ReSolve Riffs with Wade Pfau on Optimal Retirement Strategies

Wade Pfau is Professor of Retirement Income at The American College and has published several books on retirement, most recently The Retirement Planning Guidebook: Navigating The Important Decisions For Retirement Success. He joined us for an awesome discussion that included:

  • The drawbacks of privatized retirement plans
  • Why longevity pooling is so important
  • Trade-offs between defined benefits and defined contribution plans
  • Varying incentives across countries
  • How different systems can withstand long-term shocks
  • Path dependency, sequence of returns and the most crucial period for a retirement portfolio
  • Motivations for writing his latest book and debunking retirement myths
  • Safety First vs Probability First
  • Optionality vs Commitment
  • Different profiles and preferences, and a framework to accommodate them all
  • A controversial take on the importance of asset allocation
  • Why a 4% withdrawal rate is the least efficient approach
  • Navigating the tax maze
  • And much more

This is “ReSolve Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management Inc.

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Wade Pfau
RICP Director at http://TheAmericanCollege.edu , Founder of http://RetirementResearcher.com & http://RISAProfile.com

Wade D. Pfau, PhD, is Professor of Retirement Income in the PhD in Financial and Retirement Planning program, Co-Director of the American College Center for Retirement Income, and RICP® program director at The American College of Financial Services.

Pfau is a co-editor of the Journal of Personal Finance. He has spoken at national conferences of organizations for financial professionals such as the CFA Institute, FPA, NAPFA, AICPA-PFP, and AFS. He also publishes frequently in a wide variety of academic and practitioner research journals.

He hosts the Retirement Researcher blog, and is a monthly columnist for Advisor Perspectives, a RetireMentor for MarketWatch, a contributor to Forbes, and an Expert Panelist for The Wall Street Journal. His research has been discussed in outlets that include print editions of The EconomistThe New York TimesThe Wall Street Journal, and Money Magazine.

Pfau was a selectee for the InvestmentNews “Power 20” in 2013 and “40 Under 40” in 2014, the Investment Advisor 35 list for 2015, the IA 25 list for 2014, and Financial Planning magazine’s Influencer Awards. He is a two-time winner of the Journal of Financial Planning Montgomery-Warschauer Award, a two-time winner of the Academic Thought Leadership Award from the Retirement Income Industry Association, and a best paper award winner in the retirement category from the Academy of Financial Services.

Pfau holds a doctorate in economics and a master’s degree from Princeton University, and bachelor of arts and bachelor of science degrees from the University of Iowa. He is also a Chartered Financial Analyst® (CFA®).

TRANSCRIPT

Adam:00:01:42All right. Happy Friday. Welcome. ReSolve Riffs. We’ve Wade Pfau here today with us. And well, Wade, I didn’t realize you actually have — you’re like a prolific publisher. Most recently, Retirement Planning Guidebook, but also Safety-First Retirement Planning, How Much Can I Spend in Retirement, a book on Reverse Mortgages. You’ve been busy.

Wade:00:02:07Yeah. Yeah, that’s kind of been the main activity for me over the last few years, cranking out books. But with The Retirement Planning Guidebook, I’m done writing new books at this point.

Adam:00:02:19All right, good. So, maybe just for those who don’t already know you — Oh. Go ahead.

Richard:00:02:24Before we jump in and have Wade give us a bit of his background, we should just remind everyone that nothing we discuss today should be considered as investment advice in any way, shape, or form. This conversation is for information and hopefully entertainment purposes. And if you’re seeking professional advice, do so in your own jurisdiction and seek an advisor or a professional in your area. So, with that, Wade, welcome. And I think Adam was going to ask you a little bit about your background. So, you might as well just hit us with it.

Backgrounder

Wade:00:02:56Okay, sure. Yeah. So, I’m Wade Pfau. I’m a Professor of Retirement Income. I think it’s still a unique job title at the American College of Financial Services, which is located in King of Prussia, Pennsylvania. And I run the Retirement Income Certified Professional Designation Program, which is a three course sequence for financial advisors that covers all the different aspects of retirement income planning. I also do a lot of research. I’ve, my own personal website is Retirement Researcher. And then more recently, with The Retirement Income Style Awareness, it’s something I developed with Alex Murguia, where we’re trying to provide a framework for people to think about how to choose the different retirement strategies out there; to find out which one really is most appropriate for them.

Adam:00:03:42Wow. I think people would be surprised to learn that there are multiple optimal retirement strategies, I guess, that just drive towards different retirement objectives and preferences. Is that how you characterize the differences? Yeah. Okay.

Wade:00:03:57Yeah, different viable strategies.

Adam:00:03:59Okay, gotcha. I’d love to know how you stumbled into retirement income as a focus. Like what is your academic background, and then professional background that sort of led you on this journey.

Wade:00:04:13At some level, it was just personal interest in learning how to save and invest and so forth. But actually, kind of fortuitously in graduate school, I started to study the social security reform ideas that were prevalent in the early 2000s. The idea of carving out a personal retirement account or a personal account out of Social Security, kind of making social security into, partly like a 401K plan in testing how that might actually work, in practice. And ultimately, what I was doing to look at that translated into this whole idea of individual retirement planning.

So, I did take a detour after grad school. I went to Japan. I was a professor at a university in Tokyo. That mainly was for Public Policy and Government Officials from developing in emerging market countries. So, spent some time looking at pension funds from, developing in emerging market countries. But then when I was ready to come back to the US, that’s when I really came to understand that retirement income planning is a new, hot, interesting field to get involved with, and so I made that full switch over at that point.

Different Viable Strategies

Adam:00:05:23Nice. I always make the statement or have made the statement many, many times about one of the greatest policy errors of the last 50 years is the privatization of retirement plans. And I say that for a bunch of reasons. But one of them being that you lose the pooling, the longevity pooling benefits, which are just unbelievably powerful. But also, because now you’re sort of, you’re requiring every individual to get a relatively deep understanding of investment and retirement optimization, which are fairly specialized fields. And so anyways, I’d love to, maybe — Do you have any reaction to that?

Wade:00:06:07No, I couldn’t agree more. We had a Defined Benefit pension system in the US and we gave that up for Defined Contribution, where instead of centralizing and pooling risk and having a centralized management of the process, right, everyone had to become a financial planning, retirement planning expert to figure out how much to save, how to allocate, how much to spend and everything else. And it’s not necessarily the most efficient way to help people prepare for retirement when it’s easier to accommodate that and use risk pooling as part of that process through a traditional company pension.

Richard:00:06:43But there’s definitely some trade offs when you’re thinking about defined benefits, right, and the risks that are imposed on whoever is promising that particular defined benefit. So, I guess, would you be able to steel man the argument as to why Defined Contribution would be preferable to a Defined Benefit? I’m just — I’d like to hear the steel man on both sides of that argument before we jumped into your own.

Wade:00:07:08Yeah. Well, the advantages of Defined Contribution is just one, it’s more portable so that if you’re switching employers, it’s much easier to take your assets with you, and Defined Benefit Pensions could really discourage or really force people to stay at the same job, because the pension might really ratchet up in the final years before retirement. So, that gives people a lot more flexibility and freedom and of course, just being able to manage their own assets, make decisions that could be different from what the pension fund would have done, could be valuable for some people. So, that would be the main arguments in favor of Defined Contribution.

Adam:00:07:50Are there any jurisdictions around the world of — that have sort of solved this problem so that — they have a system set up that allows for that labor dynamism, right, so you can change jobs, and you’ve got that flexibility, but that also does a good job of preserving that longevity pooling and sets it up so that the majority of assets are largely guided by professionals rather than individuals?

Wade:00:08:19Well, even — Social Security to some extent, allows for that portability. So, yeah, a lot of countries do have a nationalized pension system like Social Security, but unlike Social Security, may invest in a more globally diversified type of portfolio rather than the special issued treasury bonds that Social Security uses. But yeah, a broader public pension system would be more common in other countries, and can give you those features that a private employer-based Defined Benefit Pension can’t.

Richard:00:08:53Are there any countries that come to mind that you think are sort of on the more optimal side of the retirement approach?

Wade:00:09:07Well, I think maybe, the US is somewhat unique in that so much risk is placed on the individual rather than being pooled more collectively. So, in other countries, you don’t necessarily have as much need for this retirement income planning, because you’re not necessarily exposed to long term care shocks, you’re not necessarily exposed to health care spending shocks, you’re not necessarily forced to depend on the stock market to fund your retirement because you do have a larger collectively pooled pension system. So, in that regard, yeah, many countries may actually have lessons that we could learn in the United States about how to structure a pension, and a retirement income.

Adam:00:09:52That’s a good point. It’s not just how you structure the pension itself, but also how you structure sort of the broader social safety net to support people at different stages of life and stuff, I guess, that made quite a difference. We sort of skipped over this idea of longevity pooling because we’re all familiar with it. But I do think it is worth maybe explaining what that is, for people who aren’t familiar, and just how large a benefit longevity pooling can provide in the right type of structure.

Wade:00:10:23Yeah. So, if I’m an individual planning for my retirement, maybe I’m 65 now. I don’t know if I’m going to live to be 67 or if I’m going to live to be 97. And so if I have to self-manage that longevity risk, it pushes me to act more like I might live to 97, which means I have to spend a lot less to make sure I can stretch my assets out. But what risk pooling can do and what longevity pooling does is some people won’t live as long, some people will live longer. But when you pool that risk collectively, everyone can spend like they’ll live to their life expectancies, which may be in let’s say age 85 in this case. No matter how long you end up living, you get to spend as though you live to age 85. And that can allow you to spend a lot more than you might be able to spend were you to live to age 97 and a half to, or at least behave as though you might live to age 97.

And then the longer you end up living, the more expensive your retirement becomes, the shorter your retirement is, unfortunately, but it’s also less expensive to fund that retirement. And so that longevity pooling just helps calibrate. Everyone can spend like they’re going to live to their life expectancies rather than being worried. What if I do live to a much more advanced age? And if I’m worried about outliving my money, it just lowers my potential lifestyle.

Richard:00:11:45And how does that square with the Iron Law of Retirement? It was something that I saw posted on your Twitter feed recently, and you’re supposed to pick two out of three variables. One is risky asset allocation, the other one being low probability to running out of assets, and then the smooth standard of living would be the third one. And you’re only able to pick two out of the three in order to sort of fulfill that law. Does that —

Wade:00:12:15Yeah, I think I saw that at a conference and took a picture of the slide, it was a neat way to express it. But it’s expressing this idea that if you want to have steady spending in retirement it’s hard to do that with a volatile investment portfolio. If you want to have like an upside potential in a volatile investment portfolio, you might need to think about having flexible spending in retirement, especially if you also want a high probability of not outliving your assets. So, it’s just a matter of if you want a high probability of success, and you want stable spending, and you want upside potential. It’s hard to get all three without just saying, okay, I have to spend at a very low level. And that’s where if you can sacrifice one of those options, it can create a much more efficient and higher level of spending throughout retirement. It’s just more dynamic.

Adam:00:13:09So, this is really interesting, actually, to me, because I think a lot of people would find this a little bit counterintuitive if they took the time to sort of step into the problem, right? So, one would think that shooting for high returns means your invest– so you’re investing in a higher expected return portfolio, then that should allow you to both have higher spending in retirement and leave a larger legacy.

Wade:00:13:35On average.

Adam:00:13:36So, but — on average. So, what is the missing variable here to connect the dots for people?

Wade:00:13:42Well, so we don’t — like many times, if people start talking about running a financial plan with software and talking about a probability of success, they’re not probably targeting a 50% chance for success. They might target, say, a 90% chance of success. And that’s where we’re no longer talking about the averages, we have to talk about what ultimately becomes a scenario where markets don’t do as well. And with retirement, there’s this idea of sequence of returns risk, where if I’m spending from my assets, and the market’s declining, I have to sell a bigger share of what’s left to meet my spending obligation. And that digs a hole for my portfolio that becomes difficult to recover from.

And so even if you’re talking about a 30-year long retirement, even if the average market return was reasonable over those 30 years, if you get a bad sequence at the start of retirement, and then later markets recover, your portfolio doesn’t recover and you might end up facing a very — a much lower sustainable level of spending than would have been implied by that average market return. So, that’s kind of the reality people face in terms of dealing with the real world volatility of markets and retirement.

Adam:00:14:54We use a case study all the time that sort of illustrates this. So, you can imagine the period in, let’s say, the Dow Jones and let’s — the period from 1975 to 2016. So, 30 years, and it had exactly 8% average return, right. And if you were to just distribute 5% of your portfolio, so let’s say you started with a million dollars in 1975, and you take out 5% a year, and then you see when you run out of money, right? So, keep in mind over that full time period, the market averaged 8% a year. Well, if you do that, then you run out of money after 14 years. But if you just reverse the returns, so in other words it’s like you started in 2016, December 2016. And then the second month was November 2016. And then next month was October 2016. So, you’re just running the clock backwards over the exact same period.

So, obviously, you have the exact same returns just in a completely different order. Then now you’ve got the early returns, the strong returns come early, and you never run out of money. And in fact, you end up with a $3 million legacy at the end, right? So, exactly the same return just in a different order can lead to just profoundly different outcomes, right. And I think that this is a, something that people don’t intuit very naturally.

Richard:00:16:39Time-weighted versus money-weighted returns, right. And I think this is something that we’ve touched on this podcast many times. But I noticed that you’ve written something that maybe five years would be the most critical, the first five years of retirement are the most critical for a portfolio. So, I’m curious as to why that exact date — is there a range around that? And why are those first five years the most critical?

Wade:00:17:03Yeah, yeah. Well, like you said, with time-weighted returns, there is no sequence risk. It’s just I’m investing a lump sum and watching it grow. But whenever there’s cash flows, and — so, there is pre-retirement sequence risk if I’m saving for retirement, market returns early in my career don’t impact much. I haven’t saved that much yet. But by that last year, before I retire, that return is impacting all the contributions I made throughout my career at that point. So, the market returns just before retirement are quite important. But then once I retire and switch to spending from my assets that also further pushes up the importance of those early retirement years.

And so maybe like the five years before retirement and then the first five to 10 years after retirement are the most important years in terms of impacting the success of your financial plan over your lifetime. And that’s the idea of the lifetime sequence of returns risk. I’ve estimated, for example, that if you had a 30-year retirement, and so the first 10 years, the kind of 1/3 of that retirement length, the market performance in those first 10 years will explain 80% of did you — were you able to spend a lot or a little in that retirement. What happens later on hardly has an impact. It’s really pushed in to matter with those — just before and just after retirement.

Richard:00:18:29It’s the size of the portfolio, as I hear it, that ultimately matters, right? Size does matter in this case.

Wade:00:18:36Yeah, that’s the portfolio size effective. So, when you’re just starting your career, maybe you’ve saved $10,000, and the market drops 50%, you’ve lost $5,000. Later, as you get closer to retirement, if you’re at a million dollars and the market dropped by 50%, you’ve lost $500,000 in one year, and it may have taken you 25 years to have accumulated that amount in the first place. So, that’s that portfolio size effect where the absolute wealth exposure is much greater in those years around the retirement date when you generally will have the most assets of your career at that point.

Adam:00:19:18One of the most important insights over the last 25 years for me came from a paper that Moshe Milevsky wrote, where he showed that the probability of success, in other words, the probability of running out of money before you pass away is not just a function of expected returns, but also of volatility. So, for example, if you can generate a 5% real at 10% volatility, your probability of retirement success is actually very materially higher than if you have to generate that same five 5% real out of 15 or 20% volatility, right.

And plugging that into the inverse gamma function, and then just seeing exactly how sensitive the probability of success or probability failure are in that. So, I’m just wondering, do you account for that explicitly in your modeling or does it sort of emerge naturally from the Monte Carlo or simulation-based frameworks that you use?

Wade:00:20:36Oh, yeah. It will emerge naturally. It’s right, a higher return definitely increases the withdrawal rate. Lower volatility for a given return also helps to increase the withdrawal rate. And so you could even have a lower return, but with volatility also lessens by enough a lower return, maybe still a higher overall withdrawal rate for a given probability of success. And yeah, Monte Carlo would pick up — what Moshe Milevsky did that’s really interesting is just create a whole mathematical framework around that where you can use equations. Monte Carlo isn’t plugging things into those equations, but it’s going to give you an answer that’s materially close to what those equations would have given you.

Adam:00:21:21Yeah, absolutely. And the benefit of Monte Carlo and bootstrapped-based methods is that you can then also introduce a standard error of the mean, or different assumptions about the skewness, or higher moments of that return distribution, and all of these other effects that we know are better to approximate the true distribution of returns of financial markets, which we all know are not well approximated by a normal distribution.

Debunking Myths

Richard:00:21:51Probability adjusted considerations, I guess we can summarize. I’m curious as to the main motivation for your book. I mean, obviously, you’re passionate about the theme. Were there any particular myths that you were looking to debunk? Are there a lot of misconceptions that you see in how people approach retirement that you wanted to address in this book?

Wade:00:22:14Yeah. Maybe like really the underlying theme of The Retirement Planning Guide Book, and so much of what I’ve done, even going back to the early days where I used to talk about how there’s two schools of thought for retirement, it’s just you could ask these really basic questions. And depending on who you ask the question to, you could get a completely different answer. And, ultimately, over time, just coming to appreciate that the different perspectives are all reasonable, but people are wired differently. And so you may not just fundamentally think about matters in the same way as someone else.

And so if you can then find a strategy that’s more adapted to the way you think about the world, that could make you more comfortable to then actually stick with that strategy, and stay the course and not panic, and so forth. And then for you, that becomes a better strategy, because it’s something that you’re comfortable with and can stick with. And in that regard there’s a lot of people who just say, all you need is an investment portfolio; stocks for the long run, stocks that will fund a higher level of spending, you’ll be fine. That works for some people. Other people actually will be more comfortable with like an annuity based approach where you build a floor of protected lifetime income to cover your basics.

And then that can give you the comfort to invest the rest more aggressively, and still have that upside component as well. And it’s really just a matter of helping people sort out and understand what approach is going to work best for them. And that’s definitely one of the misconceptions. I kind of got my career started on this idea that what’s known as the 4% rule, probably really oversimplifies too many factors to be of much practical use. And there are other perspectives that are also viable at the same time. Yeah, Bill Bengen’s 4% rule.

Adam:00:24:05So, this is a good way or a good time to maybe segue into some of these approaches. I mean, I remember, a few years ago, when I was spending a lot of time on this, there seemed to be a consensus that optimizing for a safe withdrawal rate was a reasonable way to approach the problem. But I know that there’s been a lot of work over the last decade or so in terms of more comprehensive utility functions, and just general ways to approach optimal retirement spending. You’ve sort of touched on a few of them, but is there a natural kind of continuum that would allow people to sort of help people to understand some of the key differences between the thinking of the different approaches?

Wade:00:24:54Yeah, so this — actually, a research study I did with Alex Murguia was this idea of the Retirement Income Style Awareness or RISA, where we just — we read as much as we could about retirement to see how people were explaining different trade offs or issues where you had to make a decision, wrote a bunch of questions around that, test it out to see what was important. And we found that these two primary factors helped to explain how someone approaches retirement income.

The first is, we call them probability based versus safety first. Probability based is ‘I’m comfortable relying on the risk premium from the markets to fund a higher level of spending in retirement’. Safety first is you know, I’d really – ‘when it comes to my basic spending, I want some sort of contractual protection to cover what I’m doing’. I don’t want to be dependent on the market to cover my core retirement spending. And then the other factor is optionality versus commitment. Optionality is ‘I want to keep my options open as much as possible to have as much flexibility to make changes to respond to new situations and so forth’. Commitment is, ‘if I can find a strategy that will solve for my lifetime need, I’d rather commit to that’, and to some extent, take it off my to-do list and not have to be as worried about this.

And so we put those on a matrix, probability based on the right, safety first on the left, optionality on top, commitment on the bottom. That gives you four quadrants, that actually, the really interesting part of this for me was how well it explains the different retirement styles out there. So, if you’re probability based and optionality oriented, we call that total return, that’s like the 4% rule is a starting point, that’s — I just want to use a diversified portfolio and take distributions from that to cover my retirement. The other contrasting strategy would be if I’m safety first and commitment oriented, that’s I want contractual protections and I’m comfortable committing to a strategy, that’s describing the idea of building a protected lifetime income floor with maybe a simple income annuity or some other type of fixed annuity, and then investing on top of that for more discretionary types of goals. And those are the two more common quadrants because there is a correlation. If you’re more probability based, you tend to also be optionality oriented. If you’re safety first, you tend to be more commitment oriented.

So, we got two other quadrants, though, that are hybrids, or they’re like not natural. And it’s really interesting to see how those strategies have evolved as being more behavioral in nature. So, if you’re safety first and optionality oriented, that’s time segmentation or bucketing that’s developed since the 1980s. This approach, it says, rather than just using a total return investing portfolio, let’s use bonds to cover kind of short-term expenses. And then we’ll use stocks to cover long-term expenses. And then psychologically, we have this framework to say, well, if the market goes down, I don’t have to sell stocks for a few years, and I hope stocks will recover and I’ll be fine. And so that’s time segmentation.

And then the other quadrant would be probability based, I’m comfortable relying on the market, but commitment oriented, I also like to commit to a strategy. And so since the 1990s, that’s this idea of a variable annuity with a guaranteed lifetime withdrawal benefit, where you can have upside investing exposures, step up opportunities, but still have a downside floor that may be less than an income annuity. But since you are more comfortable with the markets anyway, you might have more of a feeling that I will get some of those step ups and be better off that way, while still committing to a strategy and having a lifetime income protection.

And so that’s — we call that risk graph. And that’s now four core retirement strategies. It just — before they talked about three, it’s like total return, time segmentation, and then flooring or essential versus discretionary. And we just split that into two between income protection and risk graph, depending on the type of protected income flooring that one chooses.

Richard:00:29:05Do you have a sense of — in terms of the proportion of people, I don’t know if you’ve done any work or have got any data on those that are sort of the more traditional two quadrants where they’re probability weighted and optionality oriented or safe based and commitment? And then what percentage might be the more hybrid, maybe a percentage that didn’t really understand the question or doesn’t really understand the implications of that or people that are actually, just have a different wiring when it comes to their asset allocation?

Wade:00:29:39Yeah, we’ve been able to repeat the study a number of times now with a bunch of different groups. First, it was not a representative sample, it was readers of Retirement Researcher who tend to be more sophisticated, do-it-yourself type investors. But then we did do a nationally representative study through the Alliance for Lifetime Income, and we were worried, are people going to understand the questions. The retirement research community could. But no, the general public could too, because the way — they answered the questions consistently, and if they didn’t understand the questions we wouldn’t have seen — there’d be more randomness in the way people answered.

And so what repeatedly, we tend to find with a couple other studies as well is, around a third of the population seems to resonate best with the total return approach, which is the diversified investment portfolio as the starting point for retirement income. About a third or maybe slightly more than a third is income protection. And then somewhere around like 15, 16, 17, 18%, in that range, would be both the time segmentation and the risk graph. And that’s pretty consistent. And it also holds across age groups, across a bunch of different demographic factors. The only demographic factors or broader socio economic factors we see where there can be some difference is, women do tend to tilt more towards income protection, men towards total return. And then people with higher net worth do also tend to tilt towards total return versus income protection.

Adam:00:31:15Right, well, that makes sense because —

Richard:00:31:16Which aligns with some of the –

Adam:00:31:19Yeah, because I mean, obviously, if you’ve got — if you have more wealth, then a negative market outcome would still leave you with enough to sustain. Right. So, it’s — I was — and this kind of segues nicely into what I think is also super critical, and that is the constraints on the ability for safe choices to deliver the required returns, right? I mean, we certainly just went through a long period where the returns on annuities or you know, the returns on safety first type approaches were so low that it made it a much harder decision to lock in, at such low rates, right? So, how do you find that people balance off this preference for safety first and optionality against the constraint of, you know, we’re just in a super low return environment for safe investments, and perhaps for all investments. So, seems to me that — there would be a tension there.

Wade:00:32:31Yeah. Well, ultimately, like, there’s three basic ways you could fund retirement. First would be, you could just use bonds as a baseline. And that’s not going to support a lot of spending. So, if you want to spend more than bonds, then you’ve got these two options. You’ve got the risk premium idea, the probability based, rely on the markets diversified portfolio. And then you’ve got the risk pooling, the longevity pooling idea of an annuity can provide a higher spending level that relative to bonds, that can actually be quite competitive with the stock market. And so, it’s not that either one’s necessarily superior to the other, and it’s not that the annuity or safety first approach doesn’t use any investments, but it’s a different way of — a viable strategy of building a floor in a manner that these different approaches can be competitive with each other.

It’s interesting, too, that it does, as best as we can tell, seem like these retirement styles are personality characteristics that aren’t just responding to changes in the market and so forth. We just recently, with a large asset manager, conducted the RISA study again. And we added another interesting question there that was really neat to see. The question was just asking people what do you expect the stock market to do over the next 10 years with a range of answers from less than 0% average returns to more than 15% average returns.

Now someone might think total returns as a style would be correlated with a higher stock market return expectation. We did not see that at all. There’s no relation — if you could be income protection and still think the stock market’s going to do 15%, you could be total returns and think the stock market’s going to do 0%. There’s not a correlation between retirement styles and what people believe the markets will do in the future. So, I think that it’s just, it’s a personality characteristic. It’s just how somebody’s wired about how they think about the world. And it’s not going to necessarily fluctuate based on what’s been happening in the markets or based on where interest rates are and so forth.

Adam:00:34:39What about FOMO? Like, what if you’ve got somebody who prefers safety first, and they lock in, is there ever a fear that their friend group that has a different personality and didn’t lock in and therefore takes advantage of the optionality and potential upside in a more risky portfolio, may just leave them behind? I mean, I know that like this is — relative status is an extremely powerful motivator in many dimensions of life. So, I just wonder whether that enters into people’s decision making.

Wade:00:35:15I suppose that could be an issue, but part of it too is someone whose safety first might not necessarily have been using a high stock allocation as the alternative. And actually, by building that protected income floor, then they may feel more comfortable. I usually talk about annuity is treating them as an alternative to bonds not as an alternative to stocks. So, an income protection approach doesn’t necessarily require less stock holdings than a total return approach. And if that sort of thinking resonates, you’re not necessarily getting into the scenario where you have less upside exposure or less market return exposure when you use income protection or a safety first type of strategy.

Richard:00:35:59How about a hybrid, a hybrid approach that might take these building blocks and say, I want to take a two thirds approach where I’m guaranteeing minimum amount that will cover my expenses, but I want to retain some optionality and you know, address some of the FOMO or some of the upside that I want to be able to capture if we are coming into an equity bull market, which at present day doesn’t seem like the most a high probability type of event. But is that something that you’ve come across? Do you see that happening a lot or do people tend to stick to one approach or the other?

Wade:00:36:38Well, to be clear, like the income protection approach is not annuities only. It’s first, get the protected lifetime income floor and then invest on top of that. So, to some extent, it is the hybrid approach. It would be something like, total returns is only using investments. But the others are, income protection and risk graph would be — is the floor, but that’s not going to take the entire asset base. No one should be putting all their assets, locking that up into some annuity structure. So, then you also have the investment piece on top of that.

Adam:00:37:17Gotcha. Why do you think so few people seek to take advantage of longevity pooling?

Wade:00:37:26Well, there could be a number of issues that get involved there. There’s is this idea of the annuity puzzle, which came from the academic world of why don’t people use commercial annuities more often than they do? I mean, different factors. Part of it, just Social Security is an annuity. And like we were talking about at the beginning of the show, a traditional company pension is an annuity. So, at least for retirees today, who still may have traditional company pensions, they may already have enough annuity income between Social Security and the pension. They don’t necessarily need a commercial annuity beyond that. I think part of the trouble just with the way the US system evolved, annuities started to get just like a tax deferral tool and create confusion.

Like when I was living in Japan, somebody, a Japanese person asked me, why does the English language have these two different words, annuity and pension. Like in Japanese, there’s just one word to represent those concepts. And I had to think about that. And my only guess could be that because annuities kind of went down this path of being used as a tax deferral tool and not for, the original concept was to provide a stream of contractually protected income, not necessarily over a lifetime, but just a contractually protected income stream. So, it kind of moved away from that original meaning, and that in that context, became more complicated, confusing.

There’s now many different types of annuities with many different types of features that could — I think, partly the insurance world is making things too complicated. And they do that to try to get some competitive advantage of how they can market their annuity as having some feature, but you have to then really dive in and understand, okay, they made one lever look more attractive. What did that do to the other levers, and how does the overall performance look? And so that just leads to issues as well. There’s been like different sales practices that haven’t always been on the up and up. And so it’s just created a tough road along the way. And those are some of the factors that help to explain why, at least, why academics are surprised that people don’t use annuities more often than they do.

Adam:00:39:44Well, one of the things that I always felt was that the people — so, how does somebody who does want to preserve optionality or does want to rely on risk premia to deliver a higher income and lifestyle and potential legacy, how do you get that and lock in with a traditional annuity? I guess your answer there would be that a variable annuity addresses many of those preferences.

Wade:00:40:17It could at the psychological level, but the variable annuity is more of a behavioral concept, because a simple income annuity plus stocks, is probably a more efficient way to do what a variable annuity can do. And then that becomes —

Adam:00:40:31Yes, but then you’re not taking advantage of the risk pooling, like the mortality pooling in the equity allocation. Right? So, you’re only really taking advantage of that in the sleeve that’s allocated to the annuities. I think, right? Unless I’m missing —

Wade:00:40:45Oh, no, yeah, yeah. So, the income annuity or a variable annuity with a living benefit attached to it, both give you the risk pooling element. Because the way the variable annuity works, is if you deplete the underlying asset base, then that living benefit that you’ve been paying for kicks in, and you enter this settlement phase, where it will continue to pay the promised amount of annual spending for the rest of your life, no matter how long you live at that point. So, the variable annuity with a living benefit, without annuitize in the contract, does give you that same sort of longevity pooling as a traditional simple income annuity, but less so for the most part, because it has all these other features with liquidity and with the ability to invest in sub-accounts and so forth.

Adam:00:41:34Right. Gotcha. I’m trying to. Sorry, go ahead Richard while we’re still — yeah, go ahead.

Richard:00:41:40No, I was just curious, I wanted to pull on the thread that he mentioned earlier about annuity being associated with the tax benefits that one gets. And in Japan, there is no differentiation, which is why it’s the same term for pension and annuity. You wrote a piece a while back on navigating taxes during retirement, and different tax treatments and incentives will nudge investors of different jurisdictions, different countries in certain directions and almost force them to take certain approaches because it’s just more beneficial to them net, net. And I’m wondering, can individuals reasonably be expected to navigate the tax maze that is — yeah, I mean, it’s such a complex topic for any aspect of one’s financial life, not just retirement, but just anything at all. So, I’m wondering how you think about both the nudging’s and incentives that are created by taxes, and also how individuals might go about doing that on their own?

Wade:00:42:43Yeah, the longest chapter of The Retirement Planning Guide book is on the tax planning for efficient retirement distributions. Because at least in the US, there’s so many nonlinearities in the tax code, and the Social Security taxation is a big one. They could hardly think of a more difficult way to design something than how they designed the framework of how much of your Social Security benefit will be taxed. And you can think you may be in the, well, these days, the 12, or the 22% tax bracket. But it turns out that when you take another dollar out of your IRA, it’s also pushing another 85 cents of your Social Security benefit to be taxed. You may be in the 40 or 50% marginal — you may be paying a marginal tax rate much higher than you had imagined. And that’s a big one of many different examples where having tax efficiency, and planning for tax efficiency in retirement can be a huge advantage.

It can be dangerous to have too much in a tax deferred account when required minimum distributions kick in and force you to take out those funds and pay taxes on them. Not just the taxes on those funds, but how that interacts with all these other factors or with higher Medicare premiums and everything else. So, that’s why the longest chapter in The Retirement Planning Guidebook is how to think through these issues and start to structure and it becomes — if the audience is primarily in the US, I don’t know how much I should focus on the US tax code.

Adam:00:44:17Primarily, yes.

Wade:00:44:19So, yeah Roth conversion, in the United States, you have the Roth IRA, which is you pay taxes beforehand, money comes out tax free. And so strategically converting from a tax deferred IRA into a Roth IRA, especially before Social Security begins, can have a huge impact on the sustainability of your retirement funds. And then annuities kind of was a lead into that question too there. Different types of annuities have different types of taxation, that you can also start to think about how that might help the plan as well. Outside of retirement accounts, simple income annuities give you the exclusion ratio, which is just a portion of the payment is taxable until about your life expectancy, when it all becomes taxable because a portion was the return of your principal.

Deferred annuities get more complicated, they have the last in/first out tax treatment. So, any gains come out first, and then your premium. And then if the premium’s gone, then you have lifetime income protection. That would all be taxable, as well. So, you can think about how those tax flows might impact your plan as well and think about how to strategically do Roth conversions around that. So, it does get quite complicated. But increasingly, people are developing software to help with planning around this. And like I said, it’s the case study I use in the book. I think, just having, well, an efficient Social Security and tax distribution strategy, added like six years to the longevity of their portfolio. In the example, I looked at.

Adam:00:45:56That’s gargantuan. Wow. That’s enormous. For like a typical investor who says I want to just lean on risk premia and invest in say, a 60/40 portfolio versus an investor who says, I want to invest in a pooled product that invests in a 60/40 portfolio. Do you have any sort of estimate of the pickup in distributions that one might expect from just the risk pooling step of that? Do you have any estimates of that, just how powerful that is?

Wade:00:46:42Well, ultimately, it depends. Yeah. Over 30 years, it depends. So, it’s ultimately going to be, what’s the probability that that unprotected 60/40 portfolio would deplete. And then with the annuity structure, there’s going to be a fee drag that would cause the underlying account balance to deplete a couple years before the unprotected portfolio, but then that lifetime income kicks in. And so it becomes more a matter of like, what are the probabilities that you would have depleted your unprotected portfolio and benefited from the annuity. And I’ve done those types of simulations before. Like off the top of my head, it’s hard to like think of specific numbers to say for it. But it’s not insubstantial that if you have a 30-year long retirement, there’s a reasonable chance that you will outlive your investment portfolio, and therefore, the annuity structure would be a benefit at that point.

The Tontine

Adam:00:47:46Yeah. So, where I was going with this was, are you familiar with the idea of the Tontine, that Dr. Milevsky has been proposing, and they’re launching a product in Canada that has many of the features of a traditional Tontine. But then allows the underlying assets to be invested in a variety of different asset allocation methods. So, yeah, so if you’re well versed in the idea of the Tontine, maybe give people a brief explanation of what that is. And then I’d love to hear your thoughts on the benefits and drawbacks.

Wade:00:48:24Yeah, yeah. So, Tontine’s a way to provide these longevity pooling credits without having to use an insurance company as an intermediary. You just need some manager of the funds to keep track of who all the participants are, and to keep track of whether they’re alive. But the basic idea is, you bring together a group of people, they make their payments and pay premiums into this pool. And then someone invests that, and then every year, the distributions coming off of that portfolio, the interest and dividends, and also that may be structured to also spend down principal over time as well like an individual’s systematic withdrawal strategy. But that, those proceeds get shared among those who are still alive. And so not only do you get the investment return, but as you live longer, you get the longevity credits as well that become part of that.

To try to make up a very simple example, you know, of course, you need more than five people in your life, but say five people each contribute $100, you’ve got $500 pooled. Give it a 5% return, so that would be $25. And so if all five of those people lived, they would each get $5 of that return if we’re not spending down principal as well. If one of those people passed away, you’re now splitting that $25 yield between the four remaining survivors. And that’s the structure where 25 divided by four is a bit bigger number. Never can do math. Like six dollars.

Richard:00:50:04Six and a quarter.

Wade:00:50:05Yeah, you’re getting six and a quarter from it instead of five from it. And that’s the longevity credit that becomes part of that. Now, for a long time, Tontines were very popular in the US and like the 19th century, and before they became illegal, and now they became — there’s many TV shows and movies that treat the Tontine as a winner takes all type of thing, where you have a pool of people, the last survivor gets everything. And so that leads to a lot of intrigue and murder mysteries and whatnot. In real life that’s not how a Tontine works. It’s not going to be winner takes all. And so you’re not going to have that incentive to seek out the other members of that pool and knock them off. But …

Richard:00:50:45Is there a level of anonymity there that sort of creates a separation and a safety, an additional safety for the members?

Wade:00:50:57Yeah. I mean, well, partly — a lot of times in the past, these were structured through maybe a particular type of employer, Fireman’s Tontine, or something like that. And so it may not be 100% anonymous, but at least there’s not — the way it’s designed, there’s not going to be a financial incentive to worry about who the other people in that pool are and trying to do something to them.

 

Richard:00:51:23To try and summarize — Sorry, go ahead Adam.

Adam:00:51:27Why were they made illegal?

Richard:00:51:30Probably lobbying from the insurance companies.

Wade:00:51:33That may very well be part of it since, right, like you don’t need the insurance company to manage that risk pool. Now, in the US, the insurance company is the only one able to provide a longevity credit. So, naturally, they don’t want an asset manager introducing a Tontine that can do the same thing. So, I’ve got to imagine that would be part of it. And beyond that, I don’t know if there was like maybe some hint of truth in what happened with some of these TV shows and whatnot that led to a crackdown at one point. I don’t know the whole history of it.

Richard:00:52:04Like a murder mystery.

Adam:00:52:05Well, I mean, I can see — the firemen one is a really good example. Right? If you’re like if it’s the San Diego Fire Department Tontine. And so you know, you know who the people are that are members of the Tontine, then it certainly is plausible for somebody to start picking off other firemen, right? I mean, like, in a — or if it’s a Tontine set up for a town in the late 1800s, or something, and the town’s got 50,000 people in it like, you can see if you’ve got one or two degrees of separation, that it’s possible to corrupt the intent of the Tontine through nefarious activities, right. But in a modern context, it’s hard to see how that might work.

Wade:00:52:50And you’ll also put on some restriction that once the remaining number of survivors falls below a certain level, you stop giving those longevity credits so that you don’t have that sort of incentive. I mean, they can be designed to not have any of these concerns.

Richard:00:53:07So, essentially, the difference between a Tontine and an Annuity is just that the upside is retained, either by the members of the pool or by the insurance provider, right? So, essentially that the Tontine team just allows for bigger upside for those that are participating in the pool.

Wade:00:53:24Yeah, you can design the investment strategy you want. And also like with an Annuity, the insurance company’s taking on the longevity risk that if suddenly people start living longer than you anticipated, they still have to pay you what they promised to pay you. Whereas with the Tontine, I’m now bearing some of that longevity risk. Because if people suddenly all start living longer than maybe the actuary thought, well, that’s just going to reduce the payments to everyone in that pool is receiving. And so you are bearing some of the — you’ve got some investment risks, you’ve got some longevity risk as part of the product. But still, that could be an attractive solution for a lot of people.

Richard:00:54:07The Tontine is autonomous.

Adam:00:54:11The Tontine can buy a longevity swap, and offset that longevity risk as well, right? The way that an insurance company is trading longevity swaps, that’s how they hedge their, that systemic risk of maybe there’s a major innovation, we cure cancer or cure heart disease and people start living an extra 20,30 years, and obviously, that’s a major risk for insurance companies. So, they buy these longevity swaps, right?

Wade:00:54:39And they also just can hedge that sum with life insurance, because if people suddenly start living longer, their life insurance claims will go down, but their annuity claims will go up and so there is a natural —

Adam:00:54:50Right, diversification there. That’s true. That’s a good point. It just seems like — I mean, it’s purely regulatory capture by the insurance industry of a Tontine as an alternative for — I mean, just seems like it has all of the characteristics you’d want, right? You can set up … you can include, you know, diversify mortality the way you want by using a maximum number of people in any different state or city or part of the country or whatever. So, you’re sort of diversifying the potential for natural disaster, risk, or that type of thing. Buy a longevity swap, you’re cutting out the middleman of the insurance company, set up the risk profile the way you want. I struggle to see the downside, honestly, I mean, then, obviously, people’s actual …

Wade:00:55:51Yeah, Tontines, they’re an attractive idea. And a lot of people have explored how to reintroduce them. And there’s been some efforts over the years, and there’s a lot of writing on it. And what you talked about now with what Moshe Milevsky is doing in Canada, still in Canada, not in the United States. But yeah, if that has success, maybe at some point, we’ll start to see those same developments in the US. It definitely has a lot of attractive features. It’s kind of the closest annuity type idea would just be something like an immediate variable annuity, which in practice are very rare. But it’s the same basic structure where you have a guaranteed lifetime income, but you just don’t really know in advance exactly how much it’s going to be. It can fluctuate up and down, depending on market performance.

Adam:00:56:42Gotcha.

Richard:00:56:43We’ve talked a lot about behavioral considerations and just the different frameworks that one might take into consideration and approach. But I’m wondering if you might get in a little bit into the specifics on asset allocation, and particularly holding cash in a portfolio? I mean, it is definitely, I would imagine, considered in the different approaches that you mentioned, the annuities and the different hybrid allocations that you might take. But how do you think about the timing of increasing or decreasing how much cash you’re holding as a percentage of the portfolio, depending on market dynamics, or just personal preferences.

Wade:00:57:26So, the asset allocation, it’s kind of interesting how when you talk about safe withdrawal rates, the asset allocation doesn’t matter a whole lot. There’s a whole range of asset allocations that give you kind of the same sort of safe withdrawal rate. Now, the more aggressive you are, the more upside potential there is, of course. But yeah, with cash, cash is something you might think about more with like a time segmentation approach. Or if you’re just using it as a buffer asset, which is this idea of I may have cash outside of my portfolio that I don’t really treat as part of the portfolio, but that I may use as a temporary spending resource during times of market volatility, so that I’m not locking in sequence risk and selling portfolio assets at a loss.

And in that regard, so there are other buffer assets as well. But if you’re primarily thinking about cash as your buffer asset, people might want to have a year or two of spending, or more, in cash as just sort of that backdrop protection to help preserve their investment portfolio during times of market volatility.

Richard:00:58:37And how do you think about sort of the current environment that we’re in given that the answer, sort of expanded to today and how you might incorporate sort of the higher level of uncertainty and the wider probability cone that we might be facing currently.

Wade:00:58:57Yeah. So, markets are down dramatically in 2022. And as we record, it’s been another really bad day in the market. So, that does trigger danger for recent retirees because it’s the whole idea of the sequence of returns risk is no longer an abstract concept. Your stocks may be down more than 20%, your bonds may be down more than 20%. And at this point, 30% might be something that’s coming into play as a potential downturn. So, that’s where, if you have some other mechanism, whether that is reduced spending, whether that is spend from cash or some other buffer asset, like a reverse mortgage, or cash value of life insurance, those are really the three buffer assets.

Something that can help preserve you from not having to dip into your portfolio at this type of time is going to be very important for retirees right now, especially, and those are just the nominal losses and with inflation as well. People who retired say on January 1, 2022, this is not a great time to be spending from their investment nest eggs in retirement.

Adam:01:00:12How do you think about inflation then, from a hedging risk perspective for retirees?

Wade:01:00:20Yeah. So, inflation, it had been low for so long that when everyone was talking about the sequence of returns risk, there was no thought around this kind of — there’s also this sequence of inflation risk, and it’s — suppose inflation is 10% this year, and then 0% for the rest of retirement. Nonetheless, that permanently raises the cost of living by 10% for that entire retirement, because the higher price level that happens this year remains in the future. If inflation is low now and picks up later in retirement, it is a sequence of inflation risks, because inflation later on doesn’t have as big of an impact. Inflation now has a much bigger impact.

And to the extent that inflation does seem to be correlated with market returns in a negative manner, higher inflation, in the short run tends to be associated with losses on stocks and bonds, or at least a negative correlation there, the real returns can be lower. And if you’re entering into retirement, it’s like this triple whammy of high inflation, bond losses, stock losses, it does create strains on an investment based retirement strategy.

Adam:01:01:33So, yeah, so how does that — square that for me with your assertion that asset allocation doesn’t have a very large impact on, you know, safe withdrawal rate outcomes, right?

Wade:01:01:46That’s — in any sort of historical data or Monte Carlo simulation, whether you used 40% stocks or 80% stocks, it’s usually the downside, sustainable spending level for a given probability of success doesn’t change all that much. That’s what I meant by the asset allocation.

Richard:01:02:08How far back does this data go?

Wade:01:02:12You see this sort of phenomenon — I mean, Bill Bengen’s study was on the Morningstar data back to 1926. But I’ve even — the first study I did in this area was with global returns data for 20 different countries going back to 1900 See the same sort of phenomenon there. You generally can see it with any Monte Carlo simulation of a retirement strategy as well. It’s a pretty persistent type of phenomenon that, and it’s because you’re riding along these curves that, we were talking about this earlier, the safe withdrawal rate depends on both the volatility and the return. And so with the idea that a higher return is associated with more volatility, you ride along these isoquants of the same sustainable withdrawal rate, because you’re kind of moving up in this consistent manner, with higher return/higher volatility, still the same safe withdrawal rate for that particular success rate that you’re targeting.

Adam:01:03:10Yeah, I understand how that emerges from the historical data where only about 18 to 20% of months from, say, 1870, if you want to use the Shiller data. I know we can go back even further than that with global financial data and stuff like that. But only about 20% of months over that horizon did we experience meaningful inflation. Right? So, I guess the big question I think a lot of retirees are asking themselves right now is, how can I build a portfolio that maximizes my chances of positive retirement outcomes and that takes into account the kind of inflation risk that we’re currently seeing?

Wade:01:03:56In that regard, so if total return has to rely on how stocks are going to be over the long run, the best sort of shot at keeping up with inflation and providing a positive real return. Definitely traditional bonds get decimated by inflation. TIPS, of course, are another option, inflation protected bonds, that now those real yields, they were negative for a long time, they’re now most of the TIPS yield curve is over 1% real. So, that could be another option to look at on the bond side. And then also, if you have one of the other like an income protection approach, you don’t look for inflation protection through the annuity, but it might better position you so that the rest of your assets can be invested more aggressively, and have a smaller distribution need because the annuity, at least in the short term, covers more of the spending. It’s not going to grow with inflation, but it’s at least in the short run, covering more of your spending. That could help position your investments to have a better shot at growing and maintaining that inflation protection as well.

Adam:01:05:00Right.

Richard:01:05:01In your research, have you looked at anything outside of just a stock/bond allocation for a portfolio? I mean, obviously, we are alternative asset managers. We do, we manage active strategies. And so I’m wondering, have you looked at any of those, any type of either Trend following strategies or anything that sort of serves as a diversifier to a core stock/bond portfolio?

Wade:01:05:26So, one of the early articles I wrote was acknowledging that when people read some of these studies, there’s nothing they can do. They’re kind of stuck with whatever was assumed by the article. So, I built a framework around, you can assume whatever you want, with asset classes, returns, volatilities, correlations, build your own efficient frontier. And then I made these charts that you could overlay those efficient frontiers to see what sort of sustainable withdrawal rate could be supported, and what asset allocation would give you the highest sustainable withdrawal rate. And so that does open you up to assuming whatever you want, alternative asset classes and so forth.

And then at the end of the day, it’s really just this function of what’s the portfolio’s return and volatility, assuming like bell, somewhat bell-shaped distributions. You could do the same sort of analysis with a structured return if you’re using some sort of structured approach where some of the downside risk is cut off, some of the upside potential cut off and so forth. And was there an — oh and about, like, changing asset allocation. I did play around with — So, Schiller’s CAPE ratio in the historical data actually moved quite well with helping to predict what the sustainable withdrawal rate would be, and also helping to predict maybe changing asset allocation. But ever since Schiller wrote his article on that in 1998, that relationship’s gone away. And so I generally don’t dabble in tactical type asset allocation for a long term retiree, it’s — just go with some sort of, what’s your strategic asset allocation and stick with that.

Adam:01:07:09Yeah, I guess, we typically advocate for sort of an All Weather approach that is some bonds, some stocks and some commodities, and some TIPS. But just with the idea that you want to have bonds for slower than expected growth and/or disinflation, equities for a sort of typical low risk growth environment, and commodities for a period where — of an inflation shock, where both stocks and bonds are kind of designed to not do so well, right? So, holding equal risk in each of those three buckets then gives you the opportunity to protect against both negative growth shocks and positive inflation shocks, which most sort of traditional portfolios don’t really do well with. So, that’s kind of where we — how we approach the problem. But you know, I understand that your framework can accommodate our approach as well, which is great.

We keep talking about the safe withdrawal rate as though, and obviously, this is where I spend a lot of my time as well on kind of trying to annuitize or create a retirement stream that is analogous to what pensioners used to get, right, where it’s a fixed payment every month, maybe indexed to some inflation index. But there’s other ways to manage that, right, where you can have more flexibility in your retirement income that responds to maybe a combination of your age and the returns that you’ve experienced. What sort of innovations have you observed or seen in your own research over the last decade or so that might nudge people in one direction or another in terms of the benefits of trade offs of those types of approaches?

Wade:01:09:01Yeah, so the academically optimal retirement strategy, at least for like most normal looking utility functions is you build that floor for the basics. And then you do, like the RMD tables are an example of you spend an increasing percentage of what’s left as you age, to get an efficient, assuming there’s not necessarily a legacy goal, to get the most efficient drawdown of assets. And then you can make adjustments that like the RMD tables are actually designed to be pretty conservative. And so you’re not getting to spend very much in the early retirement years.

So, I like to multiply them by some factor that would raise your spending early on, and then the spending percentage goes up over time, but because you’re more aggressive early on, there’s more of a decline in the remaining portfolio balance. So, you can kind of engineer the type average spending stream that you might want to target. A lot of retirees do want to spend more in their early years, spend less as they get into the — it’s the idea of the go, go years and then the slow go years, and then the no go years spend less as they age. And so you can design those types of strategies.

And that the RMD tables are the example of spend an increasing percentage of what’s left as you age, that can align very well with being an efficient drawdown strategy. The 4% rule is the least efficient retirement strategy because it just doesn’t build in any mechanism to respond to what’s happening in the markets, or with age. And so you create a risk that you might run out of money. But you also, most of the time, dramatically underspend relative to what you could have done and leave behind a, just a big legacy at the end. So, building in some sort of response to how the market or how your portfolio is actually doing in retirement is just a huge benefit to improving average spending levels in retirement and everything else.

Adam:01:11:02Right. And then you’re able to run simulations that account for that distribution function, right, that you can sort of customize for an individual who wants to say spend a little bit more during the go, go years, and then and then wind down their spending a little bit, and then maybe expect to have to ramp it up again, if maybe they have a family history of some sort of health condition, or what have you, that gives a high probability for needing a higher level of care further down the road, so you can have this sort of custom spending function. And then as each year passes, and you get gains and losses in your portfolio, you’ll just rerun that optimization against that target spending pattern to make adjustments to what you’re going to spend that year. And then presumably, that could end up being pretty volatile, depending on the underlying investments. So, maybe there’s a smoothing element to that.

Wade:01:12:04Yeah. Yeah, you’re explaining the whole framework around choosing a spending approach that it’s going to be a lot more practical in real life.

Adam:01:12:13Right. Gotcha.

Richard:01:12:14Are there any sort of developments in technology or innovations, whether from a portfolio construction standpoint, or just ways to have better estimates, or anything at all in this space that you think weren’t mentioned and that have you excited or new research that may be coming down the pipe?

Wade:01:12:37Yeah, and something that’s not really new, per se, but in recent times, I’ve become a lot more enamored by just the Funded Ratio approach of building a retirement plan, which is where you just gather up all the assets and liabilities, and that can include income streams, like Social Security benefits, what’s the present value? And then my essential spending goal? What’s the present value of that? Collecting that all, looking at do I have enough assets to match my liabilities? Am I overfunded for retirement, underfunded for retirement? It’s a simple metric. It doesn’t require any Monte Carlo simulations. I think it can be a great approach for just assessing a basic retirement plan. And so it can also link to other — I mean, there will be a one-to-one relationship between Funded Ratios and probabilities of success that you could reverse engineer if you want.

But — so interesting research there. And also just a dynamic spending strategy that’s somehow linked to your Funded Ratio; as you become more overfunded, spend more, that sort of thing. I think that could be a good avenue for future research. And just — where that becomes more realistic, like the 4% rule is just not, even though everyone uses that as the starting point to talk about retirement income, you can’t use it in real life. Because if you’re deferring Social Security, you spend more now, you’ll spend less later. If you have to pay taxes, taxes do not have inflation adjusted constant taxation. Taxes can be all over the place.

And so the Funded Ratio approach or any financial planning software can accommodate those real world up and downs and cash flows and things and let you model a more realistic plan. And I just like the Funded Ratio, because it is so simple, doesn’t require Monte Carlo simulation, I think it can make a lot of sense for people as a starting point. So, that’s where I see a lot of innovation coming.

Richard:01:14:41Great. Wade, you’ve been really generous with your time. I really, really appreciate you coming today. Let’s give you an opportunity to let people know where to find you and maybe an opportunity to tell us the name of the book again.

Wade:01:14:56Sure. Thank you. And so the website if you’d like to get on our weekly email list is retirementresearcher.com. And then my newest book is The Retirement Planning Guidebook. And the first chapter is about that idea of retirement styles. And on page 15, there’s a link if you’d like to see, are you a total return, income protection or so forth; what kind of retirement style might be suitable for you.

Richard:01:15:21That’s great.

Adam:01:15:22That sounds really cool. Yep.

Richard:01:15:24Thanks again, and have a great weekend, everyone. Thanks for tuning in, and we’ll see you next time.

Adam:01:15:30Thanks, Wade. Thanks for all, for joining.

Richard:01:15:33Thank you.

Wade:01:15:33Yeah, thank you.

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