A Safety First Retirement | The 4% Rule and Managing Sequence of Returns Risk with Wade Pfau

[00:00:00] Welcome to Excess Returns, where we focus on what works over the long term in the markets. Join us as we talk about the strategies and tactics that can help you become a better long-term investor. Matt Siegler is Managing Director at Sunpoint Investments.

[00:00:12] The opinions expressed in this podcast do not necessarily reflect the opinions of Sunpoint Investments. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of clients of Sunpoint Investments.

[00:00:24] Hey guys, this is Justin. In this episode of Excess Returns, we bring in some reinforcements. Our good friend Matt Siegler sits in for us and talks retirement planning with Wade Pfau. Wade is the founder of Retirement Researcher and the author of numerous books and academic papers

[00:00:38] on retirement planning. They discuss the 4% rule, variable withdrawal strategies, and Wade's safety first approach to retirement. They also dig into Wade's work on retirement income styles and what it means for investors. As Matt mentions in the interview, there is

[00:00:52] probably no one who is more respected among practitioners who do retirement planning than Wade and his unique insights shine through in this interview. As always, thank you for listening. Please enjoy this discussion with Wade Pfau.

[00:01:04] Extra excited to be here. You're watching Excess Returns. I'm Matt Siegler hosting today. Wade Pfau, thanks so much for coming on the show today. It's great to see you. Absolutely. Thanks, Matt. Great to see you.

[00:01:17] I have to say this and this is as much for the viewers as anything else. Every firm, so working at an RIA, doing advanced financial planning and all sorts of investment strategies from the most basic to the most complicated. There's a handful of household names

[00:01:32] around a firm where when something comes to the table, when you hear a new idea, when you see a new idea and you go, I need to not just think through this at a high level.

[00:01:43] I need to make sure I kind of like check my sources, check my references. Who's done the deep dive and pretty much the two names that get thrown around the most are did Michael Kitzis write anything about this? Do we have something quirky about those dividend tax laws

[00:01:56] or whatever else? Or especially on the financial planning side, especially on the distribution side of financial planning. What's Wade Pfau said about this? Let me not underscore this enough for especially a lot of the more quantum

[00:02:09] investing people who are watching this when it pops up on their feed. Like Wade's your guy. If you don't know Wade stuff, we're going to do a quick overview of a lot

[00:02:18] of things he's worked on. But Wade, I have to say this first from the professionals out there, from the practitioners. Thank you, man. Oh, well, I appreciate the kind words. Thank you.

[00:02:28] Well, let's dive into this first. I want to start with one of the big ones. We've covered this a lot on this podcast already. I mean, the 4% rule, it's been around for a minute.

[00:02:38] Why couldn't they have just made it the 40% rule? Let us take so much more money. It would have been so much better, so much more fun too. Can you walk us through like what is the 4% rule?

[00:02:50] Why do you care at all? And maybe what was the gateway into why you wanted to explore this further in your own career? Okay. Yeah, I mean, sure. The 4% rule is actually now, it's the 30th anniversary this year. I think October 1994 was the publication of Bill

[00:03:04] Dangan's famous article and it was really meant to be a starting point for thinking about retirement income. And it was responding to what it fixed was this idea that folks like Dave Ramsey still talk about today where if you say, well, the S&P 500 will give you 8%

[00:03:21] after inflation. So I'll plug in 8% return in a spreadsheet. Every year my portfolio goes 8%. I can take out 8%. I've never even dipped them into my principal. But then you can realize that that was ridiculous. And he saw it to just understand what is a more realistic type

[00:03:37] distribution rate. If you want to keep that spending consistent over time, he looked at US historical data going back to the 1920s and just assumed if you're planning for a 30 year retirement horizon, what is the highest percentage of that portfolio balance you could

[00:03:52] take in year one that then gives you a level of spending that you'll keep fixed other than you'll adjust it for inflation every year but you won't otherwise adjust it based on how your portfolio does. But you keep increasing that spending for inflation and you want that

[00:04:06] money to last for 30 years. And usually it was higher than 4%. On average it was closer to 6%. But he wanted to build in safety by looking at the worst case 30 year period in the US historical

[00:04:18] data between the years of 1966 and 1995 with a, and he called for using about 50 to 75% stocks in retirement. I usually stick to 50% stocks for examples because I think 75% stocks is really pushing it for a lot of retirees in terms of being a lot more aggressive than we usually hear.

[00:04:37] But with a 50% stock allocation, you could have taken just slightly more than 4% in 1966, increase that for inflation and then you would have run out right at the end of 1995, 30 years later. And that's where the 4% rule comes from. It says, well, based on US historical data,

[00:04:54] the worst case scenario was 4%. So if you're comfortable with that, that's what you use on a forward-looking basis to derive a sustainable spending rate from your investments in retirement. It's really interesting to me too that he was, because there's the practical reality of it.

[00:05:10] Like if you could jump in your DeLorean, go back in time, you and Bangin are hanging out, making fun of that Ramsay guy, and you're saying to each other, like we want to set this

[00:05:20] in year one because there's a really important, I think psychological anchor that happens there at the onset of the distributions. How do you understand that now? You could take Wade Fow's current day knowledge all the way back in time and say, is that a good way to think

[00:05:35] about it like that initial anchor of what you're spending? But yeah, I mean, partly he was just fixing a real problem that was out there about like explained with fixed rates of return. But on the other hand, he didn't necessarily take every step towards

[00:05:52] what is a realistic strategy. I think the basic idea, now we do have evidence that this isn't true, but people generally would like to have consistent inflation-adjusted spending over time. Like they should allow for their spending to grow with inflation. They want it to be consistent.

[00:06:07] And that's really what he was using as a starting point. Now it's not realistic because most people won't. You're really playing a game with chicken in this scenario, whereas your portfolio is plummeting towards zero, you never cut your spending at all.

[00:06:19] Most people will do some sort of flexible spending strategy. And so if that could have been incorporated from the very beginning, it might have helped counteract some of the potential conversations there. But basically the issue is sequence of returns risk, that the order

[00:06:36] of market returns matters. If you get a downturn early on, even if the market recovers, if you're spending from your portfolio, you won't enjoy that full recovery. The Bill Bingen's 4% rule research demonstrated, it's really what showed the financial planning

[00:06:50] world what sequence of returns risk is. Kind of the unfortunate side effect was the specific assumptions he uses for the 4% rule create the most sequence risk. If you never adjust your spending in response to how your portfolio is performing,

[00:07:07] you have no way to manage that sort of volatility. And if you're willing to just make small cuts to spending after a market downturn, that reduces the likelihood that your portfolio gets

[00:07:16] into a death spiral towards zero and it helps manage the sequence of returns risk. So in explaining what sequence of returns risk was, he inadvertently created a default strategy that maximizes

[00:07:28] sequence of returns risk. So maybe going back in time to talk to him, we did that sort of issue, settled a little bit from the very start, might have helped with a lot of the

[00:07:37] subsequent debate and discussions. I can picture him as doc, not wanting to see the note that you're delivering to him. It's interesting too because I actually really think that's fascinating. So number one in a real financial planning conversation, nobody wants to hear about the

[00:07:54] doom spiral that you're serving up to them with their strategy. But you also wrote, and this was a real eye-opener to me because you wed some of what we know from the quantitative value investing world into this retirement income problem. You took the 4% rule and you said,

[00:08:12] wait, did this work in other parts of the world geographically or outside of the US? What did you find when you started to test this outside of America? Right, right. And that was really my first study in financial planning. Earlier in my career

[00:08:24] as more of a traditional economist and studying for the CFA exam, that's where I learned about the 4% rule with other research I was doing. I had access to the global returns data set that's now available through Morningstar. It looks at 20 different, I think still 20

[00:08:40] developed market countries going back to 1900. So I was just curious if Bill Bingen had been Italian instead of American or whatever the case may be. Did the 4% rule work with other countries' financial market data? Instead of assuming US stocks and bonds, would if

[00:08:55] you use Canadian stocks and bonds or Portugal stocks and bonds? And this is still the developed market country so it doesn't include, if you go back to 1900 and ask what are going to be the leading countries in the 20th century, maybe Argentina, Russia, China, different

[00:09:10] countries that ultimately had financial market collapses at some time in the 20th century and weren't even part of the data set. But with those 20 developed market countries, the 4% rule, it was really an artifact of US data. It also worked in Canadian data,

[00:09:26] but it really didn't work in any of the other data sets. And it's partly, like if you lost a World War and experienced hyperinflation, Japan after World War II, Italy, Austria, Germany around World War I, sometimes World War II, you got very low withdrawal

[00:09:43] rate. But that's not the whole story. If you look at a country like Australia, it's actually the one country that had a higher average stock return than the US and also less volatility and really great performing financial markets. But nonetheless,

[00:09:57] their 4% rule became 3% during the same late 60s, early 70s, stagflation era. I think it's just sort of one of the characteristics of US data is we've had downturns, but markets usually recovered pretty quickly on a relative basis whenever we recall 2008 financial

[00:10:18] crisis. Well by the end of 2009 things are on the road to recovery. The 2020 spring with COVID dramatic collapse that recovered quite quickly. And if it recovers quick enough, you don't really get locked into the sequence of returns risk because you're not taking that many distributions in a

[00:10:34] loss. And so the 4% rule survives in the US, but it really didn't work as well with other countries. And if you put all the international data together, the 4% rule worked only about two thirds of the time historically rather than like the 100% type number you'd get with just

[00:10:51] US historical data. And would you put any weight on, because I know we'll touch on this, I'm sure it's somewhere like would you put any rate on just starting conditions from the sense of how portfolio people think about this like bond yields, equity market valuations, would you

[00:11:09] put any weight on that? Or would you reduce it all just down to hey, sequence of returns is going to determine what you get out of this thing. There's a lot of debate on that

[00:11:16] point now bond yields. Yes, definitely. I continue to this day to think the initial bond yield is incredibly important for laying a base of what bond returns would be. And then also

[00:11:26] I just want to add a risk premium to whatever today's bond yields are to get an estimate around stock returns. I think that point's not so controversial, the market valuation side is more controversial. And that was something I looked at. Robert Schiller had that date in

[00:11:42] the 1990s about how well stock market cyclically adjusted price earnings explain the subsequent stock returns over the next 10 years. And in the historical data, it actually explains these sustainable withdrawal rate numbers really well. But about the time people started seeing

[00:11:59] those relationships that seem to have broken down somewhat because it's really for most of the 21st century would have been predicting pretty low distribution rates. So I don't necessarily make those adjustments from stock market valuations. But I do think the initial

[00:12:15] bond yield is very important, which really speaks to in the past with interest rates being so low. The big concern I had was that that's not translating into the 4% rule obviously being safe.

[00:12:28] If you just had a 30-year tips ladder, you could have the 4% rule in the sense of 30 years of inflation adjusted spending. To make that work, you need a 1.3% real return. So in the recent

[00:12:42] past, the tips yields were negative. There was no 4% rule of bonds. Today, tips yields are in the 2% range makes it much easier to support something like 4% without taking any sort of market risk.

[00:12:55] And then if you want market risk on top of that here, you have more upside potential, but you then also have the risk you might get an average return that falls below what the 30-year tips ladder could have supported. Do you feel like and again, I know we're

[00:13:07] going to dig a little bit more into this and some of the other frameworks you provided, but if all I gave you were the bond yields around the world and we ignored the equity side of it,

[00:13:19] we just built them from the fixed income ladders. Forgive me if you did this work and I haven't seen this work before. Has anybody showed where the 4% rule does and doesn't work just exclusively based on bond yields around the world? I'm sorry, where you're still going to assume

[00:13:35] a diversified portfolio or you're only investing in bonds? If I only invested in bonds. I think the current yield curve will just tell you, if you're going to have bond funds, you still have interest rate risk and you still have sequence of returns risk. And if interest

[00:13:51] rates go up, you'll have losses and then you dig a hole for the portfolio. So you could still have failure with a bond fund, but if you're simply building a bond ladder, the yield curve for each country would pretty precisely inform you about what the

[00:14:04] sustainable withdrawal rate would be over that time horizon. And if you hold those bonds in maturity, you don't realize any sort of interest rate risk, any paper losses you might have had

[00:14:12] while they go away by maturity. So you could have a pretty good sense of what the yield curve in each country would support for 30 years of sustainable spending just by building a bond

[00:14:22] ladder around that. I think it's really interesting and I think it's really useful to work through four planners to work through just the straight bond math of it all. So hearing you talk about something like that, it's a useful part of the exercise

[00:14:35] because it helps you, I think just understand how that's the part that's straightforward and that's some of what you can expect. So then you have to be smarter than that. Let's get into some of the variable withdrawal strategies. You've done some amazing work around

[00:14:48] this. Maybe mention what some of the different approaches are once we start to get into variable withdrawal amounts. So I'm not just starting on that 4% initial assumption, I'm allowing some dynamic flexibility over time.

[00:15:03] Okay, yeah. Yeah, let's like put two ends of the spectrum and then everything else will fall somewhere in between. So one end of the spectrum, not variable. It's what we've been talking about already how the 4% rely would just call a constant amount type strategy or constant inflation

[00:15:17] adjusted spending where there is no variation based on portfolio performance. Now at the other extreme, you could call it a constant percentage or a variable which I'll rate the if I took

[00:15:29] 4% of what's left each year. That's not what the 4% rule is, but if I simply said okay each year, January 1st, what's 4% of what's left in my portfolio? That's my spending for the year. That would be a constant percentage strategy. That's going to lead to quite variable spending.

[00:15:47] There's actually no sequence of returns risk with that strategy surprisingly. So that's really the other extreme where you could be if 4% is what you use with constant amounts, you might be able to get away with a 8% variable rate where you're not necessarily going to dip much

[00:16:03] below where 4% would have ever gotten you with the constant amounts. That'd be the other extreme. And then all the other variable spending strategies out there are some sort of compromise. The value of constant amounts is you have a pretty good sense of what your spending is going to

[00:16:17] be in the future. The value of constant percentage is you're going to fluctuate your spending to help manage sequence of returns risk and hopefully get a higher amount of average spending. So any sort of variable strategy beside that is how can we get some sort of balance

[00:16:34] where we're going to have some fluctuations for spending but not too much fluctuations. And then there's a lot of different strategies that are out there that usually different financial advisors have offered. One of my favorites is just where Bill Mangan, one of his early

[00:16:47] articles, he talked about a floor and ceiling rule where you use a constant percentage of what's left but you have a hard dollar ceiling in a hard dollar floor that you

[00:16:57] won't go outside. So if I'm going to spend 5% of what's left every year, but if that number ends up being more than $80,000 or if that number ended up being less than $40,000, this is an example,

[00:17:10] I'll then stick to that ceiling or floor until the 5% of what's left gets me back somewhere in between. So I'd have fluctuating spending inside of a band. That can do a lot to help manage

[00:17:21] sequence of returns risk and still give you a good sense of what the dynamics are for spending. You can still have failure with that strategy because that hard floor that you build in ultimately could cause you to deplete your investments. But I think that's a good example.

[00:17:37] Probably the most famous variable decision rules are the ones developed by Jonathan Geiten and William Kleiner. And they're complicated. There are this different variations of them. There's four possible different rules, but they're also looking at, they have a prosperity rule about

[00:17:57] basically when you're current withdrawal rates getting low because the portfolio is growing, let's kick your spending up 10%. They have a portfolio or capital preservation rule that well if it looks like your portfolio is losing and so the current distribution rate's getting

[00:18:10] too high, let's cut your spending by 10%. He's talked about inflation rules which tell you when you're hard or not allowed to take that inflation adjustment. And then also he has rules about when you're going to turn that off if you're getting far enough into retirement. Maybe you

[00:18:25] can stop with the potential cuts to spending. That sort of framework, it can be harder to implement at a household level but it's probably the most famous set of decision rules out there. There's others, I don't know, have Ratchey and Rules, Michael Kitsie has developed

[00:18:42] those. The Vanguard talked about it's kind of a foreign ceiling but on percentage adjustments which I think is a lot harder to think about than a foreign ceiling on dollar amounts. How do you think about these? I feel like behaviorally a lot of these are, they range from

[00:19:00] the way we feel, both as advisors and as people just spending our money, to like the surgeon general warnings of like yeah these cigarettes are gonna kill you. Like don't do this. There's a behavioral

[00:19:14] component of this and we need some matching between the behavioral reality of what people are going to do and the actual math of what the consequences are. How do you feel about like as professionals if you're guiding somebody in my seat to say like here's why you should

[00:19:28] be aware of all these rules even if you're not going to use all of them all the time? Well I think ultimately partly the rules may just be a research simplification because it also seems unlikely that anyone would follow any of these types of mechanical rules

[00:19:42] to a tee but I think where the advisor comes in and ultimately you could think of it as another type of variable spending rule but it's probably closer to what happens in practices.

[00:19:53] I mean the 4% rule idea is sort of set it and forget it. You choose the withdrawal amount in year one and then run with it. The reality is you have update meetings and you look at maybe a success

[00:20:05] rate with the financial planning software and so this year the success rate could be 94%. Great, maybe you could spend a little more. Next year though we had a big market downturn and now it looks like the success rate is 79%. Okay maybe we should make a cut to spending.

[00:20:20] So that sort of gradual adjustment based on how the plan is performing over time is probably a more practical way to implement a variable spending rule but it's not necessarily one that is easy to run research-based illustrations of especially because that would

[00:20:37] account for maybe in a particular you ended up not needing to spend as much. Maybe in a different year you had an unexpected expense and you so you had to pull out more than you were anticipating and so that's more flexible type. Let's rerun the plan and see

[00:20:50] how things look and see if we should make adjustments can account for these sorts of real world needs as well in a manner that can be more effective over time. And what about just the inside of that, the adaptations that a

[00:21:06] I mean our risk tolerance sometimes changes over time or we have whether it's a market-driven thing or a personal life-driven thing, a spouse passes away or there's a change in lifestyle quality or whatever else. How do we think about how we update those inside of those

[00:21:21] variable withdrawal strategies? Any tips on that? Well yeah those would be especially the death of a spouse and that sort of thing has huge implications where it would speak to okay we each year we update the plan with the new information that the death of the spouse

[00:21:39] can be a tricky one because partly you may not have to spend as much because like you don't need two meals at this point, one meal. There's a lot of fixed expenses though you still need one

[00:21:48] refrigerator, one house and so forth but then like taxes can go up there's the widows penalty you lose social some of the social security benefits you may lose a pension so you really have to reevaluate things at that time and I think that speaks just more

[00:22:03] generally to the value of working with a financial advisor who can help you do these sorts of updates to the planning and to make sure you're still on a sustainable trajectory and to make adjustments where needed incorporating any of these types of outside

[00:22:19] considerations as part of that process it's really becomes things you can't just do research about like you you can model what happens if one spouse dies at age 70 or age 80 or age 90 but

[00:22:31] it's still until you know what actually happens you gotta wait to make those types of adjustments I think it's hard for the researcher to model it really needs the flexibility of that real-world

[00:22:45] planning experience. I think that's a that's a perfect segue to get into one of my favorite things you've written a lot about which is this idea of safety first retirement planning you want to just define what that is what that means then let's unpack some of the layers

[00:23:00] sure and this is so originally I talked about two different schools of thought to retirement planning I've had I think later we may talk about the retirement income styles where

[00:23:09] I've made a little bit of a modification to that but the the idea the basic idea of safety first retirement planning it's really the other end of the the 4% rule is implicitly probability based retirement planning I'm going to spend from a diversified investment portfolio and that will

[00:23:27] probably work with a maybe a high probability of success if your safety first you're not necessarily comfortable basing your retirement success on something that will probably work you'd rather have some sort of protection at least behind the assets for your basic spending and

[00:23:45] retirement and so you can develop contractual protections by holding bonds to maturity social security traditional company pensions and then that's where a conversation around commercial annuities may be relevant if your safety first you really want to look at

[00:24:03] what's my essential spending in retirement how much reliable income do I already have let's just make a simple example I had I have $60,000 of essentials that I want to make sure I can cover with social security and just making them numbers here but social security I'll

[00:24:19] bring in $40,000 there's a $20,000 gap there between what I get through social security what I'd like to have covered how do I fill that gap if I'm more probability based I'm not really focused on filling that gap for essential spending I'm fine just taking that from the investment portfolio

[00:24:37] as part of my overall lifestyle distributions if I'm safety first I'd really like to fill in some sort of reliable income for that gap if I'm more of a time segmentation style I might do

[00:24:50] that with a bond ladder if I have more of a what I call income protection or risk wrap style that's where I may look to an annuity with lifetime income protections to make sure I have

[00:24:59] enough reliable income to fill that gap and have that full $60,000 that I've decided really is necessary to meet my essentials on an ongoing basis in retirement I think this this piece is it's easy to talk about it's hard to have the conversations and actually pin down with people

[00:25:18] but that that idea of just mapping essentials that's it feels like that's actually more than half the battle here and understanding what this is and there's some conflict there where I think some people it's hard to define essentials it's they have a lifestyle spending goal in mind

[00:25:37] and if you ask them well what's how much could you cut that and still feel comfortable nothing and if they really can't cut any of it then maybe their overall lifestyle goal is their essential

[00:25:48] spending but if you're safety first you you are more willing to think about this spending is more core to an essential retirement that spending I'd be okay making some cuts there and don't have to go to the fancy restaurants as frequently that sort of thing that's more discretionary

[00:26:07] and if you if you can think that way and say okay here's essential spending here's discretionary spending that would be part of resonating more with a safety first approach where you'd want to then make sure that essential spending is protected

[00:26:21] so if we have an honest conversation about essentials and we understand what those are I do want to talk about the dirty word a little bit I want to talk about just like

[00:26:33] what an annuity is in the sense of asset liability matching because I think asset liability matching in terms of covering essentials especially from the safety first framework is really important let's let's just start there if I know essential if I know my essentials how do I asset liability

[00:26:49] match that why is an annuity potentially a good way to solve that problem yeah and and that asset liability matching point that's really important because that's what that's why retirement income is different pre-retirement we usually think more assets only

[00:27:03] we're just trying to seek the highest risk risk adjusted returns on our portfolio to grow that pot of assets post retirement the reason you are growing those assets is to fund liabilities and that's where that that asset liability matching you want to match up

[00:27:19] risk characteristics so for my essential spending that that income gap I was talking about the assets you're going to earmark to cover that gap you want to match risk characteristics and if you view that as essential spending you can't take risk with essential spending so you want

[00:27:36] some sort of contractual protection that's where the annuity can enter the conversation as a tool that provides a contractually protected lifetime income that for anyone living beyond life expectancy would perform better than a bond portfolio

[00:27:52] because you get that additional risk pooling through insurance that can support more spending than bonds and that ultimately of course you could also try to use the diversified portfolio to get the risk premium from the stock market to support more spending than bonds

[00:28:05] but risk pooling through insurance really is competitive with the previous premium from the stock market so people have options and they're not necessarily sacrificing anything on the upside if they allocate a portion of their assets to an annuity to provide a protected lifetime

[00:28:20] income stream to make sure those income gaps for their basic expenses are covered talk just for a second about it because I think this gets I think this gets danced over not in defensive annuities exactly but in just defense of the concept talk about risk pooling for

[00:28:34] example just explain what that means explain why this is so important and why there's there's worthwhile conversations here because of just that thing existing yeah so I let's just say my life expectancy is 85 that means there's a 50% chance I'll live beyond 85 50% chance I won't make

[00:28:52] it to 85 but I can't if I'm going to self manage my longevity risk I can't just assume I'll live to 85 because there's still 50% chance I'll live my plan so then I have to get into well do I

[00:29:04] plan to 90 do I plan to 95 do I plan to 100 the more worried I am about out living my money the the higher the planning age I need to use and if I just think about building a bond ladder as a

[00:29:16] starting point the less I can spend because I have to stretch that out for longer same with any sort of investment approach the longer the time horizon the lower the sustainable withdrawal rate now insurance companies so that's if I self manage longevity risk I'm either alive or

[00:29:31] I'm not if I'm worried I might live to 100 I have to assume I'm alive to 100 that's going to be expensive to fund through 100 where it's different for the insurance company is they have a large

[00:29:42] pool of customers some will live a long time some won't live very long but everyone enters at risk pool and that allows the insurance company to account for the their survival probabilities so they can

[00:29:53] pay everyone in the risk pool like they'll live to 85 because those who don't live to 85 part of their premium subsidize the payments to those who live to 100 and that can like if only

[00:30:04] 10% of their customers are expected to live to 100 they only have to set aside 10% of the present value of what's needed to fund that age 100 spending whereas me on my own I'd have to set aside 100%

[00:30:15] of the present value of what I need to fund that age 100 spending so I can meet a spending goal more cheaply as a consumer through an annuity than I can through building my own structured

[00:30:28] like bond portfolio to do that because the insurance company has that ability to pool that risk that means for a given amount of assets the annuity can fund a higher level of spending than bonds

[00:30:41] well can it fund a higher level of spending than a diversified portfolio that's where you have to introduce well the stock market so it is a risk premium you may get a better performance through the investments but then when I compare the two it's not obvious that the

[00:30:54] investments are going to be that risk pooling provided through the annuity and of course you could also say well those who don't live as long they got a raw deal out of the annuity because

[00:31:04] some of their premiums just get diverted to though now it's wrong to think they get diverted to the insurance company that's not true they get diverted to those in the risk pool that

[00:31:13] live a long time but if you don't know which group you're going to fall into the annuity can allow everyone in that risk pool to enjoy a higher standard of living while they're alive and because the longer you live the more money you need to fund your retirement

[00:31:27] the more money you get out of the annuity and if you ended up not living as long it's if I only make it to 70 but I was basing my plan on the idea I might live to 100

[00:31:37] I had a very frugal retirement whereas with the annuity I could spend as always going to make it to 85 and so I could have a much higher standard of living for those retirement years and that's where the annuity really can enter into that conversation

[00:31:52] as a way to boost spending relative to bonds for retirees now not necessarily relative to stocks but that's it's competitive there and dig into the research it's a competitive source of spending

[00:32:06] to what the risk premium from the stock market like with stocks you expect to spend more than bonds with the annuity you can spend more than bonds and they're kind of comparable to

[00:32:14] each other about how much more you can spend in bonds depending on your lifestyle depending on your lifetime depending on all these things and depending really also depending on how worried you are about out living your money because the more word you are about that the less you're

[00:32:29] going to spend trying to self manage that with an investment portfolio it's interesting because it says to basically take the like the probability and based investment side of it and especially for piece of your essential expenses how do you think about what those

[00:32:47] essential expenses all add up to over some expected time horizon and does it make sense to take that probability based decision and outsource that to a company who's going to do that across

[00:32:56] a risk pool of people not just me alone with my sequence of return risk is that a fair way to characterize right right and yeah and if assets aren't volatile they don't have sequence risk and the insurance company is doing the asset liability matching they they have life

[00:33:10] insurance policies they have annuity policies they have a pretty good idea about how much they're going to have to spend each year to pay policyholders on both the life insurance and annuity side and so they can really build that diversified longer maturity

[00:33:25] credit risk type fixed income portfolio to manage that liability and therefore their internal bond portfolio will tend to be able to earn more than a household could could build if they're just putting together a bond portfolio on their own in a household level. It's really

[00:33:42] interesting as it starts to drill down on the amounts of risk that a family and individual is comfortable taking here I want to add another wrinkle to this too because I think this is

[00:33:52] super important inside of this structure spend a minute on talking about social security which is the other payment stream that often enters into this equation often for people who are wondering about this component of how do I cover my extension my essential expenses when I turn

[00:34:09] on that social security there's some there's some important details on this so let's talk about that for a second yeah yeah social security is an annuity it's protected lifetime income and importantly it's inflation adjusted there's no commercial annuities that are truly CPI

[00:34:25] indexed as CPIW not CPIU which is technical detail but you get CPI adjustments for social security survivor benefits for the high earner and the spouse their benefit will last for the joint lifetime of the couple uh government backed as well in that regard and there's delay credits

[00:34:44] you could claim as early as 62 you can delay to as latest well you can delay as late as you want but you'll get credits for delay through age 70 there's no reason to wait beyond that

[00:34:55] and generally at least for the high earner in a couple if you're thinking about annuities step one before any commercial annuity is to delay social security to age 70 for the high earner in the couple because their benefit lasts for the joint lifetime of the couple

[00:35:09] uh the delay factors for doing that really are not actually fairly fair they're they're much better than fair for consumers at this point they were set in 1983 when interest rates were even higher

[00:35:20] to than today and when people are not living as long so the odds of benefiting by delaying social security are quite high and that's the first step towards building more reliable income

[00:35:31] at least after age 70 and it's okay to spend on assets more rapidly before 70 to get you to having at this point 76 or 77 percent higher inflation adjusted lifetime spending each year from social security for the rest of your subsequent life now if that's really step one of the annuity

[00:35:52] conversation step two is if that's not yet enough reliable income then uh also look at commercial annuities but definitely don't overlook social security and it would not be efficient to claim social security early and to then put more money into a commercial annuity product

[00:36:08] you just the deal from social security is is too great to counteract anything private insurers can provide it feels like people often will get hung up on you've got a really great way of

[00:36:20] stepping back to see this very objectively feeling I think people get hung up on the asset save nobody feels like they know the money came out and went into the social security fund they know their contribution over their working years but there's that different attachment

[00:36:35] between I have money in this savings account this brokerage account or whatever else and I'm purchasing the commercial annuity versus the money that they think in social security there's it's just a hard conversation to have with an advisor it's an essential conversation I love

[00:36:49] that you're the way that you make this point yeah it's finding annuity is tough because you see that big chunk of assets disappear from your balance and so what's if social security didn't exist you wouldn't have had payroll taxes taken out you could have had more savings but

[00:37:04] setting that issue aside people love social security that and it's a it's an annuity just like a commercial annuity that provides a protected lifetime income stream but it's a really important annuity because of that inflation protection and that survivor benefit

[00:37:18] that you don't see on the commercial side so before we get into some of the RISA framework stuff which I really do want to go through with you I want to go through the one of the

[00:37:28] most common things we see in 401ks and retirement accounts is we see these equity glide baths it's this idea that as we get closer to retirement or as we get into retirement that we're reducing that

[00:37:40] equity allocation we're reducing our exposure to the sequence of returns risk of a more volatile portfolio and you've had some really interesting work around the benefits of a rising equity glide bath you just explain maybe what's going on there and why you dug into this as much

[00:37:58] as you have yeah yeah and this is what I did with Michael Kitzies and it's you know pre-retirement no major conflict with what target date funds do which are really popular now with retirement plans it's when you're young you have more human capital your future earnings that's usually

[00:38:15] more bond like in nature so you have a higher stock allocation when you're young as you approach that retirement date you've been converting your human capital into financial capital so you lower your stock allocation because you have less bonds on the human capital side of the

[00:38:30] equation so you have a lower stock allocation at retirement now the issue is what do you do post retirement I think for the most part target date funds ignore retirement income that's one of the

[00:38:41] big issues with the whole defined contribution pension world we've created with 401ks and so forth is there just accumulation based the the idea is you just flip a switch and take distribution post retirement but there wasn't any effort to think through the sequence of returns

[00:38:57] risk or the other issues we talked about so the existing target date funds are either to retirement or through retirement if they're to retirement they just keep that fixed lower stock allocation throughout retirement if they're through retirement they usually continue to lower the stock

[00:39:12] allocation as you go through retirement the idea the rising equity glide path is it's it's really the starting point is like the 4% rule which is more aggressive than target date funds are in that post retirement period and what we're saying is rather than holding 50 to 75

[00:39:31] percent stocks throughout retirement you might start with a lower stock allocation at retirement which most target date funds will be less than 50 percent stocks at the retirement target date but then gradually work your way back up to that 50 to 75 percent stock range or whatever's I mean

[00:39:48] every case is different the case we use in the paper was using 60 40 stocks and bonds through the whole retirement horizon versus starting retirement at 30 percent stocks and then working your way back up to 60 percent stocks and what that does is it helps manage sequence of returns risk that

[00:40:08] you can really think about the market returns in retirement like there's four broad things that can happen markets can continue to go up and up and up throughout the whole retirement

[00:40:17] and then whatever you do it's going to work you're not going to run out of money that's a pretty good scenario if you had a higher stock allocation you leave a larger legacy at the end but for risk

[00:40:26] management the rising equity glide path wouldn't hurt you markets could go up earn early retirement and then come back down in later retirement it's the same sort of situation if you get a good sequence of returns early on sequence of returns risk works both ways

[00:40:40] you're pretty much set for your retirement at that point then the next option would be just the actual historical worst case scenarios as markets go down in early retirement and then come back up that's going to be the scenario where you get risk management from the rising equity

[00:40:56] glide path because you have a lower stock allocation early on when markets aren't doing well you have a higher stock allocation later on when markets do well and then to just complete the list you could also have 30 years of market declines that there's no investing strategy that

[00:41:13] will help you there pretty much so and it's not historically what we I mean you could see this happen but it's hard to plan for that so the kind of the realistic worst case scenarios markets go

[00:41:23] down early on markets come up later on the idea of increasing your stock allocation as you go through retirement helps manage that risk and it doesn't hurt you from the ability to meet your spending goal if markets do better early on in retirement and so it's really just

[00:41:41] mathematically pointing this out of course there are behavioral issues like people's risk tolerance usually defines with age and so if you're telling someone to be more conservative in their 60s and more aggressive in their 80s and 90s that may not fly so I get that I don't

[00:41:57] really push this as a strategy people should use although I have heard from a lot of people over the years where this really resonates with them and I think if it resonates with you great

[00:42:07] it's a really interesting type of strategy that manages risk in retirement if it doesn't resonate with you fine don't don't use it if obey your risk tolerance at the end of the day but yeah that's

[00:42:19] the basic story of the rise in equity glide path one of the places this showed up for us a lot and then we've referenced the work that you did on this is especially when people aren't just using

[00:42:30] the money for consumption so when they're looking at the gift to that next generation or they're thinking about how this is going to go beyond lifetime this is one of those encouraging data points that says if you're past the point of covering the essential income from the asset

[00:42:45] liability matching and now we're thinking about how do we invest this future asset for a future generation on a new time horizon the rising equity glide path actually represents some of that bridge some of that bridge glue to like yeah you're 80 but look where you are now

[00:43:00] do you are we doing this for g2 or g3 or whatever it is and how do we think about it yeah yeah that makes perfect sense it's at some point if your plan is funded and you're

[00:43:09] not running out of money you're you're kind of investing for the next generation and so then you'd be using their time horizons and their risk capacity and their risk tolerance and and yeah that usually the next generation can justify a more aggressive stock allocation than

[00:43:24] an 80 year old retiree who's just investing for their own retirement at that point so they had that's a great way to also frame the conversation around the rising equity glide path I want to talk about the retirement income style awareness framework which I keep calling Risa

[00:43:38] is that wrong did I invent that okay how do we pronounce it I've heard many different pronunciations but we say Risa thank you okay good I want to make sure that wasn't just in

[00:43:48] my head it's probably from one of your podcasts or something like that so uh you and uh Alex Maria came up with this thing you put this together I want to talk through what it is

[00:43:57] kind of like the axes of it and how that works and I just want to make sure I'm saying it out loud in case as we talk through it if you want to interject at all this tool just like in what I

[00:44:07] just mentioned about the rising equity glide path gets really really interesting when we move past just like a couple and we start to think about complicated scenarios where it's more people

[00:44:17] on the team and the page in the financial plan who have different ways that they see the world it can be as simple as a husband and wife or you know spouses but it can also be blown out in super

[00:44:29] cool ways you invented one of the most useful frameworks that I've seen for thinking through this so what is the retirement income style awareness framework what's Risa let's start there yeah yeah well it's kind of preliminary for that it's kind of what we've been talking about the

[00:44:42] whole episode thus far like I talked positively about annuities well some people hate annuities I talk I can talk positively about investments well some people are very scared of like even though the stock market should perform well they just can't accept

[00:44:55] investing in the stock market well at the end of the day people are just wired differently for this and so the Risa the retirement income style awareness was an effort to try to help people understand as a starting point how they're comfortable building a retirement strategy I

[00:45:11] I think there's a lot to be said for incorporating insurance like annuities as part of retirement planning but I've also heard enough people complain about that that I recognize not everyone it's it's not right for everyone there are different viable approaches out there whether

[00:45:26] it is a more purely investment based approach whether it is an approach that will build a floor of protected lifetime income whether it's a time segmentation or bucketing approach where you just invest differently based on the time horizons for those investments how do you

[00:45:40] help people pick a strategy and that's what the Risa was all about at allots and I looked at everything we could find talking about retirement identified where tradeoffs are being discussed started writing questions about how people might evaluate those tradeoffs and work

[00:45:57] with a retirement researcher community which is a really a large kind of do-it-yourself online investing community at retirementresearcher.com they at one point we're looking at 900 questions and they're very helpful in editing those questions and then taking different preliminary

[00:46:13] versions and ultimately we got down to at the end of the day there's two primary factors and can be answered now with 12 questions and it's just based on the statistical work that's where I was saying the I used to talk about probability based probability based for safety

[00:46:28] first as school's a thought well it's now just one of these factors if you're probability based you're comfortable relying on the idea that the stock market will grow in a manner that you can rely upon to fund the higher level of spending in retirement and there's no

[00:46:41] right answer here if you're safety first you may get the joke that yeah the stock market should do well but you're fundamentally not comfortable relying on that when it comes to funding your essential spending in retirement you'd rather have some sort of contractual protection behind that

[00:46:56] the other and that factor I could have guessed was going to be important the other one that surprised me but the data really just speaks to its importance is this optionality versus commitment if you're optionality oriented you really value maximizing flexibility

[00:47:12] for all of your assets it's like you don't want to lock in anything you don't want to commit anything you just want to be able to make changes respond in new situations you really value optionality and flexibility some people are that way other people though have a commitment

[00:47:27] orientation now the idea there is if you can find something that solves for your lifetime problem you actually feel good about committing to it taking it off your to-do list even if it reduces some of your flexibility we can also see there people worried about cognitive decline

[00:47:42] and so they'd rather commit to something that will help them if they have trouble making financial decisions or that will help protect other family members and so are you more commitment oriented or optionality oriented and then the big a ha was just based on those two factors

[00:47:56] it explains all the different retirement approaches out there and so that's the the RISA matrix the retirement income style awareness if you're probability based and optionality oriented that's a total return investing approach build a diversified portfolio and take a systematic

[00:48:10] distribution from it in retirement if you're instead safety first and commitment oriented that's really before I start investing I want to have a floor protected lifetime income that may involve using a commercial annuity product then I have the foundation to invest

[00:48:25] on top of that for more discretionary goals if and those are the two core strategies that we see the most frequently the other two are really behavioral strategies and they evolved that way so if you're safety first and optionality oriented this is I want contractual protections

[00:48:41] but I also want flexibility and optionality I think that describes the bucketing approaches out there or also time segmentation the idea that well I get my protections by having short-term buckets and fixed income I get my optionality and flexibility with the long-term

[00:48:56] buckets focused on growth and investment assets and then the other behavioral approaches and probability based comfortable relying on the market but I'm commitment oriented and also in your commitment oriented you tend to also worry more about living your money

[00:49:11] and so I think behaviorally that's this whole conversation around something like a variable annuity with a lifetime income benefit that the story there is you can invest for growth but if markets don't do well you have a protected lifetime income stream that's probably going to

[00:49:25] be less than with a fixed annuity but nonetheless you have a protected lifetime income stream so you get your probability based side but you also get your committing to something that will

[00:49:36] help you manage your longevity risk and we call that risk wrap so everyone's going to have a retirement income style and we really think that that's a great starting point for everyone is a transition towards retirement to you may not ultimately stick with the strategy that matches

[00:49:51] your style or you may be income protection but because of that you have a job with a big pension you don't need any annuities you already have your income gap covered so step one is just

[00:50:01] understanding your style then step two is working towards a financial plan and figuring out whether you need to take any action to help accommodate a strategy matching your style but that's what the retirement income style awareness is really for me now the step one of retirement planning

[00:50:17] understand your retirement income style and that helps cut through all this debate about some I mean the extreme sometimes you'll see news articles saying retire should be 100 stocks well that's going to be an extremist type probability based approach or you hear the

[00:50:34] infomercial about how fixed index annuities solve every problem under the sun well is that appropriate for you it may be if you have more of an income protection approach may not be if you

[00:50:44] have more of a total return approach I think this can just help people cut through all the debate and get to a good starting point for their strategy I think it's so interesting because

[00:50:55] it it acknowledges in those those examples you just gave are perfect for this it acknowledges that a person can sort of have a hybrid approach within themselves of say like I need

[00:51:06] this up to this point and then I don't need that beyond that it can say I might have one spouse who understands the bucketing and time seg time segmentation approach and another one who's just like

[00:51:17] super super conservative or super super risk seeking right and there's so there's six possible combinations of styles but we actually we see gender differences and so the the gender distinction is men do tend to tilt more towards total returns women do tend to tilt more towards income protection

[00:51:36] and these are more common strategies in general so the most common combination you'd see is the husband total return the wife income protection and that requires some conversations and ultimately income protection can be a the compromise because it's not just insurance it's first build a floor

[00:51:56] of protection and then you can invest and so maybe a conversation around let's take part of our bond allocation put that into a protected lifetime income stream now the uh the income protection person can sleep much better at night knowing they have this reliable income source

[00:52:12] and they can then permission the uh the total return person okay you've protected me go crazy with your investment at this point for the more discretionary side so that that can just be income protection can serve as that sort of compromise when you have a total return

[00:52:27] and income protection person and that's the starting point for well how do we figure out strategies to accommodate all the different combinations because most people don't marry based on having the same retirement income style so you're going to see differences quite a bit

[00:52:40] you don't say inside of that how how have you guys talked uh as your as your engaged in all these conversations about this as you're engaged in the research on this I mean surely you found some interesting fringe cases here of some like funny combinations

[00:53:00] and hopefully you don't get married for this but hopefully you don't get divorced for this either what's what are some of like the fringe combinations that lead to either unique or surprising solutions if any come to mind well an interesting one would be the yet like the

[00:53:14] bucketing style or time segmentation along with income protection where income protection is looking at more a floor for lifetime income but bucketing likes having flexibility and so doesn't necessarily want to fully commit to a lifetime income floor so they may be a longer front end bond ladder

[00:53:34] maybe even something like the the Q-LAC the qualified longevity nerdy contract that starts at income age 85 so it's a lot less expensive to support that tail of longevity that might be a way to accommodate the income protection person while still keeping more assets free

[00:53:54] and then building a front end ladder too that can accommodate both for the at least having the upcoming expenses protected but that's where the the time segmentation wants more of that front end protection the income protection person wants more of that back end protection

[00:54:08] and so how can you figure out a way to to provide both of those without necessarily providing a lifetime prediction what about as we take this multi-generational so you have parents and they

[00:54:20] figure out their situation but then they have kids and we've been running into this more and more just as you know people's kids come into the equation start to have the conversation where sometimes you have parents who figure out what worked for them but then there's clearly

[00:54:35] going to be an inheritance a generation or more forward and they have different they had their own risk profiles they have to self discover their own agency and figure out how to do this stuff too how do you start to think about how these things stack across generation

[00:54:51] it's a good question uh and partly so I think the research we've done you could take the the RISA at 30 and it'll be accurate to explain your style but then what does that mean like

[00:55:03] usually this is most relevant at that transition into retirement I say I'm five to ten years from retirement do I start adjusting my total return investment portfolio to accommodate retirement income if I'm income protection but I'm 30 years old I'm not usually buying annuities at that point

[00:55:20] I'm still gonna have a diversified investment portfolio so I think that could help it like for the next generation that will receive that inheritance they can figure out their retirement income style later on for now if they're younger there they need more of that diversified investment

[00:55:40] portfolio and so that could be a way to think about it it's not necessarily I'm gonna go out and buy annuities for my 30 year old children because they're income protection now that's really too young to be thinking about those types of decisions

[00:55:54] it's interesting to think about how these things scale apart especially when the assets that get left over the intentionality around how those are constructed can make a really big difference that's an interesting part of this especially the more you get in beyond

[00:56:10] I don't definitely need this for consumption there's one thing to leave the I don't want to call it the accidental gift but it's the happy accidental gift if I didn't spend all the

[00:56:18] money and now somebody gets it versus the there's gonna be more than we need how do we actually make sure it's in the right condition for them to figure it out later retirement styles could

[00:56:27] speak to that but that may also just be different types of just making sure that children are part of the conversations understanding their goals and needs and and working towards accommodating that

[00:56:39] so I asked this question semi-jokingly at the beginning but I want to come back to this now I said if you went back in the DeLorean you visited with Bengin you got over his shoulder

[00:56:49] you gave him some stuff to think about how do you how do you think this evolves going forward I mean we're 30 years off the 4% rule basically being invented or documented formally what's

[00:57:00] what's the next round of research look like like what else do we have to learn still about this that's not just whatever the heck sequence of returns are for the next 10 20 40 years yeah I think we're increasingly getting to the point where people are recognizing

[00:57:16] retirement income is different and so you do the pushing the idea of retirement income styles but you really do need to have an approach to accommodate that you can't hate annuities and hope that everyone else hates them as well they're they're going to be a good tool for

[00:57:30] certain members of the population and so you really need to be flexible in how you accommodate different retirement approaches they're all ultimately viable approaches and I think we're really getting that kind of problem solved to some extent that we now

[00:57:46] there could be new designs for annuities and we are seeing a lot of innovation in that area but that's maybe just at the margin how can we make things better my research in terms of what I'm working on besides that I've recently I've focused more

[00:57:59] on like tax efficient retirement distributions and the question of should I do a Roth conversion and how should I draw from my tax bill brokerage accounts versus my tax deferred IRAs versus

[00:58:10] my Roth IRAs and I'm really seeing that can add a lot of value to the sustainability of retirement by being more efficient with taxes and boosting the the after tax rate of return on those assets

[00:58:23] and Roth conversion their importance like so much of the research I do and one way or another points to make short-term sacrifice for long-term gains and taxes is another example it's like delay social security short-term sacrifice for long-term gain income annuity

[00:58:37] short-term sacrifice for a long-term gain do a Roth conversion pay more taxes today to dramatically improve your tax situation in the future short-term sacrifice for a long-term gain and that's it seems like retirement is so much about that so maybe other research to just

[00:58:55] help understand who can make that sort of long-term focus and and when not how to accommodate strategies that might still work in the right direction without requiring too much short-term sacrifice it feels like too if we don't understand if we fail to understand the logic

[00:59:15] and we fail to raise the questions about what happens when America gets rid of the defined benefit system aside from social security what happens when we change these structures over time in different demographics boom and bust through just the ages of the people who are alive

[00:59:31] and what happens if people just start living longer on average which seems to be the skew that we're experiencing now if more of us are around longer we better understand these fundamental building blocks the spreadsheets the calculators required to say what kind of new things what

[00:59:45] new ideas or old ideas reimagined do we need to give people the outcomes we want which is less people running out of money in older age I think that's yeah it's it's different than

[00:59:57] like well to some extent retirement was a late 20th century phenomenon where you worked then you might have 10 or 15 years in retirement and you probably had a pension to help cover that today you're increasingly on your own with a defined contribution like 401k

[01:00:12] investment approach that you have to then self-manage in retirement in your retirement could last 30 or 40 years so it really is increasing the challenges that people face today as they make that transition towards retirement absolutely all right I have one last

[01:00:29] question for you I'm putting you on spot with this are there any what you would view as or somebody else would call like excessive essential expenses in the foul household is there anything that you

[01:00:41] spend money on you're like no it is essential but uh you know maybe if um if the income got short I would begrudgingly look at cutting it anything fun you're spending money on these

[01:00:52] days I actually I've always been so frugal and it's been more a matter of where I can okay maybe I could spend a little more here or there I yeah some of those things I could cut take the avenue

[01:01:05] of instead of getting a fancy car you get a more basic car but with a fancier trim but maybe you don't really need the the fancier trims maybe if you're going a family trip pick a less expensive

[01:01:17] Airbnb something like that but well what about the other direction you just made it more interesting if if I give weight how the magic wand what are you spending more money on to improve

[01:01:27] the essential qualities of life oh well now like my oldest is got two years left in high school and so it's kind of the trade-off of I should probably be spending more today when the kids are at home

[01:01:41] and you know we have this family time instead of worrying about being able to spend in the future so okay let's let's spend more now and I'll build into my plan to spend less later on

[01:01:51] but there's no reason to be more frugal now because these are the peak years of having your kids at home and being able to do things with the family and you kind of when you have a kid in

[01:02:01] high school you start to see oh they're now already spending more time in their bedroom not talking to you that's worth the pain so making sure to this is the time we should really be spending

[01:02:11] actually rather than saving everything for some future retirement scenario it's human all the way down we need all the math to help with these conversations but it's just human all the way

[01:02:23] down that thank you for sharing that wait thank you so much for your time today I really appreciate you coming on absolutely thanks for having me on the show this is Justin again thanks so much

[01:02:32] for tuning into this episode of excess returns you can follow jack on twitter at practical quant and follow me on twitter at jjcarbino if you found this discussion interesting and valuable please subscribe in either iTunes or on youtube or leave a review or a comment we appreciate