Angelica Montagano

February 18, 2021

Financial Literacy, Financial Planning, Retirement

Episode 137: David Blanchett: Researching Retirement

Angelica Montagano

February 18, 2021

Financial Literacy, Financial Planning, Retirement

David M. Blanchett, PhD, CFA, CFP® is head of retirement research for Morningstar Investment Management LLC. In this role, he helps develop and maintain methodologies relating to wealth forecasting, general financial planning, automated investment selection, and portfolio assignment for Morningstar Investment Management LLC. Prior to joining Morningstar, he was the Director of Consulting and Investment Research for the Retirement Plan Consulting Group at Unified Trust Company.

He has published over 100 papers in a variety of industry and academic journals. His research has received best paper awards from the Academy of Financial Services (2017), the CFP Board (2017), the Financial Analysts Journal (2015), the Financial Planning Association (2020), the International Centre for Pension Management (2020), the Journal of Financial Planning (2007, 2014, 2015, 2019), and the Retirement Management Journal (2012).

Today’s extensive conversation with David Blanchett covers nearly all aspects of retirement planning. As the Head of Retirement Research for Morningstar, David has published extensively on the topic and speaks energetically about how you can best manage your retirement wealth. After a brief digression on Kentucky's Bourbon Chase Relay, we open the episode by discussing how an increase in your pre-retirement income can impact your plan. David shares his insights on what your plan should factor in, including earlier than anticipated retirement, inflation, healthcare costs, and whether you should invest in high-risk options to increase your retirement income. While reflecting on why success rate is a poor metric for weighing your strategy, we then chat about David’s view on flexible retirement spending. A controversial subject for some, we dive into the role of annuities and how different annuities cater to varying retirement scenarios. Later, we touch on how human capital affects portfolio allocation and why it’s challenging to evaluate real estate before hearing David’s take on why financial advice is about helping a client accomplish their goals — and not about beating the market. Tune in for an ever-relevant overview of top retirement planning considerations.

Key Points From This Episode:

Introducing today’s guest, Morningstar Research Head David Blanchett. [0:00:03]
Swapping experiences of running the Bourbon Chase Relay. [0:02:34]
How rising pre-retirement income impacts your ability to retire comfortably. [0:04:19]
Rules of thumb in how you should approach salary increases. [0:05:21]
Why people end up retiring earlier than they expected to. [0:06:47]
What percentage of working income retirees should aim to replace. [0:08:06]
Whether your retirement plan should cover inflation and healthcare costs. [0:08:59]
Using worst-case scenarios to explain the consequences of risky investing. [0:11:52]
Why success rate can be a poor metric for retirement planning. [0:13:41]
Gauging your minimum and maximum levels of retirement comfort. [0:14:50]
David’s advice on implementing a flexible retirement spending strategy. [0:17:23]
Exploring the role that annuities play in a retirement portfolio. [0:18:32]
How the alpha of your portfolio can be equivalent to annuity benefits. [0:20:11]
Conflicts in how financial advisors help you allocate for your retirement. [0:23:06]
Further insights into the factors behind whether you should get an annuity. [0:24:47]
Why pension benefits have a higher value than most are aware of. [0:28:03]
Why bond ETFs can’t recreate the cash flow stream offered by annuities. [0:30:45]
Are you a stock or a bond? Revisiting the human capital question. [0:34:10]
How your profession might impact your portfolio allocation. [0:36:41]
The difficulty of accounting for the value of real estate. [0:38:11]
David’s view on how financial advisors can justify their fees. [00:42:09]
Evidence showing that those with financial planners have healthy finances. [00:47:18]
Hear how David defines success for himself. [00:51:13]

Read The Transcript:

How do you think people should treat salary increases? Like you mentioned, maybe not spend all of it, but if any rules of thumb in terms of how much of a salary increase people should try to save?

Yeah. So it's funny, I did the piece with three different behavioral researchers, we all had our own new heuristic we came up with that help people figure out what to do. And I mean, really it's a combination of the amount of the raise and how far away you are from retirement. But I mean, if you want a rule of thumb, try to save half of it. That way, it minimizes how much more you're spending and it gives you a chance to probably catch up on saving for retirement because most Americans really aren't there when it comes to preparing to retire successfully.

Can you dig a bit more into the heuristic that takes into account the years for retirement?

The closer you are to retirement, the more it should be. So if it's just 50% on average, if you're 10 years or less from retirement, maybe do two thirds or three fourths. If you're 30 years from retirement, do 25% to 50%. I think that the key is just that what you don't want to have happen is to get accustomed to a higher standard of living just before retirement they haven't been saving for, because that just creates a lot of difficulties. I mean, another thing people talk about often is that, hey, you can just work longer. No, you can't. I mean, whether it's the US or actually just did a webcast on this in Canada, people retire earlier than they expect. And so when you're planning for retirement, you got to plan for bad things to happen. And a bad thing to happen is retiring early, which can be difficult if you've got accustomed to a new, more extravagant lifestyle.

Since you touched on that, can you talk a little bit more about that research on people retiring earlier than they may be planned to or expect to?

Sure. So, I mean, there's actually tons out there. EBRI Group in the US has done probably the most on this, probably for the last 30 years. And what it is is that about half of people retire when they expect to retire. The other half-ish retire early, very few actually retire later than they expect. And I've done research on financial planning and retirement, all that stuff. And people would ask me like, what is the best thing that you can do to have a better retirement or improve your retirement outcomes, just to retire later, delay retirement? And so retirement early has the opposite effect, where if you retire early, it can be really detrimental for your entire retirement. And that's just a reality today, where people tend to retire earlier than they expect, and there's this huge implications for that when it comes to financial planning.

I don't know if you guys do Monte Carlo projections for financial plans. Monte Carlo is a fancy term for, we make stuff random. The problem with Monte Carlo is that we only often treat one variable as random, which is returns for a portfolio. In reality, there's when you retire is random, when you die is random, the returns are random. And I think that we often give someone too much of a sense of false confidence with, oh, if we randomize returns, this is the probability of an outcome, but in reality, lots of stuff can happen that you're not going to capture and what I would call a more traditional or plain vanilla Monte Carlo projection.

Really interesting. David, what do you think in terms of the percentage of working income? Do retirees typically need to replace when they do retire? That's a question that comes up to us all the time.

Yeah. So it's funny, I actually had a "debate" with Bonnie MacDonald, who's in Canada and talks a lot about the LSRR. There's no one metric for everyone, right? But people need rules of thumb. I love complexity, but I think that what people need to know is a starting point, where ideally you can get a heuristic and then they engage more. And so I think 70% is actually not a bad starting place, obviously, it's incredibly simplistic. I mean, people know what they need to spend in retirement, like you know what you spend on your mortgage, on eating out, on travel. And so I think that when you're younger, you don't know when you're going to retire or what you're going to be making. So 70% is a decent target, but I think that should become more personalized as you approach your actual retirement and know what you're spending, what you want to do when you finally retire.

So once you do retire and start drawing an income, past guests, we had Fred Vettese, who made the argument that you don't really need to plan for inflation because you have an automatic inflationary correction mechanism and that your spending decreases over time. Do you agree with that? What do you think about the need to keep up with inflation?

So I would say I largely agree. I've also looked at how does retiree spending change in retirement? And one thing, if you ever use survey data that track people over time, like it is an absolute hot mess. I mean, you can pull out these average relationships, but I just don't trust the data because it's just so crazy, maybe retirees actually like this, but the actual micro data is pretty wild, but there is a pretty strong trend if you look at almost any research that's been done that says that people tend to spend a little bit less on average every year versus inflation.

Now, so what's important there or nuance is that if inflation goes up 3% a year, maybe they spend one or 2% more a year on average. And so they are spending a little bit more, but not the full inflation. And now why that's important is, if you have a pension like in the US or social security that is linked to inflation, then what happens with your portfolio is they've had to become nominal withdrawals. And so that's why I would agree with that statement, because usually you have other forms of income that are linked to inflation. And so the actual need to take inflation adjusted withdrawals from the portfolio just isn't there empirically now. Sure, some households spend a lot more in retirement because of healthcare, whatever else, but on average, the assumption that you should increase the cost by inflation is a bit high.

I think you've also referred to this problem as the retirement smile, where expenses tend to go maybe down a bit or not up with inflation a bit, but then come back up later, is that healthcare costs?

Yeah. So that's a very positive way to think about retirement spending or retirement spending smile, but no, it is. And so the thing about healthcare costs is that, if you look at how much you spend on healthcare, and this is surprised out-of-pocket, not premiums that you would expect to spend regardless, the odds of spending money increase dramatically as you age, as does the amount. And so if you are fortunate enough to survive into your late 90s, the odds of having healthcare expenses just increases dramatically. And so I don't want to say if you're lucky and you pass away when you're 85, you're going to be fine, but there is this kind of tail risk when it comes to retirement, where if you do live a long time, it can become incredibly expensive.

In that healthcare basket, you also include things like nursing care or assisted living?

Those are the most expensive expenses that you can typically incur. I mean, you can spend $10,000 a month easy on a nursing home. And in the US, if you're relatively low income, you can get that covered through Medicaid, but a prolonged stay in a nursing home facility or assisted care facility can easily cost hundreds of thousands of dollars. And if you had savings, that will eat up, for a lot of Americans, what was left. I think that is the big shock or the big scare is that unknown health expense when you're 95 years old, how do you plan for that? It's just really hard to do.

We had Moshe Milevsky on our podcast…When he was on, he was making fun of basically the idea of trying to maintain constant retirement spending from a portfolio of risky assets. What are your thoughts on that?

Yeah, I mean, so again, I can't disagree with Moshe because he'd probably be right. I'm not going to take those inside. What I will say is that you have to balance what people can actually research and what actually happens in real life. And so a lot of the research that came out on retirement spending was 20 years ago, even today, financial plans almost entirely assumed that retirees spend a constant dollar amount, right? You can either do it plus inflation minus inflation, whatever. In reality, no one does that. When you're driving towards a cliff, you don't just keep driving off the cliff, you're going to slow down. Now the question is if you have to make a change, how much does that change affect you as a person? Are you able to spend less? And everyone's able, but if you spend less, what does that do to your happiness, your utility? And I think that's where you can still use that kind of basic analysis, because you can say, "hey, what level of certainty do you need for a certain level of income?"

But that being said, and I make the joke, when I have an idea, motion, wrote a paper on it 10 years ago, well, a lot of advisors use the idea of success rates, you have like an 80% success rate. It's useful, but it's also nuts because it doesn't tell you like if you were to "fail", what the magnitude actually is? And so I think a much better way to tell someone how they're doing is to say, "Hey, if you happen to live to age 95 and the worst one in 10 cases, you're going to be living off of $35,000 a year." Because that actually gives them some perception of the magnitude, not you have a 20% chance of success because what does that mean? Well, if you fail, you need to tell them how bad it can be. And I don't think that success rates really do a good job with that, especially as we extend out retirement periods into age 100 or whatever.

We've played with Monte Carlo a lot. And you can see that what you were just describing when you model more aggressive portfolios, Monte Carlo result in terms of success rates or failure rates with a 100% equities look really good, but the magnitude of failure can look a lot different than if you had a more conservative portfolio.

So you make a really good point. So there's different ways to figure out what the best portfolio should be for someone, like how much risk should you take? And I always say like, "Hey, if you want to maximize that success rate, just throw it in all equities." And over 60 or 70 years, is going to look spectacular. The problem though is that's not realistic, right? You're not capturing that full array of outcomes.

And so Morningstar, my employer, we have lots of tools that use success rates, that's our predominant metric. And I don't know what we're going to change it to, but I think that longer term, I think there's a growing recognition that, hey, it doesn't tell the entire story and where it really falls short, I think isn't guaranteed income, because if you're making a decision to transform your wealth, whether it to a public pension or through a private annuity, it's going to decrease the possible impact of what failure means, but it could also decrease your success rate. So how do you balance those for a client if you're just focused on your success rate drop from 72% to 61%, whatever that means?

Your comment about happiness and utility intrigues me because so many people as they head into retirement, they have to say, "Well, what's the normal amount that people like me should want per month in terms of lifestyle? So I always suggest having some sort of base level to make ends meet and what's the optimal level that would make your perception to be happy. But what makes people happy can change over time. Just some advice in terms of helping people gauge that min and max level.

Yeah. So what's funny is my very first job out of college was working as part of a financial planning department at a company in Louisville called Hilliard Lyons. And this is going to sound silly, but the thing that shocked me is that there was never a single plan that I worked on where the retirement income goal was the exact same amount. And I mean, that's obvious, and the thing, it blew my mind. I was like, "Everyone's retirement is a little bit different." And so to your point, that stuck with me, there isn't one number for everyone, but I think that there's lots of resources. There's a base amount of income, whether it's 30,000 or 40,000 is really, really important, but the marginal value of income beyond that, isn't vary a lot based upon each person, right? So there isn't one right answer for everyone, but how we define basic needs is very different. And once you cover those a little bit more, you're good. But a lot of people aren't saving enough to even get to some of those levels right now, in my opinion. So I don't know what the right answer is.

I think what you just mentioned brings up one of the reasons that I think failure rates are still so common in financial planning is that when you start getting away from that and into other metrics, you start having to model things like utility on marginal spending, which gets really complicated and harder for clients to understand.

I really like utility. It's a great way to quantify preferences. I have a hard time explaining success rates to people sometimes, I can't get into utility functions, but I think that one goal for me, when I do research is to use best thinking, so applies to stochastic mortality, use utility functions and all that, but then put it in a framework that advisers can actually use. I mean, for better or for worse, most people that do research in retirement were never actually financial planners. And I mean, maybe that doesn't matter, but in my experience, people are crazy. You got to do things in a certain way to help them often fight themselves.

And so the definition of optimal, if it's not going to ever happen, it doesn't matter. And so the goal of our profession is to help people accomplish their goals. You have to take into account how they're going to react to recommendations and whatever else when you're actually coming up with those recommendations. And so I'm a big fan of trying to do things using what I would call best practices, but then distilling them down in a way that a planner could actually apply that for a client, using the tool set that they have.

Well, we talked a little bit about flexible versus, I guess, static spending, in a theoretical sense. We also talked about how in reality, most people end up using flexible spending. From a planning perspective, if someone's saying I want to plan to implement a flexible retirement spending strategy, are there any best practices from that perspective?

See, I don't really know what a lot of tools do out there because I do research all the time that no one reads.

We read it. We read your research.

You skim through it. I mean, you like the summary version. A big problem with non-discretionary spending is when you have irregular cash flows. So I'm not really familiar with any financial planning tool that is a really good job of allowing someone to have effectively discretionary, non-discretionary spending, but you can overlay any kind of risk target or desire to have constant spending. And it's really complicated, you can do rules of thumb, but those will break down for clients that are going to wait 10 years to have their pension benefits start then have a DIA kick in in 15 years. And so I'd like to see more people do that, but I just don't know that the tool sets exist today that allow that to happen. Now, maybe I'm totally wrong, but I just haven't seen it available at least recently.

Interesting. Can you talk about the role that annuities play in retirement portfolio?

There is no one word that I uttered that is more loaded than the word annuities. Whenever I give a presentation, as soon as you say that one word, I don't care who the audience is, they all raise up and they look at you and they're like, "What's he about to sell me? Is there a steak dinner coming next?" And I think the problem is, is the word annuity, at least in the US, I don't know how things exist internationally, is an incredibly loaded term, it doesn't really mean anything. I mean, annuities, 2000 years ago were pretty straightforward, it was effectively an immediate annuity. You transfer some amount of wealth and some entity like the government gives you X dollars or pounds or whatever else, as long as you're alive. Today, though, most annuities are actually more accumulation focus vehicles, you use them for savings versus retiring. And my perspective on them is that I don't like to dismiss entire product categories.

And so when I talk to advisors about annuities, what I always say is that so many of you completely ignore them for clients, you assume that none of your clients would ever want one or just they aren't any good. Well, here's the thing, even if most don't, you can't dismiss the product category outright. You've got to think about how they could work as part of an overall plan. So I would say that, I'm not necessarily pro-annuity, I'm pro-consideration. I think that if it's your human capital to help clients accomplish their financial goals, understanding how annuities work and providing recommendations to them, is just an essential component, a part of that overall value proposition. So I really like them where they work, I acknowledged that there's conflicts today in terms of how they're sold and fees, but there's nothing else quite like them from a risk mitigation perspective for retirees.

From a product perspective, it's not as bad in Canada, because we don't have variable annuities that are oversold as investments. We do have a thinner product market though, which has other problems. But anyway, I don't think it's as loaded of a term in Canada, but it's still relatively uncommon for people to allocate to annuities. One of the concepts that you introduced in one of your papers on annuity was the idea of alpha equivalent benefit. Can you talk a little bit about maybe just that metric? And then also, how much alpha equivalent benefit in optimal, I mean, theoretically optimal annuity allocation can generate?

Yeah. So in my world, it's mostly advisors, advisors just love alpha. There's even shops that are called alpha, whatever. And I think that's crazy, clients don't know what alpha is. Alpha is, it's the intercept and regression, what a terrible name for a term to use for the average person. I think that we get caught up in these fancy words, but alpha is the end all be all for most advisors, you want to build a portfolio that outperform some benchmark. Sure, only like half of you can actually do that technically before fees, but we're not going to talk about that.

And so I think that what I like to do often is change the way that the benefit of a certain decision is defined. And so I can talk about how it improves your utility when you buy an annuity, it reduces the worst possible outcomes. But I think a better metric to transform the discussion is to, hey, what kind of alpha does it generate, equivalently speaking? So if door A is, I'm going to buy an annuity, and door B is I'm going to manage a portfolio, how much alpha does that portfolio have to generate to equal that benefit you receive from buying that annuity? And for the most part, it can be pretty significant. Obviously, it varies a lot by individual, but I mean, let's be honest, if you're an advisor who does their job, you're not going to recommend an annuity to someone that doesn't need one or has cancer or sick.

And so if you're thinking about, well, of those individuals that could possibly benefit from additional annuitization, it's well over 1% a year. So 1% a year of alpha, in my opinion, is pretty much impossible to do purely through investments, but you can do that actually pretty easily through guaranteed income. So my point there is just that, hey, if you want to improve your client's retirement outcomes, the easiest way to do, it is not through, I don't know, picking stocks or building exotic portfolios, it's through the financial planning process of including annuities as part of that retirement plan.

So say it's 1% alpha equivalent, is that based on ending wealth or failure rate? What's the metric that you use to define the 1%?

How it works is, I run the analysis where you have the annuity and then you have the portfolio, and then you test different levels of alphas on that portfolio for the entire length of retirement and figure out what generates the same utility or benefit as the annuity allocation did. So it's really, it's like a lifetime alpha. It's not this alpha in year one, it's alpha in year, throughout year 30 for the entire length of retirement.

Based on utility?

Yes. So 1% makes it sound quite small, but if you do an NPV, it's a 10% increase in your effective wealth when you retire.

How big an issue are costs between door A and door B?

Well, so that's funny, door A often has like a 1% AUM fee for it. I'm a huge fan of financial advice. I don't want it to sound like I'm not, but door A has an additional 1% fee for those marginal assets. Door B, for the annuity, there could be a commission. If it's an immediate annuity, maybe it's 3%, but you just pay it one time, then you're locked in forever. And so we've mentioned variable annuities, well, those can be really expensive and have surrender penalties. And so it can be a lot higher, but the fees for annuities can be quite low for the more plain vanilla products. And in reality, a lot lower than what you'd pay on an ongoing basis to manage a portfolio. So it varies, but not necessarily more than it would cost to have an advisor do it for a client.

But could that sway the decision as a hypothetical scenario, if an advisor's choosing between continuing to manage a portfolio or allocating to an annuity, with a third alternative being that they could just reduce their fees by 1% or something like that? How much of a difference does that make in the best approach?

I'm not sure the advisor's going to do that. And the thing is, I want the client to work with the advisor. Again, if door A, a new door A, they do it themselves. Well, that's probably not going to be a very good outcome either. And so I want them to work with the advisor. I just think that part of it is there are conflicts that exists. I think that there's been a significant rise in interest in utilization of the only platforms in the US for annuities. I find that very promising. Compensation is going to be an issue. It does affect everyone's lives on everything. We just have to be honest here about that. Actually, it's the variable annuities that I think are the most interesting right now where rates are and everything else, but those are really complex. And the average consumer won't understand how they work. And so I think that's where advisors can really come in and help consumers by giving them information about how these things work and then helping them utilize them correctly throughout retirement.

So we talked about flexible spending as a concept when we're thinking about the optimal annuity allocation and measuring that using utility, like you were just talking about, how much does the desire for certainty and cash flows versus flexibility, how much does that affect the optimal annuity allocation?

Well, I mean, I think annuities, the biggest benefits are the behavioral aspects of them. It's not like all the weird utility stuff that I do. It ensures that, I mean, what's the point of retiring and managing a portfolio if you're worried every day about, will I achieve my retirement income goal? If you're just worried, if the market shock and Q1 just hurt you and you're just still worried. That's not a fun retirement, but in terms of who benefits from annuitization, it's individuals that have that desire for certainty. It's, I want the assurance, no matter what happens, I have some minimum level of income because annuities are forms of insurance.

Insurance is not wealth maximizing. I have life insurance, I have disability insurance, I didn't buy my life insurance to make money, I bought it to ensure that if I die, my wife and four kids are taken care of. The same thing with an annuity. And so the actual cost of the annuity can vary significantly by product, what your comparison is, whatever else, but the more that you benefit, the fact that, the worst outcome is whatever that only pays you., the more you should own of them or an equivalent type of product.

Someone decides they want to have some annuity exposure, do you have a thought on, should it be immediate or deferred? Should they be buying immediate annuities over a number of years? Do you have some thinking around the timing of all that?

So I would say whatever they're actually willing to do, because it's pulling the trigger that is often proved to be incredibly elusive for most individuals that want additional guaranteed income. I mean, if you ask any kind of economist or financial researcher, likely, they're going to say that deferred income annuities or longevity insurance are the most efficient hedge for the risk, because you don't usually need a guarantee of income when you first retire. At some point in time in the future, if you're still alive and you're broke, then that's the bad outcome. It's not, I'm broke in day one of retirements, I'm broke at some point in the future. The problem is, is that, behaviorally speaking, deferred income annuities are really, really difficult to sell or for someone to buy. It's, wait a minute, you mean, I only get any money at all if I'm alive 20 years from now? And then I get a little bit of money every year, as long as I'm alive. That seems a terrible deal. I've been saving this pot of money for 40 years.

Now, I mean, immediate annuities aren't a whole lot easier because it takes a much larger pot of money to buy the product. And you can bolt on period certain in cash refund provision, where you get some money back. But still, those are very hard because they're irrevocable. Once you've made that decision, the money goes away. And then that's why I like the variable annuities a little bit more that have what are called guaranteed lifetime withdrawal benefits attached to them because those are revocable decisions, give the money to the insurance company, they are providing you a guaranteed lifetime minimum benefit that you can always change your mind.

Now, I mean, obviously, when you move from a DIA to a SPIA to a VA, you're losing some of that guaranteed lifetime withdrawal benefit, but it's the collection of all the attributes that matters the most. And so sure, you're getting less income from the variable annuity, but you can also get your money back, you can also get possible increase. I think it's really, it's a question for each retiree, what are they most comfortable with? If you'll buy DIAs and SPIAs, that's a great option, but in my experience, those really aren't products that people want to buy.

Similar line of thinking to the question I asked about the relationship between flexibility and spending and the annuity allocations, maybe kind of the other side of that question. If someone has a larger amount of annuity income, maybe they have a defined benefit pension that they didn't necessarily choose to allocate to, they just had it. How does an increasing amount of annuity income affect the optimal equity allocation decision?

I'd love to have a defined benefit plan. I don't think I'll ever get one, but that'd be awesome. I think that's great. I mean, the first off, I characterize pensions as public pensions, social security, whatever, private pensions from a company or an annuity, it's guaranteed lifetime income, a pension is a guaranteed lifetime annuity. And if you have that, you have a very bond-like asset. So you mentioned Moshe earlier, Moshe has a book, is titled, Are You a Stock or a Bond? And that is a question that you should ask about all of your client's assets. So ask the client, is this asset a stock or a bond? And we think about, well, what is a pension benefit? Is it a stock or a bond? Well, it provides you effectively a coupon every month or every year, as long as you're alive, it's just like a bond.

And so, if I'm building a portfolio for a client, one thing that no one does is, I don't think advisors almost ever include the value of pension benefits in a financial plan. So what I'm talking about here is, if you do a financial plan, the assets are always included in the income statement for retiree, you're going to use the assets to fund retirement, but no one ever includes pension benefits as an asset. So assets get double duty. They're both an asset and income source, but income sources should be assets. And so my point earlier was that, if you have a lot of pension benefits, that's a bond-like asset and makes your portfolio more aggressive. But the first part of that is just to figure out what it's worth and show it to a client, hey, Mr, Mrs. Client, your pension benefits are worth a million dollars. You may not realize that, but that has a big impact on how much you can spend, how you should spend, how you should invest, all that. And if you're not showing someone what those are worth, you're not going to capture their true economic value.

We've actually seen this recently with a client where once we had that conversation about the value of that as an asset, it started to change the way that they were thinking about asset allocation as well in the financial markets portfolio.

I think that's the key. I mean, the goal of all this is to set right expectations and everything else. And if you don't tell a client, a lot of clients are millionaires. If you add up the value of their pension benefits and their portfolio, they're millionaires. I wouldn't want someone to not enjoy their retirement because they don't understand what all their wealth actually is. And I've done other research, there's human capital and other stuff you can throw into it. That, to me, isn't important. I think what is essential for every advisor to do is to just somehow approximate the value of pension benefits and include them in your balance sheet and give the client some idea of what their true net worth is, adding their financial assets and their pension benefits altogether.

One of the things that we've seen related to annuities, but like we've been talking about, a lot of clients and advisors for various reasons don't really want to allocate to annuities. So we've seen some people trying to recreate the cashflow stream of an annuity using bond ETFs, kind of like how an insurance company tries to manage their liabilities with an asset liability matching approach. Does that work for individuals in the same way that it would work for an insurance company?

Kind of, but not really. In theory, if you have payments that you'll receive guaranteed throughout your life, you've created an income stream. The problem is, is you could outlive it, right? So, I mean, technically, if you create that income stream that last until like age 120, and it's all guaranteed and that you've got 40-year maturity bonds, yes, you've done the same thing. It's just a lot more expensive, though.

And so I think that, I understand why people want to do that because it's liquid, doesn't require that kind of commitment, but individuals, by definition, can't do the mortality pulling aspect of what annuities do. And so that's why I think that they're so valuable is that it's incredibly inefficient for us as a society to have each individual planning to live to age 100, because most folks aren't going to get there. And I mean, that's why we have pensions. That's what we have private annuities. And that's where I think that advisors want to say that, "Hey, I can have this portfolio that's going to have a 90% chance of lasting until age, whatever." But it's not, you can't create the same level of certainty with a portfolio as you can with a product that by definition guarantees some amount of income for life.

Do you think it has other implications? When I look at that approach, it seems like you would end up with just a really conservative portfolio from an asset only framework perspective.

Well, you do. And the thing is, is annuities are on sale right now. And so what that means is that we all make decisions based upon market environments, right? And this is going to shock everyone listening, but interest rates are pretty low right now. That has actually important implications for what you should do when it comes to your portfolio. So right now, as interest rates decline, the marginal benefit of annuitization over buying bonds actually increases. So it is totally true that if you buy an annuity, the payout is lower, but at the same time, if you buy a bond, the expected return is lower. However, when we get to a lower return environment, you get the mortality pooling benefits through annuities. You don't get that through fixed income.

So, to your point, you can build those bond ladders today, but it is incredibly expensive. And so that's why, actually, now more than ever, I know that it's a little bit more painful because payouts are lower, but the value of annuitizing is actually quite a bit higher. Now, it's harder to convince someone to do it because it's, you're buying a 25-year duration bond that's yielding 3%, but now more than ever, it actually makes sense to think about annuitizing because it's so expensive to generate any kind of income that's guaranteed from a bond portfolio.

Let me just make sure I understood the idea, though, because expected returns are so low, the mortality pooling benefits relatively on that fixed income asset are proportionally a lot higher than they have been previously. Is that right?

Yes. That's much more succinct way to describe it. So, but for annuities, yeah, the benefit of annuities now is higher because mortality pooling doesn't go anywhere, but at the same time, if rates go back up to 12%, then the benefit of annuitization actually decline significantly. So it does work both ways. I totally acknowledge that, but in a low yield environment, annuities are going to win more versus fixed income.

That's a really, really interesting perspective. I hadn't thought about it like that, like the way that you just described. That's really interesting.

So I have a totally separate question for you, David. And it has to do with constructing portfolios. On the podcast lately, we've talked a fair amount about human capital. And I know you have some empirical evidence around how investors decide to construct their public market portfolio based on large assets like human capital and real estate.

So what is human capital? I mentioned this actually earlier. Human capital is this weird idea that people have a value to go out and work for the next 20 or 30 or 40 years. So you just graduate from college, let's say you're 25 years old, you have very little income, you've got no assets, no debt, but the value of your human capital is you're going to work for the next 40 years. And if you bring all that back to today, if you discount it and mortality weighted, well, maybe that's worth $5 million, whatever else it is. That human capital, your ability to earn a wage and work should impact how you design your portfolio, right?

So earlier, there was a question, are you a stock or are you a bond? That's Moshe's book. It's actually directly in reference to this idea of human capital. And so I think the key with human capital is, is understanding the risks of what you're doing and how that should affect how you invest. And so I think the most obvious example here would be, if you're a tenured professor, you have relatively safe human capital. It's not as safe as it was, say, a decade ago, given things going on, but you'd probably need to have, for example, less than emergency savings. If you're a realtor or you work in sales, you have a higher risk occupation, you, by definition, need to have more liquidity should something go wrong.

And so I think the key is understanding the risks of your job and how that affects your portfolio. And I've done quite a bit on this. And I looked at, for example, in 401(k)s, do participants who work in riskier jobs have more conservative allocations? They do by a tiny bit. I didn't expect it to actually be there, but there is a slight relationship where people do. If you work in mining, you tend to have a little more conservative portfolio, but it's not at the level that most academics would call optimal.

So I think the key is, is just, to me, the largest takeaway is to not blend your human capital and your financial capital whenever you can. Enron, the most innovative company America by Fortune for six straight years back in the 2000s, almost the entire 401(k) was an Enron stock. And is a terrible idea. I don't want to get people too caught up on the value of human capital and the risks, but I think the key is you want to diversify your sources of wealth as much as you possibly can. If you own employer stock, you should probably sell it, you should do the things you can to ensure that if you lose your job, you won't also lose your financial assets too.

So do you think there'd be value in having nudges in those programs that somehow links your human capital to your asset decision in those planned programs?

What do you mean?

If in that plan, it's known that if you do a very high human capital and safe human capital, therefore, it may nudge you towards a higher equity allocation, whereas if you're in a riskier occupation, may nudge you the other way. Perhaps even inside a single company, you could have people that have riskier occupations. So depending on your occupation, they're not just going to push you one way or the other.

That's a weird cross section, there's the industry you work in, there's the occupation of your job. So we actually build custom targeted funds for about a dozen clients, where we do incorporate the risk of their industry into the decision of what the target-date allocation should be. So a more aggressive and more conservative glide path is you're gonna have a pension. I mean, the problem with target-date funds is that it's one size fits a lot of people. So you can generalize for a given industry, but you can't do it at the individual occupation level. We do some of that. We have a robo-advice tool called Manage Accounts that's used in 401(k) plans. We do some of that too. I like the idea of incorporating the risk of your industry and occupation into the allocation decision. It's just really complicated and not in the wheelhouse of most advisors.

So maybe we'll get there as an industry, but today, I think the biggest thing for me is, is to ensure that, let's say you have your own business. That's a lot of risky human capital in yourself. That means you need to have a more conservative portfolio. To me, level one here is just thinking about all your assets, are there risk in how they're related? And then making decisions in your financial wealth based upon that.

In the paper that Cameron was thinking about when he was asking those questions there, you also talked about real estate, the geographic location of real estate and how that affects portfolio decisions. Can you describe that?

Yeah. So real estate is the craziest asset that people have, right? So when I think about assets, you've got your financial wealth, you've got pensions, you've got human capital. Well, real estate, and I'm defining real estate here is like your home. Your home is both an investment good and a consumption good. There's nothing else quite like it. When you buy a car, you can say, well, David, a car is both an investment good and a consumption good. Well, it's a terrible investment because it appreciates like 1% a month, as long as you own it. So a car is not an investment, no matter what anyone tells you, but a home is actually both. We all need to live somewhere. Okay. You can pay to buy a house, you can pay to rent something. Now there are differentials and costs and everything else involved there, but a home can be both. It can be an investment good and a consumption good. Now, how does that impact your portfolio? I don't know because homes are actually very risky. So the equity in your home is equivalent to about a 50/50 portfolio.

A lot of people thought that homes were like super safe pre-2008. That's gone away. The problem right with homes is that you only own one home in one place, right? So people will often use, in the US, these things called Case-Shiller Indexes, like I'm going to look at the volatility of the national Case-Shiller Index and talk about home prices. Well, here's the thing about repeat sale home indexes, one, it's tens of thousands of homes. You own one home in one place. And like in the US, if you lived in Detroit, I'm sorry, it's been a rough 20 years from you. If you live in California, it's gone up 4% a year for over two decades. And so you can't diversify that at the same time. It's not reasonable to assume that homes go up 1% a year, because same home price indexes don't capture all the improvements folks do to their homes. You can literally buy a home, put a million dollars into it and flip it. And they have no way of knowing that.

And so I think that when it comes to homes, people often way overestimate the expected return of the home and underestimate the risk. And so it is actually a very volatile asset, but you could argue that, well, I have to live somewhere, regardless. And so that's why it's hard for me to come up with a framework that generalizes how that impacts the overall portfolio decision.

Did you find empirically though, that there was an interaction between geographic location, real estate ownership and portfolio decisions?

I did. So that was the other thing we found in the piece looking at. So it was a piece that you looked at 401(k) investors. We have their equity allocation, we know the state of residence, and we know the industry they work in. And there was a relationship to both, where individuals that had homes in riskier areas tended to have more conservative portfolios. The effect wasn't as strong as it was for human capital. But again, the home stuff is so hard because if you didn't own a home, you'd rent a home. Well, if you were renting out in California, your rent could go up 10% a year for a long time. And so it's hard to capture the kind of unique nature of the rent liability when comparing that to owning a home.

Thinking back to human capital, when you look across industries, how well does a well-known factor model like the Fama–French five-factor model, how well does that describe differences in human capital risk?

It doesn't do a very good job when we think about the risk of human capital at Morningstar. So 20 years ago, we used to be called Ibbotson, the group I work in, Morningstar Investment Management. And Roger Ibbotson, he's an all-star under Ibbotson Associates. Now he works at Zebra, professor at Yale. A group of people said that human capital is like 30% stock-like. And it was this arbitrary decision that this idea is that it's kind of like a junk bond where, when times are good, it provides you this kind of regular coupon, but when the markets go crazy, people lose their job. And so there's this rule we use, human capital is 30% stock-like. We did find that that is roughly correct in some of the research, that's actually a great approximation. The problem is, is that it's really hard to do a great job generalizing for everyone. I'm comfortable doing that for a plan when there's 10,000 employees. For each individual though, I think it's really tough to say, hey, your human capital is 29% stock-like, and then this should be how it affects your portfolio.

Interesting. It's really interesting. So there's great portfolios available in the marketplace, super cheap, from companies like Vanguard and iShares, what do you think about financial advisors charging fees in excess of those solid portfolios at low fees? What do you think that they have to do in order to justify the excess fee that they're charging?

So, it's funny, I was talking to a reporter earlier this week and it was about this idea of like, the Bogleheads have the three fund portfolio, it's the cash, the global stock and a global bond. And I'm like, "Wait a minute. I can give you a one fund portfolio, just go out and buy the Vanguard Balanced Index, whatever else it is." And so again, we have to get paid for what we do. We all help people do things, we get paid to do it. And I think the question is, is what is your value proposition? I'm not convinced that advisors are going to add a ton of value by beating the market, right? And so, again, alpha, I want alpha. I want alpha. Well, if you want alpha versus advisors, invest in an incredibly low cost portfolio.

So, if you as an advisor can convince a client to own a balanced portfolio of indexes, I'll contend that you'll, on average, outperform the average advisor because the expenses of your portfolio are lower. Right now, that's not nearly as sexy as owning 13 mutual funds and allocating so this new emerging markets fund, but what is the objective? The key objective at the end of the day is to help someone accomplish their financial goals, okay. And a huge piece of that is behavioral. And so, if you can define your role as, hey, I'm going to create a portfolio for you that's very good and very cheap, I'm going to keep your investment into that for the next 20 or 30 years. That could be worth 1% easily if you're doing extra stuff too, if you're doing the financial planning.

And I think that for better or for worse, our industry has evolved from stock brokerage, where you have to pick stocks and beat the market. Well, beating the market doesn't matter if you can't help a client accomplish their goals. And so to me, the focus is on doing what it takes to accomplish a goal. And sure, alpha helps if you can beat the market by 8% a year, that client is going to do a spectacular job. The problem is, is that's a zero-sum game before fees. Everyone can't do that.

And so I think that the question is, is how do you define yourself as an advisor? And if you're an alpha guy, it's a cool story, I get it, but what is the true impact of that on clients? And are you really adding alpha in the grand scheme of things? Maybe, but if you ever pull an audience of advisors and ask them how many don't add alpha, nobody raises their hand.

So does that value add a perception on the side of the client? Or can you actually quantify the value added from advisors?

I mean, you can. So I have this fun word that I use, it's called gamma. Vanguard has advisors alpha, Envestnet has now this Capital Sigma, there's Zeta. There's all these fun Greek symbols that describe this concept. And it's just the idea that you can do more to help someone then build what I'll call a sexy portfolio, right? I mean, I would argue that doing the portfolio stuff was really important 20 years ago, but now, there are incredibly well built solutions available effectively for free online. There's great online resources, investment information has been largely commoditized. You can go to morningstar.com, I'll put a plug in for my company and get lots of great information effectively for free. Now, that isn't to say, though, that just putting in a good portfolio will get you to accomplish your goal, you need to do lots of other stuff.

To me, it's more of a pivot to a more holistic service model, where you just don't define yourself as, I build really good portfolios. It's I build good portfolios in the context of helping you accomplish your financial goals. And that's worth a lot. It can be. I think that, again, what are you actually doing? What would the person do on their own? I like the idea of robo-advice. Robo-advice is somewhat controversial. I actually worked for robo-advisor, so I guess I need to note that, but to me, people need help.

And this idea that it has to be a person, I think, has changed dramatically over the last, we'll call it year. I mean, the idea that people would exist on Zoom for eight hours a day wasn't realistic a year ago. But I think a lot of people have learned to embrace this new digital. And so I don't see robo-advisors, for example, as like competing necessarily directly against advisors. I see them giving people that weren't going to get advice or get bad advice a better solution. People need help. And there's lots of ways to get it. I'm pro anything that helps someone accomplish their goals and does a good job. And I think that robo-advice is a huge compliment there, will help a lot of folks that weren't large enough to get what I would call quality advice, advice moving forward.

Your papers on gamma were some of the earliest, I believe, to frame the different components of how advisors can add value without generating alpha. So I think that's pretty cool. And I think that field of study, even though you laughed when we asked can you quantify it. A lot of people have tried to quantify it and it is kind of silly because you see like, oh 2.67% value added. I think it's harder to measure than that, but the concept I think is important.

It's gotten a little ridiculous. I'm not going to name names, don't even have to come out. I'm like, "This is just nuts." And so context is important too. So like an updated piece that came out, I think, in 2018, I was like, "Well, what would you do without help? What is your sophistication level?" Because certain people don't need advisers. They are awesome. They can do it themselves. They don't need the help. Others would like literally implode financially without someone to be there with them. And so I think it depends on so many things, but to me, the consensus is that advisors can definitely add value for folks that need and want the help.

Yeah. You did a bit of a paper on this too. And I want to ask about that. That paper was Financially Sound Households Use Financial Planners, Not Transactional Advisers. You looked at different streams of advice and how the people consuming that type of advice are doing financially. Can you talk a little bit about that research?

Yeah. So again, there's lots of all this kind of, I would call it fluffy research on, can advisors add value? If so, what it's worth? And so that's like, ah, yeah, they can have tons of value. A different question though, is if you do research on what is the actual impact of a financial advisor. And that's a really difficult thing to quantify, because if you ask people, do you have an advisor? They might say yes, they could have a broker, whatever else.

And so what I did is I looked, it's called the Survey of Consumer Finances, is a trial survey through the Federal Reserve. And it actually asked people, where do you get financial information? And they can say like the internet, a financial planner, a broker, a banker, a newsletter, your friends. And so what I looked at was, well, are there any differences in the decisions that households are making based upon their stated advice channel? And what I found was is that individuals that said it was the internet or like a financial planner were doing better than everyone else. And so that actually is some empirical evidence that individuals that use those sources are making better choices. Now, the problem always is correlation versus causation. So I know that individuals that have a planner are doing better, is it because they would do better regardless? You can't disentangle all these effects very easily, but it does at least suggest that planners are helping clients make better choices, because they did have life insurance, they did have less credit card debt. They had this certain habits you would expect of someone that is actually utilizing financial advice properly.

Yeah. That's really interesting. We have a community, an online community, of people that listen to the podcast that spend hours. I mean, we were actually looking at the data yesterday. This community has existed for three months and there are people who have spent six days of time reading content in this forum. It's nuts. Can you just touch briefly on the... So you mentioned internet and financial advisor were the best two categories of advice in terms of people making good decisions, how do they rank relative to each other? Are people on the internet doing better than people who have advisors?

So the internet was. This used data from six different periods and internet people were the best initiatives, the early adopters of the internet, getting advice. They were all stars. The problem is the effect has gone just like straight down as more people go online and get advice. I don't know why that is, but I think the early adopters were the ones that were really into it. And so I haven't updated the analysis for 2019 that came out a few months ago. But I mean, the value of the planner was constant over the entire time period. Internet advice has gone way down. I think what that is, is that individuals that now get advice, there's a lot out there, but you still have to do something with it. It's easy to browse online. I love the idea of googling a question if you have it, but the Internet's kind of like asking your friend, it's a little bit better than asking a friend because most people don't know anything about financial stuff. There's different sources, there's different quality, there's the implementation.

So I like internet because it's free, it's easy, it's fast, but it's not what I'll call a trusted expert. And if you can talk to a trusted expert that does things in your best interests, that I think will and should be the best place to have those better outcomes versus infringer like, the absolute worst. You don't have to talk to friends at all because your friends don't know what they're talking about. They'll recommend you buy Bitcoin.

And that might not have been so bad in the last few months.

It's actually true.

The note that it's declined that the quality of decisions based on internet as a source has declined over time. That's really interesting.

You never know why it happens, but if you are using the internet for financial information advice back in like 1998, you're probably a pretty smart dude, you're really into this kind of stuff. Today, anybody can do it, and that's not necessarily a bad thing, but there isn't the same self-selection bias as there was initially for all that online advice. But at the same time, while planner and what I would call it broker have stayed constant, friends used to be the predominant way people got information. It is rapidly going to nothing because I think people realize, I really just go online and ask Google than ask a friend about it, at least initially.

So I want to break our last question into two parts. The energy you bring to this whole field of study is amazing, you're a prolific writer. So the first part of the last question is, where did this interest come from? And part two is how do you define success in your own life?

I've actually wanted to be a financial planner since I was in high school, I had my own weird little mutual fund and I was doing internships at advisory companies in high school, I did them in college. I just always liked the idea of helping people do stuff financially. I joke now, I've been climbing the ivory tower for 20 years. And so I used to do one-on-one financial advising. I enjoyed that, but I made a comment, people are crazy. And I like what I do now more because I can maybe help more people, I can help advisors, help clients make better choices. And so I don't know, my parents were both teachers, math and science. I think I got part of it from them. I've always been interested. It's weird, people will get asked, what do you want to do for a living? And I was always like, "I want to be a financial advisor." And that just always for some reason stuck with me.

The second question is a lot more complicated. I want to be a good dad, I want to be a good father. The work stuff's great and all, but I got a one-year old and as much accolades you can get from writing a cool paper and having eight people read it, seeing him smile means the biggest thing in the world. So I'd like to help people make better choices. And I love the fact that I worked for a company that's not conflicted. I can do whatever I want and help people independently figure out what they should be doing. But I don't know. At the end of the day, work stuff's awesome, but the family stuff means a lot more to me. So successful would mean raising a good family and then there's the work stuffs, the benefit, but that's a distant second or third.