubled, you maybe gain a couple thousand dollars because you haven't saved much.
But then by the time you get to your target date, that's where you have 30 years’ worth of savings, given market upturn or downturn can have a much bigger impact. But that argument was this is your only opportunity to actually benefit from market growth. So you should have the higher stock allocation near retirement. Yes, that's more quantitatively trying to look at what might work best.
But you do got to consider the real-world implications of people's comfort and ability to stay the course and not panic and whether that market volatility. As the research that Michael and David have done notes, that does become harder to do with age.
Ben Felix: Okay. So you guys are like the perfect people to ask this question, too. There's a paper going around right now, you may have seen it, that shows in a sort of quasi-empirical setting using bootstrap sampling of a big historical data set that being 100% in equities with a big chunk of international equities, so big domestic international split 50/50, dominates any other asset allocation; target date, any of the stocks minus age type things, anything. Anything that has bonds in it basically gets dominated by this all-stock portfolio. What do you guys think about that?
David Blanchett: Well, I've seen the paper. I have the data, but I'm not a robot, and people aren't robots. It's just not realistic, right? No person that works with real humans would suggest that. I mean, it's also – I know the paper you're talking about. Michael and I have been doing research on investors for longer time horizons. I just don't believe it. We don't know what's going to happen over longer time horizons. I like the fact that they took like 10 years of bootstrap data because they capture the time diversification effects over.
So like it's a better way to think about it versus pure ID returns, but it's not clear how much all that's going to persist in the future. We don't know what's going to happen. There are these growing dependencies across global economies historically. So I would never recommend that for retiree investors.
Michael Finke: I want to talk about this because I think it's a good way to revisit investment theory again, which is something that I love. First of all, a 100% equity portfolio is never going to be the Sharpe ratio maximizing portfolio. In other words, the amount of extra return that you're getting for a given level of risk is never going to be maximized by 100% equity portfolio and even using the historical data, which probably overestimates the amount of equity returns that we're going to be able to get in the future.
The right way to do it is to select the Sharpe ratio maximizing portfolio. If we want to take a little bit of extra risk, then we can maybe leverage it. But if you incorporate these leverage constraints, then you can say, well, maybe 100% equities is the right approach.
There's a lot of reasons why equities historically might have outperformed. If we think about how difficult it was for people to invest in equities, the transaction cost. You had to trade it. It would cost you $70 to make a trade back in the early 1970s. You could not put together a well-diversified portfolio at a low cost. You had very high capital gains, tax rates in the United States. It was just far more difficult to even capture the equity risk premium historically, and it's one of the reasons why you would have expected it to be higher to induce investors to buy stock in the first place.
Today, we've gone from like one out of every seven people owning stock to one out of every two. People do it automatically in the retirement savings account. The question becomes like how much of a reward do you really need to give people today to get them to invest in stock, as opposed to investing in bonds? That's going to determine then whether or not going forward that allocation of 100% equities is the right strategy because if that equity risk premium is really only, say, 200 or 300 basis points, then there's going to be a lot more risk, a lot more variation in future lifestyle outcomes that has existed historically.
Essentially, it all is based on this premise that there is a stock premium puzzle. So an equity premium puzzle which has existed historically, there's just no way to justify it in any sort of rational model. If that's going to persist in the future, then something that has no basis in efficient markets has to continue in the future. I'm just not willing to place my bets on that. Like a lot of economists, I just don't think that you can get something for nothing. Essentially, what they're saying is you can get an equity as risk premium with very minimal downside historically.
Wade Pfau: I saw the abstract of that paper, and I feel like these kinds of papers come out every few years. I haven't read this particular one to know if it's got some secret sauce that did something different. But I remember a few years ago, it was you should actually leverage your portfolio and be 200 or 300 percent stocks. Or every couple years, someone writes in the New York Times how retirees should be 100% stocks because of the risk premium. Yes, if you assume a high enough risk premium, you can get to 100% stocks, giving you the highest safe withdrawal rate.
In that international study that I did with the different countries, I think there were five countries that the worst-case scenario was the best with 100% stocks. Again, can people actually pull that off and feel comfortable with that? Or is it – as Michael is alluding to as well, can you really rely on that sort of risk premium environment as a surety for the future?
I agree that the peer quantitative research usually does point to higher stock allocations. I don't know about 100% stocks. I'd have to see exactly what they were assuming. But in practical terms, it doesn't take you very far to just tell retirees they should be 100% stocks because, mathematically, it will support the highest withdrawal rates.
David Blanchett: Important nuance here is if you assume returns are independent, it doesn't usually work 100%. But when you incorporate zero dependence over time, like in the piece that you're referring to, that's where you tend to see this benefit. I think others have very different perspectives on how that will persist in the future. I think it will. I think there are some important diversifying effects of equities versus bonds over longer time horizons. But even like the remote suggestion that 100 people should be at 100% equity just doesn't pass even like the most basic sniff test, in my opinion.
Cameron Passmore: That was good, good comments all around.
Ben Felix: What do you guys think about Dave Ramsey's suggestion that the 4% rule is just too depressing?
David Blanchett: I actually agree. I think that a lot of the assumptions that we use on our models are overly conservative. I think that success rates are not a great way to quantify outcomes. They ignore the fact that the portfolio is only a marginal part of someone's total assets. If you think about what Dave Ramsey is talking about, it's actually more of an endowment approach versus an initial withdrawal increase by inflation.
I think that five percent is a more realistic starting place than, say, four percent for most Americans. When you capture the total economic balance sheet, when we quantify outcome, when we make changes over time, I'm even okay with six percent for a lot of people. That's not out of bounds. I think that eight percent, though, is just a step too far. I agree that a lot of the key assumptions in the 4% rule are way too conservative. But, again, it depends upon your situation, your preferences, all that.
Wade Pfau: Yes. The 4% rule was just a set of simplified assumptions to point out sequence of returns risk exists. I never really thought about it as being depressing. I guess anytime you have to tighten your belt or pay down debt or anything of that nature, that can be a little bit depressing.
Yes, I agree with David, too, that one of the primary assumptions of the 4% rule that you always increase your spending for inflation every year. If you can relax that assumption and build in some dynamism, that helps manage sequence risk. So that can allow for higher initial spending rates, and there's other – well, David’s retirement spending style, the idea that people don't really need their spending to grow with inflation. You can definitely get yourself set at a higher sustainable spending rate than four percent.
But I think it's still just a reasonable baseline. You need some set of assumptions, so you can make comparisons about what's somewhat realistic versus not at all realistic. In that regard, I think it plays its role. It was never meant to be an actual retirement strategy. It's more a research simplification. Sometimes, people take it too far. Then I even see sometimes because all these advisers think the 4% rule is what you're supposed to use that I've found this secret trick that, no, you use a variable spending strategy. Yes, it's – we all understand that. It's just a research simplification. A starting point may be depressing, but I never had really thought about it that way.
Michael Finke: Yes. Let's talk about some of the issues with the 4% rule. So the 4% rule assumes that you're going to spend the exact same amount of money adjusted for inflation every single year, no matter what happens in the market. Of course, any human being if they got a bad sequence of returns, if they saw their money that's starting to dwindle a little bit, they're going to cut back on spending. That's just what we do. In fact, we probably, most of us, have space in a retirement budget to cut back a little bit. That gives us the ability to start at a higher level and then adjust based on how well our investments are doing.
But it also highlights one of the major inefficiencies of the 4% rule, and that is that there is a huge amount of unintended bequests for people who didn't adjust upward. What does that mean? So if you get lucky and you started out with a million dollars, all of a sudden the market does well. You're at age 75, 80. You've got two million dollars. Am I going to continue to spend the exact same amount of money when I know that if I would have just simply retired today and someone was using the 4% rule, they would have increased my spending up to a higher amount.
We have to give people the ability to spend more if that's their goal from that money. That's why I think you have to be very clear about what your legacy goal is and what your income goal is. Once you do that, then you have to give people, first of all, the flexibility to decrease their spending if the markets don't do well. But, also, I think it's something that we just don't talk enough about, and that is that it is in some ways a fiduciary violation not to encourage your client to spend more if that's the goal of that money.
If you set the money aside, the market does well. They've got plenty. They're going to be just fine. You need to give them the license to be able to spend the money that they've saved because oftentimes with an advisor, they have an incentive not to – basically to scare you so that you don't spend that money. But a lot of people could live better if they were going on more cruises or if they were even giving gifts to relatives. They could live better, instead of simply dying with more money that really represents just a lot of joy that was unspent.
Cameron Passmore: Okay. So you guys all talked about various types of dynamic spending or variable spending. David, you mentioned potentially even a six percent initial withdrawal rate if you're willing to take some variability. Can you talk about some of the alternative approaches to spending from portfolio of risky assets? So the 4% rule is constant, inflation-adjusted withdrawals. What else could people be doing?
David Blanchett: Lots of ways to do it. I mean, you can rerun a financial plan. There's modified RMDs. There's guard rails. I mean, I don't know that there's one way that's better. I think that you could run analysis and based upon your assumptions and everything else. One thing that I fully acknowledge is that there's a mass amount of estimation error in any kind of financial plan. We don't know where someone's going to be next year, the following 5 years, the following 10 years.
But I think what's important is that if you run a financial plan and you use static assumptions, you’re not replicating what they’re going to do in real life. So I don't get too caught up on how someone should do it. I just think it's increasingly important that as we're doing these plans for people like using financial planning software, we somehow capture this because the retirement isn't static. It's dynamic. What happens is this frees up money you could have spent earlier in retirement. When you acknowledge the capacity to make these changes, I think it would make people more comfortable going on those vacations and doing more when they're younger.
Wade Pfau: Yes. Like David said, probably the most realistic kind of approach is people just – they spend what they need to spend or what they want to spend. Maybe if, ideally, they're going to do a periodic check-in, see if what they're spending is sustainable. If that's not, maybe that's realized as if the probability of success and the financial plan starts to dip too low. Maybe they'll make some cuts at that point.
Now, when it comes to doing research about variable spending strategies, you can't test that sort of ad hoc approach. So then there are clearly delineated variable spending strategies to look at. I've looked at a number of those, and two of the ones that I have a somewhat more favourable look upon is Will Bengen developed one of them, and he called it the ‘floor and ceiling rule.’ It's just you use a fixed percentage of what's left, rather – the 4% rule is really about the first year of retirement. You spend four percent of the balance, and then you increase that amount for inflation every year.
A fixed percentage rule is you spend a fixed percentage of what's left every year. So your spending is going to fluctuate, but then you have a dollar floor and a dollar ceiling that will adjust for inflation. You don't let the spending go outside of those bounds. So that's a way to build in some variability that can allow for a higher initial withdrawal rate that then, ultimately, the floor with that strategy may not be all that much less than you get with the constant inflation-adjusted spending of a four percent style rule.
The other one I like, too, and it's more for discretionary expenses if you have a floor of income already, is some sort of modified RMD rule. That's in the US require – well, it's basically an actuarial rule. As you age, your time horizon gets shorter. So you can spend an increasing percentage of what's left in the portfolio. Because your portfolio is fluctuating in value, it will lead to variable spending. But it's a way to spend down the assets more efficiently, and you can use that money for discretionary types goals or maybe even as a part of the legacy. But rather than waiting to the end of retirement, a way to share that while you're still alive and can see the benefit of those gifts and so forth.
Ben Felix: In general, how much do you think a dynamic spending strategy can improve that initial withdrawal rate? Do you have any rough sense of you met some and what you'd say how much improvement it could be?
David Blanchett: Twenty-five percent or more I would say. I mean, again, I think what's really important is thinking about the role of dynamic withdrawals, there's at a minimum two important toggles that exist. One is how much guarantee does someone have? So earlier, I’d said that six percent makes sense. Well, you're getting like $100,000 a year from Social Security, whatever it is, and your 401(k) is $100,000. They got six percent. Who cares? That's like $6,000. You get $100,000 from Social. You're going to be fine.
But if for some reason, you have no guaranteed income and your entire portfolio is going to fund your retirement, that changes things, right? There's this question. Well, like how flexible are you? You have all of your essential expenditures covered from existing guaranteed income? You can go crazy. If you don't have any of it covered, it's going to really reduce your ability to make a change.
But if you use better and more realistic models, at least what I found is that like that's why I say five percent is like the new four percent because incorporating just dynamic rules moves you from four to five if you overlay how retirees don't increase their funding, their retirement, or spending by inflation. It can go to six percent. I think at a minimum, it's 20, 25 percent. But it can be a lot more than that using other more realistic assumptions.
Michael Finke: If you increase that initial withdrawal rate at the beginning of retirement, I think it's also important to remember that it's going to affect the average slope of your lifestyle over time. So if you start out with a higher income goal, and then you adjust from that higher income goal, the median is going to have a lower slope than if you started out at, say, four percent. You're going to be able at the median to generate a higher slope over time.
But a lot of this has to do with how do you want to live. My perspective, I want to be able to spend more money when I'm physically and cognitively able to actually enjoy it. I mean, if you think about the average retirement period for, say, a healthy 65-year-old woman, she gets 25 years on average. She may get more. She may get less. But on average, if you think about it there like two rows of 10 dots and one row of 5 dots, she has a certain amount of savings. She's got to fill each one of those dots with her savings.
How do you do it in a way that's going to make you the happiest? I'm going to maybe put more of my chips on some of those early years. That is one of the reasons why I might want a higher initial withdrawal rate. But I have to recognize that I'm depleting my portfolio faster. If I get unlucky, that's going to lead to some worst-case scenarios where I might have to cut back significantly later on.
Wade Pfau: Also recognizing, too, being related to that idea of front loading your spending. For a lot of people, their spending doesn't keep up with inflation, other than possibly uncertain health expenses. David has the retirement spending smile concept and looking at what he created with data. I tested, well, how much could your initial withdrawal rate change if you simply applied the spending smile, which is your spending doesn't keep up with inflation. It dips.
In the scenario, I looked at David. It was about a 26% real drop by age mid-80 somewhere and then starts creeping up due to late-in-life healthcare expenses. But applying that pattern compared to inflation-adjusted spending, you could increase the initial distribution rate by 17%. That was still without any sort of variability based on market conditions. It was simply the variability and spending of a fixed pattern that you incorporated. So if you then added on a variable spending strategy on top of that as well, yes, you could easily get to a much higher number.
It's already a fairly conservative assumption to assume when you're 95 years old, you want to spend the same inflation-adjusted amount as you did when you were 65 years old.
Ben Felix: So we talked about how much of a potential boost you can get in the first year withdrawal. How much variability year to year do people have to deal with if they're implementing this kind of strategy?
David Blanchett: there's the modelling assumption. Then there's like real life. So what you'll find if you model these, we're going to use the fun fancy word, [inaudible 00:47:09], like there could be lots of variability in these over time. I think that that's just to provide a directional context of where you could be heading. Endowments do 20-quarter averages. So I think that you can imply smoothing effects on spinning evolution. It just depends on what you're willing to do.
One thing I just always get back to is just all the things that life throws at you, you cannot capture in a financial plan. So I think that it's our job to do a good job and to kind of try to reflect how things evolve on average. But I think that we've got to be realistic and say, “Hey, like over the next 30 years, no one knows what's going to happen. So let's keep it reasonable but not worry too much about kind of all these nuanced details about.”
One thing I say is why are returns the only random variable in our projection. You could have life expectancy. I think that retirement age should be a random variable because most people retire early, and that can devastate a financial plan. I mean, I get why I think one random variable hurts most people's minds. If you had like three or four, they would just lose it, and people's heads would start exploding. But there's a lot more that can happen in life than just a bad market that would devastate your retirement plan.
Wade Pfau: Also, the variability in spending would be less than the variability in the portfolio distribution because when you look at the overall spending, you probably have Social Security or other types of pension income that are not fluctuating with the market. So to the extent, that covers a portion of spending that reduces the variability of overall spending.
Then with taxes, if you're having to cut your spending, that may also be partly offset by lower taxes as well. So on an after-tax basis, you will see fluctuations in spending, but it may not be as dramatic as what we were talking about with like what could potentially be the drop in the portfolio distribution.
Michael Finke: I'll just mention quickly that the more rigid your withdrawal strategy, the higher likelihood that you're going to run out. So a guard rail strategy which says that you can only adjust down a certain percentage, that's going to result in – for the very unlucky retirees, a certain percent are actually going to run out because they can't adjust enough. They should have adjusted downward more.
Anytime you adjust the adjustments because you're never going to run out of money if you have a high enough adjustment. Then, essentially, you can every year adjust your expected longevity and whatever the value of your portfolio is. As you become more rigid, as you limit the amount of adjustment, that exposes you to that risk of potential failure over time. So really what you're doing is you're widening the range of potential lifestyle outcomes by allowing a higher adjustment every year. But you're also protecting yourself against the possibility of completely running out of money.
David Blanchett: So you're saying you need to be careful how you adjust the adjustments to your adjustments?
Michael Finke: That's right. It’s so – yes.
Ben Felix: Speaking of adjustments, so we've been talking stocks and bonds. When should people be looking at other products like annuities?
Wade Pfau: Yes. It's always a consideration for retirees. I kind of look at it with there’s three basic ways you could fund a retirement spending goal over an unknown time horizon. You start with bonds. You could like build a bond ladder if you're, “I think I want to plan for 30 years. I build a 30-year bond ladder.”
Then generally, there's two possible ways to spend more than that. One is the investment diversified portfolio. Don't just use bonds but have a healthy allocation of stocks. Rely on market growth to support a higher level of spending than you could with bonds. That's mostly what we've been talking about thus far.
The other approach is use longevity pooling through insurance which can then support a higher level of spending than bonds since those who end up not living as long will have less expensive retirements. But some of their annuity premiums then help to subsidize the payments to those who did live longer and therefore have more expensive retirements.
That raises the standard of living of everyone in the risk pool, where you can consistently spend more throughout retirement than you could with bonds alone. Now, you have an option. What are you more comfortable with? Are you comfortable relying on the market and the risk premium through the market to support a higher level of spending? Or would you prefer the protections and safety of annuities and risk pooling to support a higher level of spending than bonds?
It's really at that point up to individuals and their preferences to decide on the direction they're most comfortable with, especially when it comes to funding basic expenses in retirement. Not necessarily the overall retirement spending goal but a floor of income that they really want to feel comfortable. It'll be there, it's reliable, and it's there on a lifetime basis. That's where a conversation around annuities to fill in any sort of gaps can be more meaningful.
Michael Finke: This all feels very subjective. Is there any frameworks that exist that can help advisers figure out ways to allocate to annuities? I'm just – I'm confused here. Do you have any thoughts at all?
Wade Pfau: Yes, yes. Well, in that regard, a big question is who prefers a different type of framework? Alex Murguia and I did a research study to develop this idea of retirement income style awareness. We found two primary factors that help to explain how people think about these things. This is all based on statistical work, but it was what I was just describing, what we call probability-based versus safety first. If you're more probability-based, you're more comfortable relying on market growth to fund your retirement. If you're more safety first, you're looking more for contractual protections to cover your core expenses and retirement.
The other factor is optionality versus is commitment. If you're optionality-oriented, you really value flexibility above all else. If you're commitment-oriented, you actually find satisfaction in if I can figure out a solution that will solve my lifetime need, I'd like to get that taken care of and not worry about it. Take it off my to-do list. So the investment-based approach, the 4% rule, the conversation about it being 100% stocks, that's the world of total return. It’s probability-based and optionality-oriented.
But if you're safety first and commitment-oriented, we call that income protection, and that's much more the world of being comfortable committing to risk pooling and annuities and lifetime income protections to support basic expenses and retirement. Then that creates the comfort to invest more aggressively with the other assets because they're more for the discretionary types of goals in retirement.
Michael Finke: There's a different way of thinking about this. If you follow, say, a 4% rule, a fixed withdrawal rate rule, then you have a traditional retirement portfolio that's maybe 60% bonds and 40% stocks. You're going to invest your bonds in a bond-mutual fund. The amount of income that you can withdraw from that bond, let's say you have $200,000, and you're going to withdraw $8,000 every year from that bond portfolio. But you're still going to have a certain amount of risk every year. Interest rates could go up and down.
It's more efficient to take that bond portfolio and instead do an LDI kind of approach, where you're essentially getting rid of all the downside risk of holding a bond portfolio to fund that same amount of expenses. If you're going to do an LDI approach, the problem is that you don't know how long you're going to live. So maybe you do an LDI to the age of 100 because if you're a 65-year-old healthy woman, you've got a 10% chance of living to the age of 100, and you're willing to accept a 10% failure rate.
Well, if you buy an annuity, then you're buying an LDI portfolio to the average longevity, and you're transferring the idiosyncratic longevity risk to an insurance company if you live longer than, say, the age of 90, which is the median longevity for a 65-year-old healthy woman. In other words, from that $200,000, she might be able to spend – instead of $8,000, she might be able to spend 12, or, 13, or $14,000. Now when you think of the impact that has on your spending goal, you can cover more of your spending goal from that chunk of the bond portfolio, which means that you're pulling less money out of the remainder of your portfolio.
And in fact, you can take greater risk with the remainder of your portfolio as well. When you actually map out the outcomes with a partially annuitized portfolio at every age you're going to be spending more on average and you're not going to be at risk that if you live a very long time, you're going to have to cut back significantly.
And that's one of the reasons why we call the failure to annuitize the annuity puzzle. And you don't get any reward for accepting an idiosyncratic risk. And the only way to get rid of it is to transfer it to an insurance company. So, why wouldn't everybody just do that? And I think one of the problems is because people don't really understand these tradeoffs.
David Blanchett: Michael used lots of big fancy words there. And to be fair, I would say most of my research and probably our research has really been focused on like the economic benefits of allocating products that provide more lifetime income. But I honestly believe it's more behavioral. It's very difficult to spend your portfolio when you have an uncertain future market returns. I don't want to go back to work. And I'm afraid. I don't know what to do.
I honestly believe that we could exhaust your listeners with the economic arguments behind why individuals or households should have more money that's protected or guaranteed for life. I think it really just creates that kind of foundation, where if you know that your essential expenditures, there's lots of fun words you can use there, are covered, it changes your relationship with your retirement savings, with how you're going to consume, things like that.
For advisors that are listening especially, I wouldn't view the role of annuities as just that kind of economic piece. There's just that behavioral angle that you just can't overcome with a portfolio. I know that you the adviser help clients do that, but there's nothing that you can do that can assure them that they're going to have enough income to live off of to pay their essential expenditures for as long as they're alive.
Wade Pfau: Yeah, I definitely agree with the math being behind this whole idea of taking bonds and replacing some bonds with lifetime income protections that kind of support stronger financial outcomes in terms of spending and legacy. With this retirement income style awareness research, we found about two-thirds of the population ultimately resonates with an approach that builds protections into the financial plan as well. But we do still find a third are comfortable with that total return investing approach. And I've been in so many battles about this over the years.
I mean, Dave Ramsey, his total return, that's a clear example of this idea that there is a third of the population that just doesn't resonate with the idea of annuities. And I talked about the primary factors, but there's secondary factors as well. If you are comfortable with a purely investment-based approach to retirement income, so you're probability-based comfort relying on the markets, optionality-oriented, you want to maintain as much flexibility as possible. You also maintain an accumulation mindset, which is, post-retirement, you're not worried about predictable income. You're still focused on risk-adjusted returns. And it implies you're going to accept a more variable spending stream because it's just not as important to you.
You also tend to want to frontload your expenses and retirement. You want to maximize lifestyle and make sure you can really enjoy your retirement. You also value technical liquidity, which is this idea of you just have a big pot of assets and you'll draw from it as necessary for different spending shocks, for your basic retirement expenses. You don't really try to do an asset-liability matching this pot of assets is meant for this expense and so on. You draw from your pot of assets.
And so, when you have all those types of characteristics, that's the total return investor. And we think it's about a third of the population. And though I think the math again is not in favour of it as being a better way to support retirement, at the end of the day that's what people are comfortable with. And I've stopped trying to argue that they should do something different.
Ben Felix: We've had conversations with both Wade and David, both of you guys, about this and with other people. We talked to Moshe Milevsky about it. He's got a software that actually helps you model the optimal annuity allocation and how it relates to the optimal stock bond allocation. And we took all that and we started talking to our clients about it. And nobody was interested. Either we're bad at selling annuities or there's a selection bias and we attract total return investors. I don't know what's going on there.
Wade Pfau: There's a lot of self-selection going on too, that if you're mainly discussing total return concepts, the people who reach out to you are more likely to self-select into being comfortable. You may be missing out two-thirds of your listeners are potentially not calling you because – although I guess you did. You are offering. It's just you got to build that audience more and get more of the income protection crowd into the audience mix as well.
David Blanchett: To Wade's point, it's the language that we use to describe everything, right? I mean, in the US, on statements, it's so balanced and return-focused. And it's not – I mean, now we have new rules about relaying income. But we've created especially wealthier Americans are like hyperfocused on returns and the market. And it's not the goal and how do you accomplish the goal. It's how do you get solid performance?
And the structural story behind guaranteed income, lifetime income is a bit different, right? And so, I think it might require different software, different tools, different ways to have conversations that make it more acceptable for retirees. I think that that is changing if you look at surveys on perceptions of annuities over time. But I don't know that a lot of advisers that are traditional investment managers are necessarily well-equipped to tell that story. Michael, what do you think?
Michael Finke: Yeah, I think there is a loss aversion and a framing problem as well, is that people frame on the value of their savings, their nest egg. And if it gets smaller, then they have an emotional response to that. You need to start thinking about the language that you use to describe how you plan for retirement. Because if you start focusing on income, and lifestyle and essentially early in the planning process, then let's say if you create an expectation that you are going to buy $225,000 of income as part of the retirement plan, you even maybe separate an account where the purpose of the account is to buy that income. Then if you don't buy the income, it's going to seem like a loss. It's going to seem like you lost that $25,000 per year instead of you lost that dollar amount.
It's one of the reasons why everybody loves their pension. Any guaranteed income that we get at retirement, we don't want to give it up. I mean, in the United States, we have this political battle over cutting Social Security. Social Security is an annuity. And people get bent out of shape when you try to take it away. And the reason is because you've built this expectation that they're going to get this income. And when you reduce it, you're taking something away from them.
If you can set that expectation with a portion of their savings early on enough that they feel like they own that income and that taking the income away is like a loss, then I think you can do a much better job of helping people wrap their brains around what is ultimately going to be in their best interest.
Ben Felix: Just that framing of it is a really interesting perspective and not something that we've tried. How impactful is the idea of deferring government pensions like Social Security? Or in Canada, we have the Canada Pension Plan. Same kind of idea. How impactful is deferring those to later ages?
Wade Pfau: Well, in the US it's pretty impactful. It's an actuarial calculation that was done in 1983 assuming a higher real interest rate and less longevity than we see today. In 1983, it didn't matter what age you claimed on an actuarial basis. But today, you benefit from delay.
And we're actually seeing a lot more. It used to be we'd say half of people claim Social Security at age 62, which is the earliest possible age. But since 2009, that's been dropping dramatically. It's now under 30% are claiming at 62. And if you talk about waiting past the full retirement age, full retirement age is now somewhere between 66 and 67. But if you delay until 70, you continue to get these delay credits.
In 2009, it was still under 6% of people who waited past their full retirement age. But in 2021, it's now 24% are claiming past their full retirement age. This is a point that us super nerds have been harping on for a long time as well about the value of delaying Social Security. And it really does seem like that message has been getting out there in a dramatic fashion these past 14, 13 years.
David Blanchett: I have some research with Jason Fichtner that will be published soon in the Retirement Management Journal using data from the Survey of Consumer Finances. And what I was really curious about is there is any kind of relationship between when individuals claim Social Security and whether or not they use a financial advisor.
I think if you were to ask me that question, I mean you have to control for effects for individuals that have an advisor tend to have more wealth. But if you were to ask me, “David, how does the relationship to claim Social Security relate to having an adviser?” I would say, “Well, advisers are highly knowledgeable of effect. People that have advisers claim later than those that don't, right?” That's the obvious answer.
Well, that is not what you actually see. There's a market difference based upon when individuals claim and the type of the advisor that they're using. Whereby individuals work with brokers claim two years earlier than those who work with accountants, right?
And so, if you think about it, there's lot ways that you can nudge someone to claim early or later. If I wanted to scare you to claim it, like, "Oh, my God. The trust fund is going bankrupt. What are we going to do? How are we going to fix this? We can't rely on Social Security." Alternatively, you can say, "Hey, even if it runs out of money, they're still 80% funded." The odds of a cut to benefits is incredibly small. And the fact that there's this market difference in claiming ages by advisers to me at least implicitly suggests that advisors can help drive that narrative to the extent they want to.
And I don't want to get in this kind of fight about who's a better advisor. But think about the way that a broker versus an accountant makes money. They're very different business models, right? And that could I think be directly affecting the way that people receive advice around the benefits of delay claiming Social Security.
And let's be honest here, retirement academics don't always get along. But that's one of the few things that we almost all say makes a lot of sense. And I was very disheartened to see that advisors – I would have thought that they're having their clients are delaying years longer than average. Individuals that use brokers actually claim before the average American does. That does not jive with what I think anyone would expect.
Wade Pfau: Yeah, there's a strain of investment advisers who think they can "invest the benefits better". It's better to claim early and invest it. And they think that will help you be better off in the long-term that is definitely more of a total return style compared to if your income protection, you view delaying Social Security as the best annuity money can buy. And so, it's a natural inflation-adjusted part of the retirement income floor that you want to build into your retirement plan.
David Blanchett: And to loop back to earlier comment. If you think you can earn 12% a year without risk, you're not going to delay claiming Social Security.
Wade Pfau: Yeah, if you could earn 12% a year, you claim at 62.
David Blanchett: You're not – you're going to claim at 62. And so, there are really important implications about, "Oh, he's just talking about withdrawal rates." Well, individuals that utilize that advice and those perspectives are going to make poor choices in other domains potentially as well.
Michael Finke: Yeah. Just a quick point also about any sort of a government pension that is inflation-adjusted. It's really the the only way to buy more inflation-protected lifetime income. If you want to buy an annuity that doesn't lose purchasing power over time, the only way in the marketplace to get it is by delayed claiming of your government pension that's going to then adjust for inflation over time.
Some things that are just kind of no-brainers as part of the retirement income planning process. And to me, delayed claiming of a government pension is a no-brainer because, A, it's annuitized income, which you should get anyway. B, it's inflation-protected, which you can't get anywhere else. And C, the ability of the entity to always make that income payment is pretty good if they print the money. It's not like an insurance company where there is some chance of insolvency risk with the government. Generally speaking, if they can print the money, then you're going to get the check.
Wade Pfau: Though it is harder to print money to pay for inflation-linked claims because that can cause more inflation. Increasing the amount you have to pay into a negative feedback loop.
David Blanchett: But that just makes everything else that's not like to inflation worth less. People be like, "Oh –" I mean, that's true. But that means everything else that's not linked to inflation will be hurt even more, right?
Ben Felix: You guys have a paper looking specifically at delaying social security for higher-earning women. Can you talk about why it's more important in that case or why it's important in that case?
Michael Finke: Yeah. When you get a delayed claiming credit, it's gender neutral. In other words, everybody gets the same bump up in income. Where if you did this in the private sector, you would give women a less of a bump than you would for men. Why? Because women are going to live longer. In other words, the way you price an annuity is you take the probability that they're going to be alive to cash the check multiplied by the present value of that payment.
And since women are expected to live longer, by delayed claiming, they're on average going to have a higher probability of being alive to cash the check. Present value is going to be the same. All else equal. The actuarial value is going to be higher for women than it is for men.
It's something to consider that, because of this gender-blind pricing that goes on with delayed claiming, women actually get a bigger advantage to delayed claiming than men do. And also, you have to pay attention to some of the claiming rules. Because if you, for example, have an older higher-earner and the younger spouse can get the income benefit of the older higher-earning spouse, then they should delay claiming. Because, essentially, the value of the annuity is based on the younger spouse whose expected lifetime is significantly longer. When you delay claiming and they have the eligibility to receive that benefit when the higher earner passes away, that increases the value of that annuity.
Ben Felix: Really cool.
Cameron Passmore: My final question for each of you, what final message would you have about retirement income that you might want to leave our listeners with?
Wade Pfau: Than kind of came up in the conversation. There's a lot of different ways to get it right. You really need a retirement plan that you're most comfortable with. If you're not comfortable with an 8% withdrawal right in 100% stocks or you're not comfortable thinking about an annuity because you just don't want to make that irreversible decision, it can be hard to sort through those options. And so, that's really was the motivation of really trying to identify there's these different retirement income styles. And I think people are interested to determine their style. There's definitely possible ways to do that now. And it's important to understand what your style is so that you can quickly cut through all these debates and find the approach that actually resonates with you.
David Blanchett: I would say that there's a really important value to just a second opinion when it comes to retirement income. If you're a do-it-yourselfer, engage an adviser. I mean, it could be like an hourly plan. If you have an advisor, I still see value in getting a second opinion. I think that whether you're your own adviser or you work with one, just getting a gut check. If you really enter retirement and make a lot of choices, that can be incredibly valuable, right?
It's not that your advisor is competent or you as an individual aren't competent yourself. But having someone else that can just say, "Hey, this makes a lot of sense. This is really important." Because you're going to make a lot of choices when you first retire that have massive long-term locations. You're going to set your spending. You might claim Social Security. You might buy a product. You want to have a high level of certainty what you're doing is correct. I think that's where having someone else to give you ideally a second set of eyes is just really important.
Michael Finke: David, there was just an article in Barens today about someone who hired a professional advisor and had $50 million and now has one and a half. I think, also, when you're hiring an adviser, it's very important to find someone who you trust who is going to be looking out for your best interest, especially once you get older. Because you do change cognitively when you're in your 80s and 90s. I think part of the retirement planning process is accounting for the fact that your ability to manage complex financial decisions is going to be different in your 90s than it was in your 60s. Figure out a way to protect your ability to consistently make high-quality decisions. And the other thing I'd say is just to be more deliberate and to recognize that there really are only two places that your money can go. You can either give your money to someone else when you die or you can spend it.
And I think that one of the biggest mistakes I see among retirees is they believe that there's a third option that doesn't exist. They preserve their assets as long as they possibly can. And if you ask them, "Do you want to give that money to your kids?" They'll say, "No. That's not why we're hanging on to all this money." And essentially, what ends up happening is, by fault, the kids end up spending it. Because they didn't feel like they had the license to do that. And I think that's one of the parts of being deliberate, is giving yourself the license to be able to spend the money you saved for the purpose of living better.
Wade Pfau: And it didn't come up organically, but I was proudly wearing my Rational Reminder t-shirt for today's episode.
Ben Felix: Very nice.
Cameron Passmore: It's very nice.
David Blanchett: He just went full Super Man on it. He just pulled it off and showed us the cape.
Wade Pfau: Rational Reminder.
Cameron Passmore: That's Wade.
Ben Felix: It's pretty good for a super nerd. I mean, that's what a super nerd would –
Cameron Passmore: Would do.
Wade Pfau: Rip off the jacket.
Ben Felix: Wade, wait you mentioned earlier RISA risk profiling tool. And you mentioned that there may be tools available for people to use. Where do people find that?
Wade Pfau: Yeah. I'll get a link put together for you to include in the show notes if you like. We'll put it at risaprofile.com/rationalreminder. And it'll be an opportunity to take the questionnaire assessment and get a report that shows your retirement income style.
Ben Felix: That is super cool.
Cameron Passmore: That is.
Ben Felix: All right. Thanks a lot, guys. We really appreciate you all coming on. I think it was a great conversation.
Wade Pfau: Really. Thank you.
Michael Finke: Yeah. It was fun.
Cameron Passmore: Yeah, this was fantastic. I'm very grateful to have you guys join us. Thanks so much.
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Wade Pfau on X — https://twitter.com/WadePfau
Retire With Style Podcast — https://risaprofile.com/retire-with-style/
Episode 89: Wade Pfau: Safety-First: A Sensible Approach to Retirement Income Planning — https://rationalreminder.ca/podcast/89
Episode 137: David Blanchett: Researching Retirement — https://rationalreminder.ca/podcast/137
Episode 254: David Blanchett: Regret Optimized Portfolios and Optimal Retirement Income — https://rationalreminder.ca/podcast/254
The Ramsey Show — https://www.youtube.com/@TheRamseyShowEpisodes
The Ramsey Show: You Can’t Win With Money if You Don’t Know Where Your Money Is — https://www.youtube.com/watch?v=Xg4Z8EQY3Ao
‘Supernerds Unite Against Dave Ramsey’s 8% Safe Withdrawal Rate Guidance’ — https://www.thinkadvisor.com/2023/11/13/supernerds-unite-against-dave-ramseys-8-safe-withdrawal-rate-guidance/
RISA profiler — risaprofile.com/rationalreminder
‘Quasi-empirical bootstrap sampling paper’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4590406
Jason Fichtner — https://bipartisanpolicy.org/person/jason-j-fichtner/
‘The Value of Delayed Social Security Claiming for Higher-Earning Women’ — https://dx.doi.org/10.2139/ssrn.3849653
Tune Out The Noise — https://film.dimensional.com/podcast/login?redirect=%2Fpodcast
Discount Code for Tune Out The Noise — RATIONAL