PPR 24: Optimizing Retirement Income with Doctor Wade Pfau

Transcription:

Kraig: Alright. thank you Tosh for that fantastic introduction, we are back here on the Personal Pension Radio and we are joined again this time, not in studio, by Doctor Wade Pfau. Hello out there Doctor Pfau!

Dr. Pfau: Hey, how are you Kraig?

Kraig: We are doing great! Also here in studio with me is Marc Miller and we are back as I said on Personal Pension Radio, excited to have Dr. Pfau back on to talk about a recent research paper that he released. But a little bit about Personal Pension Radio. If you haven’t joined us before, we are focused on bringing together the experts needed to help business owners, professionals, and just everyday folks build and protect their wealth and their lifestyle, so that they can actually take that lifestyle into retirement with them someday, without having to sacrifice income in retirement. And DrPfau is, I think it is fair to say now, you’ve just become one of the most well known experts in the area of retirement income planning. Maybe if you could, for those who did not listen to the first episode where we had Dr. Pfau on, you can go back to our archives at www.personalpensionradio.com and you can see the interview there with Dr. Pfau. But maybe before we begin, give us a little background, kind of like the term that we use a couple of times in the interview today “the reader’s digest” version of Dr. Wade Pfau and how did you come on to the scene and the retirement income space.

Dr. Pfau: Okay sure. Well, I have my PhD in Economics, but it’s somewhat related to a personal thing. It’s a personal and a really new field after I finished my PhD, I went and I taught in Economics at a University in Japan for 10 years and then I moved back to the United States. I was realizing that, at that time, I was already researching about the National Pension Systems in different countries. And that was not really very marketable for trying to find a job in the US.

Kraig: (laughs) right.

Dr. Pfau: And so I was looking to sort of make a transition and sort of stumbled in retirement income planning which became my niche. It is a lot of fun to do the research, write computer programs stimulating different income retirement strategies. I started a blog and started right in for outlets like the journal financial planning that are focused more on the personal finance area and yeah helped really kind of develop a niche in this area.

Kraig: I think it is interesting how you pointed out some area that is very important to note, that economics is not really perceived as something tied to personal finance and it is unfortunate because the education that most students, most people just in their school life academics and even in their work life, we rarely ever understand the economics behind our finances.

Marc Miller: Well, what did not make sense Dr. Pfau that we have a strategy in place that is economically sound that allows us to accomplish whatever goals that we have set up to accomplish.

Dr. Pfau: Right, there is a whole theory of life cycle thing, that is basically the foundation of personal finance and academically, my point actually is Economics is actually one of the really odd field where you learn as an undergraduate. Getting a bachelor’s degree in economics is completely different from what graduate students studying in economics. The undergraduate Economics does have more a lot of applicability. You could say it is a lot more related to personal finance. When you get into graduate school because it becomes mathematical models and proofs and all these other types of things that do not have much connection to the real world anymore. That is just my point.

Kraig: I know, that is what I do with my checkbook every other day. I love the mathematical models and stuff (laughs).

Marc: (laughs) I thought that if you just have checks left, that that mean that you still have money, that is not how it is

Dr. Pfau: (laughs)

Kraig: Well, exactly, your checkbook accounting right there. I have to ask, when we talked first, we were together in an economics summit in Indianapolis and you were actually about to release a research paper that you have been working on for some time now and this research paper, just for everybody who is listening to the show or maybe even those who are new to the show, all of these will be linked in the show notes including a link to download and get access to Dr. Pfau’s research paper. So, tell us, since you’ve released this paper, this “Optimizing income” research paper, you have been popular. I think just looking at your website, atwww.retirementresearcher.com . Forbes, Marketwatch, Wall Street Journal, Financial adviser magazine, Investment News and the list goes on including Personal Pension Radio, you have been pretty popular.

Dr. Pfau: (laughs) I have been making rounds recently and some of those have been calling but yeah, in May, I talked about this in the last show but in New York Times about spending strategies in retirement that actually became the most emailed article in the past 30 days out of everything in the New York Times.

Marc: Wow

Kraig: Wow that is outstanding! Congratulations on that! That is fantastic! Have you seen though, in all of the interviews and the work and the responds, as you’ve made the rounds, have you seen a common theme among these various interview? Has it been, for example, scepticism, doubt, fully supportive, push back? What have your experience been?

Dr. Pfau: In terms of the white paper?

Kraig: Yes! The optimising retirement income. Although we do not find it to be controversial here, there are some circles in the investment world that can find it to be somewhat of a controversial topic. JUst wondering what your feedback has been, what your experience has been?

Dr. Pfau: Right. There really has been that divided feedback. In the financial services profession there is the investment side and people in the investment side generally think that investments can provide the answers any questions. And there is the Insurance side, and people in this direction believe that insurance can basically solve any question. And so, what I was doing in the white paper is, actually there is a role for both the investments and insurance and there is a group of advisers and individuals who are in the middle area, understanding the role that both sides can play. But that is a relatively small group. I did not really receive pushback from anyone in the insurance side but there has been a lot of pushback from the investment side.

Kraig: Oh, yeah, I was just going to say that there is always that feeling I think of that threatening when the idea of changing the paradigm that they live live under and I guess it is just the nature of anything that might be new or different.

Marc: Well, part of that may come from, you talked about the buy term in investment the different ideas that has been somewhat of a conventional thought process for most. So, based on your research Dr. Pfau, how do you see the buy term in investment different strategy apply to income planning for retirement?

Dr. Pfau: Basically, the structure the white paper was thinking about was, well as it appear, it is still pre-retirement and you decide you do need to buy an insurance for the normal reasons that in case the worker passes away and is unable to support their family. Should you do that conventional buy term and invest the difference, or should you do something with a more permanent type of death benefit that you could then incorporate into a retirement income strategy as well. And that was kind of a basis of the white paper was. If you have a more permanent death benefit it will have a higher premium, so that you put less into your investment accounts. So, what is the overall impact in terms of how much income you are able to sustain in retirement? What sort of a legacy will you still be able to leave after taxes? And, just looking at it from that perspective. The buy term in investment crowd believes in the idea that stocks is going to outperform bonds and that you will always be able to get a higher investment return that way you will always be better off.  But I do not think that is the case as with the Monte Carlo. The simulation approach that I use will just try to quantify that and markets have to do incredibly well and it is less than a 50% chance that the upside growth potential investment will be significant enough. But it is able to beat out some of the actuarial side of the insurance approach where there is this concept of mortality credit. But, if you are trying to manage your retirement on your own with just investment, you have to plan to have it a very long time. But if you are able to use actuarial science to an income annuity, to life  insurance, you can basically set your planning horizon to your life expectancy. And there is a 50% chance to live longer than your life expectancy so that is why with investments, you have to assume something much longer than that.

Kraig: You got to be very cautious

Dr. Pfau: Right. If you bring in some of this actuarial science, it is a risk-pooling. A number of people getting together and pooling their risk of how long they are going to live. Those who end up not living very long, do not end up of needing to spend that much. They subsidise those who live longer, who need more because they live longer and need to spend more. And if you do not know which group you are going to be in advance, well this is the way for everyone to just spend more throughout their retirement because everyone can set their planning horizon to their life expectancy. That is a really powerful concept that I think is not well understood on the investment side.

Marc: I think what he is talking about is the upside potential that the fear is, if I do that kind of a strategy or if I am engaged in that type of strategy then I am going to give up some of the upside potential of my investments.

Dr. Pfau: Right. And they are really focused on upside potential. There is this big debate within the investments industry whether the stocks become less risky or more risky over a longer holding period. And those advocates of the investments really believe that stocks become less risky  and it is very unlikely that stocks will underperform bonds. But all that as well, and this is why income retirement planning is different. There is this amplification of sequence of returns risk.

Kraig: Right

Dr. Pfau: It is not just the average investment returns, it is also the order of those returns come and when you are spending from a portfolio, if your retirement lasts 30 years, the average market return over the 30 years might be pretty high. but if you have poor market returns early on, and you are spending from your investments, your portfolio is going to decline in value. You have to spend and increase 15% and then what is left. And then even if the market recovers, your portfolio does not recover and you are already on a trajectory. And that is sort of a sequence risk amplifies what we think of as an investment risk, and it really pushes back against the argument that stocks will be less risky if you are holding on to them long enough.

Kraig: Right, I think it is interesting. Have you seen this in your research because we have seen it in our experience, that years ago, you had a standard kind of easy advice that said “you should have a certain amount of bonds based on your age and a certain amount of stocks”

Marc: Yes, they call it the rule of 100.

Kraig: Right. Just various different kinds of rules. But nowadays, I have actually seen more emphasis on you should have higher stocks percentage than ever before. It is just an interesting shift. I am wondering if you have a feedback of why that might be. We used to have that common advice that says if you are 60 years old, you should have 60% in bonds but now I have actually seen talk of designing portfolios with 70% and 80% for a retiree in the stock on investment side.

Dr. Pfau: I think a lot of that goes back to this whole discussion about the 4% rule, of just spending really about how much you can spend in investment and retirement. When William Bengen did the original research in the 1990’s, he used historical data to show much could you spend with different asset allocation. What he wrote about in his original 1994 article was “retiree should have between 50-75% stocks, but as close to 75% stocks as possible. And that s really where all researches is pointing just because in the historical data and because it is (laughs) what other problems that researches if focused on is called the probability of failure and ignores the magnitude to the failure. So, if you have a 30 year plan in horizon, if you miss your goal by $1 and you are 30, that is a failure. If you run out of money and you are 20, and you do not have anything left for the next 10 years, that is the same failure. It does not make any distinction.

Kraig: Yes

Dr. Pfau: And with that kind of measure, it does lean you more towards the higher stock allocation. If you actually incorporate the magnitude of how bad things can go when you fail, then you will not want to use as much stocks.

Kraig: Yes

Dr. Pfau: But the historical data is really saying that 75% stocks seems to be a “sweet spot” to minimize the probability of failure.

Marc: Well they also build failure as one of the options. I have always been perplexed and somewhat confused that failure is one of your retirement income strategies. But it is actually built into the plan that you may fail.

Dr. Pfau: Right, that is allowing for, if all the acceptable probability that you completely run out of money before the end of your planning horizon.

Kraig: Right and the actual situation of a retirement scenario is very different than in an accumulation scenario where there are certain risks namely for example like the big one, the elephant in the room for most retirees is the heightened risk for long term care, the heightened risk of long term chronic illness. That is huge risk that generally does not exist in the accumulation phase. So there are outside forces that introduce additional risk into the equation. Is that fair to say?

Dr. Pfau: Right, that is why retirement income planning is different, that retirees end up having less risk capacity than they had in their pre-retirement period. They have less flexibility to maintain their standard of living in response to poor market return and that really decreases their ability to take on as much financial market risk towards retirement.

Kraig: Right

Dr. Pfau: It is a different world when someone stops working and stops having having the flexibility of being able to work longer or save a little bit more from their salary and support what they are committed at that point.

Kraig: And it is not as simple getting a job at Walmart. How many thousand times have I heard people say, “I will just be a people greeter at Walmart” and as it turns out, with the increase in minimum wage, less and less people Walmarts are hiring for the people-greeter position (laughs). There is not a guarantee that you can go get that additional job

Marc: Well working for me, does not denote retirement. I mean, if I want to work and I go work at a golf course will be something that I enjoy that might be one thing but..

Kraig: Right, but in a previous couple of episodes ago, Doctor Pfau, we actually had done a quick retirement calculator at www.bankrate.com and we ran in numbers just a typical retirement scenario and the solution came back with a casual little warning that said, “nah, you might not make it” and possible solutions are to almost tripple your retirement savings or work until you are 77, or something like that (laughs). That was the standard answer. When you said something, just back a little ways, having more money to spend in retirement and I want to just emphasize on that a bit. The whole idea of retirement is ultimately to be able to maintain your lifestyle to actually spend to get the lifestyle you want without the fear of having to cut it back all of a sudden one day. And, this term that you used in the research paper which is the “actuarial bond”, as it relates to to whole life insurance and income annuities, give us a readers digest version of an actuarial bond and how it will be used in a retirement income plan.

Dr. Pfau: Yes. In this regard, what my research has repeatedly been showing in multiple different research papers, is I basically do not seem to throw in a traditional bond in a retirement portfolio. Instead of having stocks and bonds, actually the point before was stocks and income annuities and now it in this white paper as well, or maybe  of your pre-retirement, you can think of about of even moving further along than otherwise through stocks and income annuities and whole life insurance. This whole life insurance income annuities, I call them actuarial bonds because they are like bonds in the sense that  the insurance company is investing that money in a bond portfolio, but primarily holding bonds rather than you investing it among yourselves. You are handing over the premiums which is going to be invested in bonds by the insurance company but then the reason where the reason where the Actuarial word comes in is, they are bonds that have their payments that they make that (you know, if you are thinking of a traditional bond like a coupon payment) it is like you are receiving a coupon payment from an income annuity that is calibrated to your life. As long as you live you receive that coupon payment. So if you live a long time you are going to have an extensive retirement and you will also going to receive a lot more from your “Bond Investment” investment, your Actuarial Bond.

Kraig: Right.

Dr. Pfau: And so, it is linked to the individual lifetime, that is the reason why I called it the “Actuarial Bond”. That is also the reason why I really think retiree should consider just replacing their traditional bonds with the bonds that have this link to their lifetime.

Kraig: That is such an interesting perspective. As you went through that, that the investment community is for example completely pro-bond, and the solution to retirement is bond and to actually quote a funny thing that a friend of mine said, Michael Canet at a Savvy Investor Radio Show, he says “If you get a flat tire, you need a bond, if you run out of gas on the freeway, you need to go get a bond..”

Marc: How many bonds do you have that are tied to your own personal mortality?

Kraig: Exactly.

Marc:that also take advantage of the pooling features of an income annuity that give you the ability to get those higher incomes? That to me is really powerful when someone is planning for retirement.

Dr. Pfau: Right, to make sure that the listeners understand, to simplify the numbers a little bit. Supposed you are 65 and the statistics show your remaining life expectancy, you have 20 years left. Well, you might  live 5 more years, you might live 40 more years, if you are trying to manage that with your own investment, bonds and so forth. If you are really worried about outliving your assets, then you really just have to assume that you are going to live 40 years. That means you have to spend more conservatively to make sure that your money will last for 40 years. But with the Actuarial Bond, with, the risk-pooling, many individual get together and though you do not know how long a particular individual will live, you know that a certain percent will make it to each age and that the average person will make it to the life expectancy of 20 years and then everyone is able to spend like they are going to live for 20 years instead of everyone having to spend like they are going to live for 40 years. And that is because of this mortality credit. Those who not end up living not living very long, subsidizethose who live longer and that allows everyone in the pool to behave like that they are going to live for 20 years and then spend more than if they were trying to manage the risk on their own and all just trying to conserve their assets and and spending them like they are going to make them last over 40 years.

Kraig: There is that individuality that you talked about on our first interview when I asked you about the pension systems in Japan and the Japanese culture still has a very community based tied together, let- us-go-together kind of approach, where we here in the US and other countries as well but in the US especially have this very individual approach to things and there is strength in numbers in that pooled risk, in that pooled income approach.

Dr. Pfau: Yes, there is. Because it is the risk you are not compensated for taking. It is a risk of how long you are going to live. It is usually a quick way if you think of investment. if you are willing to take on risk, you do that because you have an opportunity for more reward and I guess that is sort of true just to the extent that if you have a very aggressive investment portfolio, you might possibly end up doing very well. But generally speaking, there is no reward for taking on your own longevity risk. It is much more efficient to pool that risk with a large number of people than try to manage it on your own.

Marc: Pensions worked in the past right? and with the advent of the 401k, one of the things that we have found interesting is we have gone through this process, many of those who are now just saving into their 401k which is the primarily the traditional means of saving for retirement. They do not understand these issues, that they are faced with with. I mean, if they could have a pension they could probably want it. In fact, we just read a study here a couple of weeks ago in one of our podcasts about 8 out of 10 Americans would love to have a pension.

Kraig: Right, yes.

Marc: And in fact they give up some of their current income to be able to get that opportunity. But we see that many future retirees do not have the education or the knowledge to be able to put these things in place.

Dr. Pfau: Right, yes. People do love the idea of a pension providing a guaranteed income but the hangup comes when it is time to buy the income annuity which is the pension. It is defined as a pension. But then you are seeing this large amount of assets disappear from your balance sheet to convert it into a lifetime income. And that is where some of the hold ups happened here.

Marc: Unless you have the whole life protection behind that purchase

Dr. Pfau: Well that is why behaviorally they could just justify the purchase because they know that the whole life death benefit, they can think of this replacing new assets for their beneficiaries.

Kraig: I would love to say that this is one of the things I love about your research is that your previous paper, the work that you have done on www.retirmentresearcher.com  did I say it right?

Dr. Pfau: Yes

Kraig: Make sure I get your website correct. That you have never actually ever come across as one of those people  that the solution is “x”,  the solution is “y” \, it is always “let us look at the comprehensive combination of x,y, z in this case, investments, Actuarial Vehicle such as Annuities Life Insurance. How did those things combine to create a better outcome? It is not an “either, or”.

Marc: Well, that is because we only have one shot at this right? We only have just one opportunity for a successful retirement.

Dr. Pfau:  Yes, and that is why we have these two different philosophies and the one that I think makes a lot more sense is that you do distinguish at least between essential spending needs and then more discretionary type of expenses. And you might take more risks with your discretionary type of expenses.

Kraig: Okay, yes.

Dr. Pfau: But in terms of your essential spending, the idea of taking on a 10% chance that you are not going to be able to meet your essential spending for as long as you live. I think that is really going to be frightening for a lot of people. Some people might be willing to take on that risk, but a lot of people are not comfortable with that.

Kraig: Well, as I send a daughter off to College coming up in August and Mark over here has welcomed some grand kids and  we looked down the road and my parents’ old joke goes was “Just do really well Kraig so we can live in your backyard”, in our RV or something.

Marc: (laughs)

Kraig: Unfortunately, when I look at my daughter sometimes and I wonder, I am pretty sure she is not going to have a big place for me to have an RV. I need to make sure that I take care of my own retirement.

Marc: She will give you a tent though (laughs)

Kraig: (laughs)

Dr. Pfau: (laughs)

Kraig: I have to ask. When we look at it, there is a piece inside as we finish up here today. In the research paper, you have said something to the effect of even when the retirement scenario that has a low draw rate and for those listening for the first time, the Draw Rate refers to an income distribution term when you are actually in retirement. We are not worried about rate of return anymore or averages, we are worried about how much are we withdrawing from it. But you said in there that, “even in retirement scenario that has a low draw rate, and a low risk of running out of money, you only have one opportunity for that successful retirement, and it’s a one shot deal. With that piece in mind, what should do we do at the very least to prepare for the very possible outcome? So if you can give us again that readers digest idea, what can we do to prepare for the best possible outcome? If we only have a one shot deal.

Doctor Wade Pfau: Well, just focus on how much income could you generate sustainably with different types of strategies. So when you then try to apply that to an individual case that really thinking in terms of at least covering the essentials with. Something that has some sort of contractual guarantee behind that whether that would be holding individual bonds or whether that would be an income annuity and then having life insurance potentially as a backdrop to help justify making the income annuity purchase. Those are again the drivers of a retirement income and having enough math to cover the essentials. It can make a big difference because it allows you to  spend more and because you do not have this risk that even with a low spending rate there is still this risk that you are going to run out of assets         and not be able to cover your essentials if you are using only an investment portfolio with stocks and bonds on it.

Kraig: I have to say from a personal experience, that I actually see this on a regular basis with my own Mom. My mother lives with a two guaranteed annuity pensions. She is guaranteed annuities, her own personal pensions,  that more than cover her lifestyle needs. Gives her a great deal of security. So much so when I asked her for a copies of her statements on her annuity contracts that pay her income, she hands me unopened envelopes. The reason is why they are unopened, because I asked her and I said why don’t you open these and she says “you said I would never run out of money right?” and she kind of poked me on the chest and said, yes Mom, you will never run out of money. And so she said, that is it. Why would I need to open them? The checks come in every month and she goes off on vacation. So it gives her a great deal of security.

Marc: It is awesome to have that type of income and you know my parents have that same type of income, provided it for them. It is great not to get worried about opening that envelope but unlike those back in 2008, that would not open their 401k statements. They just let them pile up in a box.

Kraig: (laughs)

Marc:  But Doctor Pfau, we really appreciate you taking the time with us today, we have just one more question to end this off. What did you personally take away from work that you have done on this white paper that changed your perception of retirement income planning?

Dr. Pfau: This whole matter of, repeatedly this idea of integrating and just being agnostic about what is the best retirement solution. You really to have to look at all the options and educate. People do have different personalities and mindsets about how they view some of these trade of. But really, the key point that I came up with in this article for me was, even surprising for myself that just how difficult it is for the upside or the growth potential of the investment to be sufficient to beat the power of that risk-pooling, but is not obvious that you will be better off with just investment, even though historically stocks outperformed bonds, well they have to outperform bonds pretty dramatically for you to be better off and the probabilities are not in your favor for the investment.

Kraig: Yes. The odds are not in your favor (laughs)

Dr. Pfau: Well that was surprising for me and I thought well, this is maybe going to be a conservative strategy and still more often than not will be better off than investments. But actually, that is not the case, really. It is only going to be a rare case for investments to be so great that you will be better off with investments.

Kraig: And the hard part about that is, you have to be in the right place, at the right beginning time for the right moment.

Dr. Pfau: Yes

Kraig: to do it, or else you might have missed your window.

Marc: Well, the retiree does not get to pick the market returns when they retire. They do not get to pick that.

Dr. Pfau: Right. And it is  that first few years after they pulled the trigger and retire and that end up being the key to whether or not they are going to be successful with their investment form of strategy.

Kraig: Well, I have to say once again, Doctor      Pfau, fantastic to have you again on the podcast and for everybody listening, if you have not already done so, you can find Doctor  Pfau’s website at www.retirementresearcher.com . You can actually sign up for his email list. He has great content there. Lots of information. You can catch all of his other works, all of his papers. I subscribed to Dr. Pfaus’ website and constantly following him. I am stalking him on twitter and Facebook and on his website.

Marc: Alright stop it (laughs)

Kraig: We will have this linked to the note show. Definitely go to the Personal Pension Radio and get the Personal Pension Radio. You can actually download a copy of this research paper. To say that your retirement lifestyle, and your retirement could depend on it, I think is an understatement. So get there, download it today for sure, and Doctor Pfau, thank you so much again for taking time to be with us today.

Marc: Thank you so much.

Dr. Pfau: Sure, it is my pleasure.

Kraig: Outstanding! Folks we will be back again next week with another episode of Personal Pension Radio. Take care for now.

Download Dr. Wade Pfau’s Retirement Income Report

Disclosures:

Marc Miller is an insurance agent representing multiple insurance companies. CA Insurance License #0D36340.

Kraig Strom (CA Insurance License #0C80457) is a Registered Representatives of and offers securities through OneAmerica Securities, Inc., Member FINRA, SIPC, a Registered Investment Advisor4160 Temescal Canyon Road, Suite 302, Corona, CA 92883, (951) 278-5555. Insurance Representative of American United Life Insurance Company? (AUL) and other insurance companies.Personal Pension Radio and Dr. Wade Pfau are not affiliatesof OneAmerica Securities or AUL, and is not a Broker Dealer or a Registered Investment Advisor.

The views and opinions expressed by Kraig Strom and Marc Miller are solely their ownand do not necessarily reflect the views and opinions of the companies of OneAmerica. The information is provided for educational purposes only and is not intended as investment,financial or legal advice. For answers to specific questions and before making any decisions, please consult a qualified attorney or tax advisor.

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