Bogleheads® on Investing Podcast 024 – Dr. Wade Pfau, host Rick Ferri (audio only)

00:00:00.000 | [MUSIC PLAYING]

00:00:10.700 | Welcome to Bogle Heads on Investing, podcast number 24.

00:00:14.520 | Today, our special guest is Dr. Wade Pfau,

00:00:17.680 | a professor of retirement income at the American

00:00:20.200 | College of Financial Services.

00:00:22.520 | Dr. Pfau is the author of three books and over 60 articles

00:00:25.680 | on how you can get the most out of your retirement savings.

00:00:28.380 | [MUSIC PLAYING]

00:00:39.180 | My name is Rick Ferry, and I'm the host

00:00:41.040 | of Bogle Heads on Investing.

00:00:42.720 | This episode, as with all episodes,

00:00:45.080 | is brought to you by the John C. Bogle Center

00:00:47.680 | for Financial Literacy, a 501(c)(3) nonprofit organization,

00:00:53.760 | and can be found at boglecenter.net.

00:00:57.960 | Today, our special guest is Dr. Wade Pfau.

00:01:00.640 | Dr. Pfau is the program director of the Retirement Income

00:01:04.440 | Certified Professional Designation

00:01:06.560 | and a professor of retirement income

00:01:09.080 | at the American College of Financial Services.

00:01:11.920 | He holds a doctorate degree in economics

00:01:14.280 | from Princeton University and has published more than 60

00:01:17.720 | peer-reviewed research reports.

00:01:19.680 | He is an expert panelist for The Wall Street Journal.

00:01:22.680 | He has written three books, and his latest book,

00:01:25.440 | Safety First Retirement, An Integrated

00:01:28.040 | Approach to a Worry-Free Retirement,

00:01:30.360 | is the subject of our talk today.

00:01:33.000 | So with no further ado, let me introduce Dr. Wade Pfau.

00:01:37.240 | Welcome, doctor.

00:01:38.680 | Thanks, and feel free to call me Wade.

00:01:40.600 | It's great to be on the podcast.

00:01:42.160 | Well, thank you so much for joining us today.

00:01:44.960 | The Bogle Heads are extremely interested in the work

00:01:47.680 | that you're doing, and I think it's fascinating.

00:01:50.240 | I've read all your books, and we've

00:01:52.520 | got a lot to talk about, a lot to get through today.

00:01:54.880 | But before we get there, let's start

00:01:57.120 | by having you tell us a little bit of something

00:01:59.120 | about yourself.

00:02:00.000 | You decided to go into this field,

00:02:02.400 | and what was your motivation?

00:02:05.080 | Sure.

00:02:05.640 | Going back to the early days, I grew up in Michigan and Iowa,

00:02:08.880 | went to--

00:02:09.440 | majored in economics, went to grad school for economics.

00:02:12.960 | And then from there, just slowly started

00:02:15.440 | stumbling into personal financial planning.

00:02:18.440 | My dissertation was about the Bush Commission proposal

00:02:21.800 | to create personal retirement accounts

00:02:23.880 | by carving out part of Social Security.

00:02:26.360 | I was just exploring how that might work out in practice.

00:02:29.520 | And that really became the foundation

00:02:31.960 | for what I'm doing today in terms

00:02:33.760 | of simulating retirement outcomes based

00:02:36.720 | on different strategies.

00:02:38.280 | I did spend 10 years in Japan as an economics professor.

00:02:42.080 | That was my first job out of grad school,

00:02:44.440 | focusing more on the pension systems

00:02:46.560 | and developing in emerging market countries.

00:02:49.000 | But in wanting to move to the US and find something

00:02:52.240 | more marketable here, started studying for the CFA curriculum

00:02:58.080 | and so forth.

00:02:59.240 | And I came across this 4% rule of thumb

00:03:01.840 | about how much you could spend from a retirement portfolio.

00:03:05.560 | So from that, I had another data set, the 4% rules,

00:03:10.240 | just based on US historical data.

00:03:12.640 | But I had the global returns data

00:03:14.480 | for 20 developed market countries.

00:03:17.200 | And I was curious, did the 4% rule

00:03:19.880 | work with other countries' data?

00:03:22.120 | And that really became my introduction

00:03:25.280 | into the world of retirement income.

00:03:27.440 | When you started researching safe retirement rates using

00:03:32.200 | basically what you call the probability-based system, which

00:03:34.720 | is a stock and bond and cash portfolio,

00:03:38.280 | you discovered that there was risks to that.

00:03:41.720 | And basically, you came up with three risks--

00:03:45.480 | longevity risk, a sequence of return risk,

00:03:49.200 | and also spending shocks.

00:03:50.840 | And those three things together gave you the idea

00:03:54.560 | that maybe that's not the most optimal way

00:03:56.640 | to build a portfolio for retirement.

00:03:58.320 | Could you explain those risks and why it may not

00:04:01.720 | be the most optimal way?

00:04:03.200 | Right.

00:04:03.720 | I mean, the 4% rule, this idea that if I had a million dollars,

00:04:07.320 | I could take out $40,000 in the first year

00:04:09.800 | and then every year just spend that same amount

00:04:12.480 | with inflation adjustments.

00:04:14.960 | That's the fundamental way the investments world thinks

00:04:17.680 | about retirement income.

00:04:18.960 | Of course, there's a lot of variations on it.

00:04:20.840 | But that's the fundamental idea.

00:04:22.240 | And the way it seeks to manage these three

00:04:25.600 | types of retirement risks may not be the most efficient way.

00:04:29.880 | With longevity risk, this is the idea

00:04:32.440 | that you might live longer than anticipated.

00:04:35.000 | The 4% rule is meant to be conservative in the sense

00:04:37.960 | that it plans for longer-than-life expectancy.

00:04:41.480 | In 1994, the article was written,

00:04:43.920 | which now is 26 years ago.

00:04:46.200 | The idea was a 65-year-old couple--

00:04:48.400 | it's pretty unlikely that either of them would live past 95.

00:04:51.400 | So if you build a plan that worked for 30 years,

00:04:54.280 | you should be in good shape.

00:04:55.680 | Now, there's no protection there.

00:04:57.360 | You might live longer than 30 years.

00:04:59.160 | But at least you're trying to be conservative in that regard.

00:05:02.760 | And then it's the same sort of story with the market risk.

00:05:06.120 | The 4% rule, it introduced the idea

00:05:08.360 | of sequence of returns risk into financial planning

00:05:11.520 | because it accounted for how the market volatility impacted

00:05:15.560 | a sustainable spending rate.

00:05:17.680 | And it was based on the worst-case 30-year period

00:05:20.280 | in terms of not necessarily the average return over 30 years,

00:05:23.520 | but the retirement that had the most negative experience early

00:05:28.280 | in the 30 years.

00:05:29.440 | And well, in this case, it was in the mid-1960s.

00:05:33.280 | Markets do great after about 1982,

00:05:35.600 | but it was still this worst-case scenario

00:05:37.920 | through the sequence of returns risk.

00:05:40.120 | But you try to spend conservatively,

00:05:41.960 | that your plan will work in the worst-case 30-year period

00:05:45.080 | from history.

00:05:46.680 | And so people who are comfortable with it

00:05:48.360 | are comfortable with that being an appropriate way

00:05:51.440 | to manage the market risk in the sequence of returns risk

00:05:54.840 | based on a worst-case historical experience.

00:05:58.080 | And then the spending shocks.

00:05:59.720 | So these are, well, I've got my baseline retirement budget.

00:06:03.000 | I want to spend the $40,000 a year.

00:06:05.200 | But I may have surprises along the way

00:06:07.160 | with long-term care, big health care

00:06:09.520 | bills, different types of events that can happen.

00:06:13.520 | And the 4% rule, strictly speaking,

00:06:16.320 | doesn't help manage spending shocks

00:06:18.600 | because it does anticipate just spending your budget,

00:06:22.040 | you're going to end up with zero after 30 years.

00:06:24.680 | But that's only supposed to happen

00:06:26.280 | in the worst-case scenario.

00:06:27.640 | So if you're in any other sort of scenario,

00:06:31.080 | you don't necessarily end up at zero.

00:06:33.760 | And so you would have some excess funds

00:06:35.560 | available to provide a source of spending for spending shocks.

00:06:39.920 | And that's how the 4% rule manages

00:06:42.400 | those types of retirement risks.

00:06:44.600 | Now, it's not necessarily the most efficient way

00:06:47.440 | to manage these risks because it really just

00:06:50.320 | means I'm going to be extra conservative to try

00:06:53.360 | to not run out of money.

00:06:55.040 | I may not be conservative enough.

00:06:56.520 | There could be a new worst-case scenario.

00:06:58.760 | But most of the time, I would just end up underspending

00:07:01.920 | and then have a bigger legacy at the end

00:07:04.320 | than I otherwise had anticipated.

00:07:07.280 | But you also wrote in your latest book,

00:07:09.400 | Safety First Retirement Planning,

00:07:12.800 | which is a whole different way of doing this, that--

00:07:16.120 | and I'll quote-- "there is no such thing as a safe withdrawal

00:07:18.680 | rate.

00:07:19.600 | A safe withdrawal rate is unknown and unknowable."

00:07:22.840 | So your research has shown that even if you said,

00:07:26.280 | well, let's make it a 3% rate instead of a 4% rate,

00:07:30.040 | even then it might not work.

00:07:33.000 | Yeah, that's just kind of the academic concept behind,

00:07:36.080 | well, if you are trying to spend a fixed amount

00:07:38.880 | from a volatile investment portfolio,

00:07:41.840 | that there really is no such thing as a, quote unquote,

00:07:44.520 | "safe withdrawal rate."

00:07:46.080 | Anything could fail.

00:07:47.880 | That's the inherent issue of volatility with fixed spending.

00:07:52.000 | And so if you wanted to have fixed spending,

00:07:55.120 | you probably shouldn't have the volatility in the portfolio.

00:07:58.440 | Or if you want the volatility in the portfolio,

00:08:00.800 | your spending should also be flexible or volatile

00:08:03.680 | or adjust for the portfolio performance.

00:08:06.720 | The 4% rule of thumb does assume you use 50% to 75% stocks

00:08:11.240 | throughout retirement.

00:08:12.760 | And that inherently creates the most sequence risk,

00:08:15.360 | because it leaves you the most exposed

00:08:17.400 | to being forced to settle assets at a loss in a market downturn.

00:08:21.960 | Right now, if I wanted the 30 years of inflation

00:08:24.280 | adjusted spending with where KIPP's yields are,

00:08:27.240 | at this point, we're getting close to about a 3% safe

00:08:29.920 | withdrawal rate.

00:08:30.760 | And that would ensure you run out of money

00:08:33.200 | at the end of 30 years, because you build a ladder of Treasury

00:08:36.000 | inflation-protected securities.

00:08:38.440 | And if I'm trying to spend more than that,

00:08:41.240 | I'm investing more aggressively.

00:08:43.760 | I'm hoping and anticipating that the upside from the stock

00:08:46.880 | market will allow for a higher spending rate.

00:08:49.560 | But if I get a poor sequence of market returns early on,

00:08:52.760 | I end up having to sell principal

00:08:54.680 | and digging a hole for my portfolio.

00:08:56.520 | And so the portfolio may not recover with the overall market.

00:09:00.120 | And so that's really the risk created

00:09:02.160 | by that sort of probability-based approach

00:09:05.160 | in the purest form, with how the 4% rule is structured.

00:09:09.720 | And your solution to this is what's

00:09:11.240 | called the safety-first retirement approach, which

00:09:14.800 | would also feed in, basically, annuities, and life insurance,

00:09:19.720 | and perhaps reverse mortgages, and other types of assets

00:09:26.120 | into the portfolio to try to mitigate the longevity risk.

00:09:29.960 | So in a broad sense, could you talk

00:09:32.400 | about the safety-first retirement planning approach?

00:09:35.520 | Mm-hmm.

00:09:36.200 | So and to just be clear, I know some Bogleheads take issue

00:09:39.560 | with, which can be expensive assets to use, annuities.

00:09:44.000 | We know life insurance, reverse mortgages,

00:09:46.440 | all can have significant costs attached to them.

00:09:49.680 | But what really-- and the reason I

00:09:52.080 | find that these things can help in retirement

00:09:55.120 | is because of this sequence of returns risk

00:09:57.680 | and how small changes to this need

00:10:01.120 | to take distributions from a portfolio at a loss

00:10:05.160 | can really disrupt the retirement plan,

00:10:07.440 | and how just being able to cut back a little bit on that

00:10:10.440 | can have such a huge positive net impact on the retirement

00:10:13.440 | plan, that that's kind of the avenue

00:10:16.360 | where these different types of tools can help.

00:10:19.000 | It goes back to just looking at what's

00:10:22.000 | the efficient frontier for retirement income

00:10:25.000 | with an article I wrote now about eight years ago,

00:10:29.600 | and just finding that stock bond allocations are really

00:10:33.240 | the least efficient way to try to meet a spending

00:10:35.960 | goal with downside market risk, while also preserving

00:10:39.280 | an average, like the highest average legacy at the end

00:10:41.880 | as well, that if you basically shift from bonds to income

00:10:45.800 | annuities so that--

00:10:47.880 | I mean, an income annuity is effectively a bond portfolio

00:10:50.720 | held by the insurance company.

00:10:52.920 | But rather than paying coupons for a fixed number of years,

00:10:57.360 | they pay for the lifetime.

00:10:59.080 | They hedge your longevity risk.

00:11:00.720 | If you end up living to 110, they pay you until you're 110.

00:11:05.360 | Now, if you end up only living to 70,

00:11:07.280 | they don't pay you until you're 70.

00:11:09.640 | But by pooling that risk, you can have your retirement

00:11:13.560 | outcome based more on an average experience,

00:11:16.320 | rather than if you have this worry about outliving

00:11:19.280 | your money and therefore spend less,

00:11:21.000 | just try to stretch those assets out for longer.

00:11:24.240 | That's where the stock income annuity

00:11:26.800 | mix can work better for retirement

00:11:28.680 | than a stock bond mix.

00:11:30.680 | And that's a basic idea that safety first is.

00:11:33.760 | It's based on more academic type models,

00:11:36.280 | going back at least to the 1920s, which

00:11:38.560 | is, if you have a basic spending floor where you really

00:11:42.000 | don't want your spending to have to drop

00:11:43.840 | below a particular level, the most efficient approach

00:11:47.640 | is you lock in that level with lifetime protections

00:11:50.720 | through risk pooling.

00:11:52.440 | And then you can invest the rest more aggressively

00:11:55.280 | and spend more aggressively at a variable rate, so something

00:11:58.720 | like just following RMD rules on here's

00:12:01.600 | how much I'm going to spend from my discretionary investment

00:12:04.320 | portfolio.

00:12:05.760 | That increasing spending rate as I age

00:12:08.800 | from an aggressive portfolio mixed with an income floor,

00:12:12.440 | that that's a more efficient way to build a retirement income

00:12:15.480 | strategy than something like using the 4% rule

00:12:19.720 | from a total return, like 60-40 style investment portfolio.

00:12:24.360 | This sounds an awful lot like a replacement almost

00:12:27.480 | for defined benefit plans, which 50 years ago, a lot of workers

00:12:31.880 | had defined benefit plans, which were this annuity based

00:12:34.920 | on risk pooling, correct?

00:12:37.960 | And so people had this money coming in

00:12:39.560 | for the rest of their life.

00:12:41.000 | Now that defined benefit plans have gone away,

00:12:43.400 | it sounds like what you're advocating for at a basic sense

00:12:47.000 | is to replace that.

00:12:49.000 | Yeah, yeah.

00:12:49.640 | And Moshe Molesky even calls it pensionize your nest egg.

00:12:53.960 | That's the idea.

00:12:54.840 | With Social Security and with traditional defined benefit

00:12:57.800 | pensions, we do get risk pooling.

00:13:00.400 | And with a defined benefit pension,

00:13:02.760 | the longevity risk is pooled.

00:13:04.360 | Some workers don't live as long as others, and some live longer.

00:13:07.360 | And also market risk is pooled because the insurer,

00:13:11.560 | assuming they select the correct average,

00:13:14.480 | they base outcomes on an average rate of return

00:13:17.560 | that some people would have been better off on their own

00:13:20.240 | with their own sequence of returns.

00:13:21.840 | Others would have been worse off.

00:13:23.640 | But that market risk over time gets pooled.

00:13:25.920 | And so a defined benefit pension,

00:13:28.640 | it pays your pension based on an average market performance

00:13:32.160 | and based on a formula linked to your work history

00:13:36.440 | versus in a defined contribution pension,

00:13:38.960 | where if you're investing that in a market portfolio,

00:13:42.440 | you're now fully taking on the market

00:13:44.120 | risk of your specific sequence of returns.

00:13:47.320 | And if you're going to do systematic distributions

00:13:50.400 | and not use any sort of annuity, you're

00:13:52.640 | then also taking on that longevity risk.

00:13:55.360 | So indeed, annuities just provide a way

00:13:57.920 | to create that pension with that risk pooling

00:14:01.120 | that if you had a defined benefit pension,

00:14:03.920 | you would have been getting that way before.

00:14:06.640 | We're not talking about everybody here.

00:14:08.920 | I think that the target market for what you're talking about

00:14:15.480 | are people who ordinarily would have had, say,

00:14:18.560 | a defined benefit plan.

00:14:20.520 | We're not talking about people who have $10 million

00:14:23.240 | and only spend $150,000 a year, correct?

00:14:28.360 | Well, I mean, to some extent, correct.

00:14:30.360 | But at the end of the day, it's still the same sort of idea

00:14:33.120 | that anyone--

00:14:34.680 | now, they're not going to run out of money, clearly.

00:14:37.560 | But to the extent that you take some of your bonds

00:14:39.840 | or if somebody in that situation might

00:14:41.680 | have a big pile of cash sitting on the sidelines,

00:14:44.720 | if you took some of that and put that into that lifetime income

00:14:47.360 | annuity, and then you feel all the more comfortable investing

00:14:50.760 | what's left more aggressively, though you're not

00:14:54.520 | going to run out of money anyway,

00:14:55.920 | you're creating a better foundation

00:14:57.840 | that you're, at least if you live past life expectancy,

00:15:00.720 | going to be able to leave behind a larger legacy than if you

00:15:03.400 | still just spent your $150,000 a year from a 60/40 allocation

00:15:08.160 | on a $10 million portfolio.

00:15:10.200 | It's just this mathematical outcome

00:15:12.960 | that doesn't depend on the spending rate.

00:15:16.000 | Now, if you are more constrained,

00:15:18.600 | you can see a more noticeable increase

00:15:20.800 | in your probability of success.

00:15:22.280 | It's not that you're going to see the success rate increase

00:15:24.480 | there.

00:15:24.960 | If you've got $10 million and you're

00:15:26.640 | spending $150,000 a year, your probability of success

00:15:30.720 | is probably 99% no matter what you do.

00:15:34.200 | But still, in terms of legacy, it's

00:15:36.200 | what's the most efficient way to build the retirement strategy?

00:15:39.800 | And in that regard, using bonds to fund the retirement budget

00:15:44.000 | is really the least efficient way you can approach things.

00:15:47.360 | I did a little math to take a look

00:15:49.600 | at if my wife and I decided to take $1 million

00:15:54.360 | and annuitize it at age 62--

00:15:57.640 | I am 62, and she's 60--

00:15:59.720 | went to the website that you recommended,

00:16:01.720 | which is-- what's the website?

00:16:04.080 | Immediateannuities.com.

00:16:05.480 | Immediateannuities.com.

00:16:06.760 | OK, not a plug for Immediate Annuities.

00:16:08.480 | We are non-commercial.

00:16:10.560 | But I went there, and I plug in some numbers.

00:16:13.960 | And I see, well, what could I get right now at 62?

00:16:17.520 | And my wife is 60.

00:16:18.520 | If we put $1 million into this-- and it came out to $46,000

00:16:23.280 | a year, I believe it was, with 4.6%.

00:16:26.040 | And then I said, what if I never spent that money?

00:16:28.080 | What if I just took that money and I invested in it

00:16:30.880 | in Treasury bonds?

00:16:32.040 | So as the money came in, I invested in today's Treasury

00:16:35.800 | bond rates.

00:16:36.760 | At what point would I actually make more money

00:16:39.520 | than if I just took that million dollars

00:16:41.520 | and invested it in Treasury bonds?

00:16:43.320 | And quite frankly, doing that gave me a much higher legacy

00:16:48.560 | rate of return, as long as one of us lived until we were--

00:16:52.440 | I think it was one of us had to live until our 80s.

00:16:55.480 | And if one of us lived until our 80s,

00:16:58.000 | by taking the higher return from the annuity

00:17:01.400 | and just taking the income from that

00:17:03.200 | and investing it in the same Treasury bond

00:17:05.680 | that we would have bought, we ended up

00:17:08.240 | having a higher legacy.

00:17:09.480 | So the return, if you live long enough,

00:17:12.680 | the return from the annuity is higher.

00:17:16.200 | And if you could explain why that is.

00:17:18.560 | It's not just interest rates that

00:17:20.160 | drive the return on an annuity, correct?

00:17:22.920 | It's the pool of investors that you're in.

00:17:27.320 | Right.

00:17:27.800 | I mean, the income annuity, you really

00:17:30.200 | want to think about it as the cash flows,

00:17:32.120 | because there is an underlying interest rate,

00:17:35.160 | but it's not reported.

00:17:36.640 | It's part of the payout rate that you get quoted.

00:17:38.880 | And that's what you see.

00:17:39.920 | It's the payout rate.

00:17:41.200 | If I put in a million dollars, how much

00:17:43.720 | will I get on a monthly and annual basis

00:17:45.640 | for the rest of my life?

00:17:47.360 | And so naturally, the longer you live,

00:17:50.000 | the more cash flows you're getting back

00:17:51.600 | on your initial investment.

00:17:53.520 | Now, with a pure life-only income annuity,

00:17:55.720 | the return is going to be negative

00:17:58.000 | until you get your full premium back as payments,

00:18:01.600 | and then you'd have an internal rate of return of 0%.

00:18:04.880 | And then as you live beyond life expectancy,

00:18:08.280 | your return gets higher and higher.

00:18:11.040 | And if you live into your 90s, yeah, you're--

00:18:13.880 | or even to beat bonds, probably more like your mid

00:18:19.280 | to late 80s.

00:18:20.280 | Depending on what the interest rate was on the bond,

00:18:22.440 | it came out to 87 or so.

00:18:25.040 | One of us had to live till we were 87.

00:18:27.560 | And then if I would have just invested

00:18:29.200 | 100% in a treasury bond versus investing in the annuity,

00:18:32.520 | taking the money and put that into a treasury bond,

00:18:35.600 | that's when I started making money in the annuity.

00:18:38.880 | Yeah.

00:18:39.360 | And if you're both in average health, at least--

00:18:42.280 | not even good health, but just average health--

00:18:44.720 | for a couple, the joint longevity

00:18:47.000 | is going to be higher than 87, especially

00:18:49.400 | if you're non-smokers, that you have a 50% chance that at least

00:18:53.960 | one of you is still alive in the early 90s.

00:18:56.000 | So the probabilities are in your favor

00:18:58.560 | of living long enough, where you can beat out

00:19:01.400 | bonds with an income annuity.

00:19:03.760 | You're right.

00:19:04.360 | As far as a legacy asset and what

00:19:06.400 | I'm going to leave to my children,

00:19:08.400 | even if I'm not going to be needing

00:19:11.120 | the income from an annuity, it's actually

00:19:13.960 | sometimes a good investment.

00:19:15.840 | Right.

00:19:16.320 | If you're comparing just annuities versus bonds and not--

00:19:20.480 | because then you can add in the stock market as well.

00:19:22.760 | But with annuities versus bonds, you're

00:19:24.680 | going to be lagging on the legacy for a while,

00:19:27.720 | because bonds, you still have the full liquidity for that.

00:19:30.880 | But yeah, once you're past life expectancy--

00:19:32.760 | and then with the bonds, eventually, you're

00:19:34.560 | going to deplete that entirely.

00:19:36.320 | And then you could talk about whether there's

00:19:38.200 | a reverse legacy.

00:19:39.120 | Like, if I was just going to fund my retirement with bonds

00:19:41.560 | and I outlive the age that I anticipated,

00:19:44.360 | I'll need someone to take care of me at that point.

00:19:46.800 | But with the annuity, though you may be giving up

00:19:49.640 | legacy in the early years-- and we're

00:19:51.800 | talking about a partial annuity strategy--

00:19:54.400 | in reality, no one's going to put all their money

00:19:57.040 | in the income annuity.

00:19:58.640 | So legacies may lag for a while.

00:20:01.200 | But if somebody ends up having a short retirement,

00:20:03.360 | their heirs are going to be getting a lot anyway.

00:20:05.840 | It's really with the long term, where you still

00:20:09.560 | can have a reasonable legacy with a partial annuity

00:20:12.480 | strategy versus with the bonds.

00:20:15.080 | Eventually, they run out, and you don't have any spending

00:20:17.680 | source at that point.

00:20:19.240 | So it's changing the dynamics of what

00:20:21.240 | the legacy will be over time.

00:20:22.880 | The annuity strategy will have a lower legacy

00:20:25.600 | before life expectancies, but a bigger legacy

00:20:28.920 | after life expectancies.

00:20:30.600 | And that's because of that risk pooling,

00:20:32.440 | where as you live longer, more and more of your spending

00:20:36.080 | is coming through the subsidies of these mortality credits

00:20:40.280 | that investments just simply don't provide.

00:20:42.080 | It's the premiums from the short-lived helping

00:20:44.200 | to pay to the long-lived, raising

00:20:46.620 | that standard of living for everyone in that risk pool.

00:20:49.600 | And that's what they call mortality credits.

00:20:52.520 | In other words, I'm kind of making a bet

00:20:54.760 | that I'm going to live longer than you,

00:20:56.760 | and we're all in the same pool together.

00:20:58.440 | But I think my genes are better than your genes,

00:21:00.520 | and my wife's genes are better than everybody else's genes

00:21:03.120 | in the pool, too.

00:21:03.880 | So if we get in this pool, and if we actually win,

00:21:07.280 | we only have to be on the top 50% as far as our longevity,

00:21:10.640 | if you will, we come out ahead.

00:21:13.400 | Right, and you can't think of it that way.

00:21:15.320 | But often, behaviorally, it's not necessarily

00:21:18.320 | good to think about annuities as bets or investments.

00:21:21.160 | Because you can frame any sort of insurance that way.

00:21:23.400 | Like if I buy homeowners insurance,

00:21:24.920 | I'm making a bet that my house will burn down.

00:21:27.440 | And if it does, I'll get this big payout.

00:21:29.620 | And with the annuity, it's a little bit different.

00:21:31.660 | It's to protect a good outcome in a scenario

00:21:34.320 | where I live a long time.

00:21:35.680 | And therefore, my retirement becomes more expensive,

00:21:38.760 | and I don't have the resources to fund that sort of longevity.

00:21:42.960 | So it's insurance against outliving my assets

00:21:46.080 | more than it's a bet that will pay off

00:21:49.000 | if I beat the rest of the risk pool.

00:21:50.960 | I mean, you can think about it either way.

00:21:53.040 | Think about the insurance side as well.

00:21:55.520 | When you're looking at your retirement plan,

00:21:57.360 | you say there were basically four priorities.

00:21:59.400 | And you start from the bottom and work your way up.

00:22:01.920 | And at the bottom is your basic needs.

00:22:03.680 | In other words, how much you need to live on.

00:22:06.720 | And this is where the annuities could help,

00:22:09.960 | along with Social Security.

00:22:11.600 | And then the next thing you have is called a contingency fund.

00:22:14.520 | Now, a lot of people think of that as an emergency fund.

00:22:17.360 | But I think the word contingency fund is actually

00:22:20.040 | probably a better word.

00:22:21.880 | Your house could need a new roof.

00:22:23.720 | That's not an emergency, but it is a contingency.

00:22:27.400 | The next level is discretionary and then legacy.

00:22:31.240 | So I like the way that you prioritize that.

00:22:33.360 | Then you basically looked at this and said,

00:22:35.320 | this is how you have to think about your retirement.

00:22:37.960 | And you have to fill your basic needs bucket first

00:22:41.960 | with known income.

00:22:44.160 | And then you have to have a contingency fund.

00:22:47.800 | And then you could have your discretionary fund,

00:22:49.840 | which might be filled more with equity,

00:22:52.800 | and a legacy, which might be filled

00:22:54.840 | with equity and fixed income or real estate or something.

00:22:57.560 | Am I getting that correct?

00:22:58.880 | Yeah, yeah, that's the idea.

00:23:00.400 | Anyway, it's a contingency fund.

00:23:01.720 | It's really for any of these spending shocks.

00:23:03.680 | So in retirement, there can be a lot more health-related

00:23:07.560 | or long-term care and so forth.

00:23:08.920 | So yeah, right, it's more than an emergency fund.

00:23:11.840 | But yeah, that's the basic order of prioritizing and working

00:23:16.360 | your way up to your financial goals.

00:23:18.720 | In your book, you talked about those liabilities

00:23:21.840 | of your basic needs and contingency and discretionary

00:23:24.680 | and legacy.

00:23:26.120 | And you married them up against your assets.

00:23:29.840 | So you did liability matching.

00:23:32.520 | These assets would be used to match up

00:23:34.840 | against these liabilities.

00:23:36.920 | Yeah, and that's an important part of the safety-first

00:23:39.680 | approach.

00:23:40.240 | It's an asset liability matching problem.

00:23:43.320 | The liabilities are just the expenses

00:23:46.160 | associated with your goals, which you are describing.

00:23:48.400 | And I use the term 4Ls as well, the longevity, lifestyle,

00:23:52.160 | liquidity, and legacy, are your 4Ls,

00:23:56.000 | longevity about your core expenses,

00:23:58.040 | lifestyle about discretionary, liquidity for the contingencies,

00:24:02.240 | and then legacy for legacy, of course.

00:24:05.360 | Those are the liabilities associated with your goals.

00:24:08.120 | And then positioning your assets to match to those goals

00:24:12.920 | with reliable income assets, so things like Social Security,

00:24:16.520 | individual bonds, traditional pensions, and then annuities

00:24:20.800 | as well, potentially, and then diversified portfolio,

00:24:24.640 | and then reserve assets.

00:24:26.640 | And so with this asset liability matching,

00:24:29.840 | that's another thing where you can't double-count assets.

00:24:32.760 | So reserve assets are just what you

00:24:35.120 | have that's not already earmarked for something else.

00:24:38.120 | And that's important in the context of retirement income,

00:24:41.600 | because if I believe in the 4% rule

00:24:45.200 | and I'm looking to spend $40,000 and I have a million dollars,

00:24:49.600 | so I put it in a brokerage account

00:24:51.640 | and put it in a 50/50 stock bond mix, do I have any liquidity?

00:24:57.040 | Technically, the answer is yes.

00:24:58.400 | My brokerage account's liquid.

00:25:00.600 | But in the meaningful sense of this retirement income problem,

00:25:04.200 | the answer is no.

00:25:05.320 | The entire million dollars is earmarked for that $40,000

00:25:08.440 | spending goal.

00:25:09.600 | And even though I could spend it on something else,

00:25:12.040 | doing so directly jeopardizes that future spending goal.

00:25:15.600 | And so the reserve assets are just

00:25:18.440 | what you still have available for contingencies that

00:25:22.360 | are not earmarked for one of your other three L's--

00:25:25.320 | your lifestyle, longevity, or legacy goals.

00:25:28.880 | OK, well, now we're going to dig into all

00:25:31.760 | these different insurance products,

00:25:33.360 | because they can be very simple, and they

00:25:36.600 | can be very complicated.

00:25:38.400 | And in your book, you go through them all.

00:25:42.160 | And some of them, believe me, especially

00:25:44.960 | when I got to the variable annuity,

00:25:47.760 | it got to be extremely complicated.

00:25:50.320 | And I don't know how anybody could keep

00:25:54.800 | this in their head difficult. But let's go ahead

00:25:57.760 | and move on to the different types of annuities,

00:25:59.720 | because you talk about them all in the book.

00:26:01.560 | And there's the basic immediate annuity, deferred annuity,

00:26:06.280 | getting into a whole life policy.

00:26:08.840 | If you could go through the pluses

00:26:10.920 | and minuses of each one of these types of annuities,

00:26:13.200 | that would be great.

00:26:14.520 | Yeah, so on the annuity side, the spectrum

00:26:16.880 | would be the simple income annuity,

00:26:19.240 | so single premium immediate annuity,

00:26:20.960 | or deferred income annuity.

00:26:22.920 | Those are fixed annuities.

00:26:24.920 | They're on one side of the spectrum

00:26:26.920 | in terms of the most guaranteed income,

00:26:30.360 | but the least or no liquidity, and least or no--

00:26:34.440 | showing no upside exposure.

00:26:36.960 | And then as you move along the spectrum from that end

00:26:40.760 | towards the other end, it's going to be the fixed index

00:26:43.000 | annuity and then the variable annuity.

00:26:45.440 | So the fixed index annuity is in the middle,

00:26:47.880 | where it is a fixed annuity, but it's deferred.

00:26:51.160 | You haven't locked up your money with it in the sense

00:26:54.520 | that you still have access to the funds.

00:26:58.560 | And they're generally based on some sort

00:27:00.440 | of a financial derivative strategy.

00:27:02.600 | That's where you can read about how

00:27:04.880 | people can create their own fixed index annuity return

00:27:07.920 | structures.

00:27:08.800 | They can't create the mortality credits

00:27:10.440 | if you have a guaranteed living withdrawal benefit.

00:27:12.800 | But it's generally, you have principal protection

00:27:14.840 | because the insurance company buys enough bonds

00:27:17.680 | to protect your principal.

00:27:19.640 | And then with what's left over, they

00:27:21.440 | buy some call options to give you

00:27:23.120 | some exposure to the upside.

00:27:25.120 | It's like the very basic level of how they work.

00:27:28.000 | So downside protection with some upside exposure

00:27:31.160 | and with a guaranteed living withdrawal benefit

00:27:33.400 | can provide that lifetime income.

00:27:35.880 | And especially with the tax deferral,

00:27:38.920 | their returns could be competitive with a bond

00:27:41.800 | portfolio after taxes.

00:27:44.200 | And then you've got moving along the variable annuity

00:27:47.680 | at the other end, which would generally then have

00:27:50.480 | the least downside protection.

00:27:52.400 | You can have the guaranteed lifetime income,

00:27:54.320 | but it would generally be lower than what

00:27:57.040 | an income annuity or a fixed index annuity would provide.

00:28:00.520 | But the most upside potential with the ability

00:28:03.160 | to invest in an underlying asset allocation and sub-accounts

00:28:06.880 | that are not the same as mutual funds,

00:28:09.720 | but they're the annuity equivalent of mutual funds.

00:28:12.800 | And then also the liquidity as well,

00:28:15.040 | because it's a deferred annuity.

00:28:16.400 | You still can tap into and get access to those funds

00:28:20.280 | if you wanted to get them back and take them out

00:28:22.480 | of the annuity.

00:28:23.800 | So that's the spectrum.

00:28:25.080 | Income annuity, fixed index annuity, variable annuity.

00:28:28.760 | And where you end up on that spectrum

00:28:31.080 | really just depends on that trade-off

00:28:34.480 | between the most income in the worst-case scenario

00:28:38.880 | versus maybe less income in the worst-case scenario,

00:28:41.560 | but the most potential for a higher income

00:28:44.080 | if markets end up doing well.

00:28:46.400 | You recommend that if people are going

00:28:48.080 | to buy an immediate annuity, that they should first

00:28:54.280 | not take Social Security, delay Social Security.

00:28:58.040 | Oh, yeah, yeah, that's an important point,

00:28:59.920 | because step one of thinking about annuities

00:29:02.960 | is delay Social Security, because delaying--

00:29:06.080 | especially for the higher earner in the couple.

00:29:08.240 | The spouse might start sooner.

00:29:10.720 | Delaying Social Security age 70, the delay credits

00:29:15.160 | that you get from doing that were based on the situation

00:29:18.800 | in 1983, when people were not living as long,

00:29:22.240 | when the assumed real interest rate was 2.9%

00:29:25.720 | instead of the negative territory that it is now.

00:29:28.720 | And so the implied benefit of delaying Social Security--

00:29:32.640 | if you think of if I delay Social Security,

00:29:35.360 | the benefits I give up become a premium for at least

00:29:39.520 | the difference in benefits.

00:29:41.080 | The benefit increase I get at 70,

00:29:44.320 | that's a really high assumed payout rate,

00:29:47.080 | much higher than any commercial annuity could provide.

00:29:50.880 | And so it'd be really inefficient

00:29:52.440 | to start Social Security at age 62,

00:29:56.440 | and then also buy an annuity.

00:29:58.800 | First, delay Social Security to 70,

00:30:01.480 | then figure out what's going to be your income gap

00:30:03.520 | at that point, and then think about the annuity from there.

00:30:07.680 | I kind of think of it in many ways

00:30:09.160 | as if you're going to go buy an immediate annuity that you are

00:30:13.480 | trying to beat the pool, you're trying

00:30:15.400 | to be in the 50% that outlives the rest of the pool,

00:30:18.720 | that you have other people in the pool who

00:30:21.560 | are thinking the same thing.

00:30:23.200 | They're healthy, and they think their longevity

00:30:26.920 | is going to beat the pool.

00:30:28.520 | So everybody who's in that pool is, I think,

00:30:32.920 | probably more healthier than, say, the average person

00:30:38.440 | out there.

00:30:39.120 | But that's not the case with Social Security.

00:30:40.960 | I mean, everybody's in the pool.

00:30:42.560 | So if you're healthier, delaying seems to me

00:30:45.960 | to be the best option.

00:30:48.360 | Oh, yeah, yeah, absolutely, right.

00:30:50.000 | With annuities, there's adverse selection,

00:30:52.160 | that those who have a feeling they're

00:30:55.400 | more likely to live longer are more likely to buy the annuity.

00:30:58.240 | But right, Social Security is based

00:30:59.800 | on the aggregate US population.

00:31:02.560 | And so to the extent--

00:31:03.760 | there's all these factors that are correlated with longevity.

00:31:07.800 | Some people, because they have more of a long-term focus--

00:31:10.360 | and this is going to be a lot of bogey heads,

00:31:12.320 | they're just higher education, higher income levels,

00:31:15.920 | saving and accumulating more wealth--

00:31:18.440 | that ultimately, they're going to have a longer average

00:31:22.920 | lifetime than the average American.

00:31:24.680 | So that's even speaking stronger to the idea

00:31:28.120 | of delaying Social Security, because your likelihood

00:31:31.200 | of living beyond the breakeven ages

00:31:34.360 | is all the more greater than the average person.

00:31:37.280 | And generally, it's once you get past age 80,

00:31:40.320 | you benefit from delaying Social Security.

00:31:43.080 | And 80 is well below life expectancies

00:31:46.120 | for almost anyone who's going to be listening to a podcast

00:31:50.560 | about retirement income.

00:31:51.520 | But I mean, there's going to be accidents or illnesses that

00:31:55.160 | happen randomly on occasion.

00:31:57.320 | But the average person listening to this type of podcast

00:32:00.920 | will live dramatically longer than the average American.

00:32:04.000 | And that's even a stronger case for delaying Social Security

00:32:06.880 | and for annuities.

00:32:08.760 | You also talk about another type of insurance,

00:32:11.280 | which is called whole life.

00:32:13.000 | Normally, out there in the world,

00:32:14.560 | it's stay away from whole life.

00:32:16.120 | But what you're saying, and you're

00:32:17.120 | making the argument that this could actually

00:32:19.000 | be a good option for people.

00:32:21.000 | Yeah, that's what I found in doing my simulations.

00:32:24.320 | And just to be clear, I'm still a little bit

00:32:26.560 | young to be buying the annuities.

00:32:28.160 | I anticipate doing that, but still in my early 40s.

00:32:31.880 | But after doing this work on whole life insurance--

00:32:35.240 | and I am at the right age, so I found it so compelling--

00:32:38.480 | I did get myself a big whole life policy.

00:32:41.840 | I know bogey heads generally don't like it.

00:32:44.000 | But it's not about whole life versus the stock market.

00:32:46.560 | This is about as a replacement for bonds.

00:32:49.520 | If you just think about the cash value

00:32:51.560 | as an alternative for taxable bond investments,

00:32:55.280 | it can be competitive in that regard.

00:32:57.440 | But the simulations I do, they start

00:32:59.600 | at somebody who's still either 35 or 40 years old.

00:33:04.200 | And they decide they need life insurance pre-retirement.

00:33:08.080 | Then they think about, do they buy term and invest

00:33:10.200 | the difference?

00:33:11.760 | Or do they buy whole life insurance, which

00:33:14.040 | is going to have a much higher premium

00:33:16.080 | and is going to reduce the amount they have

00:33:17.920 | in their investment accounts, but then lays

00:33:21.400 | the foundation for then having different strategies

00:33:23.680 | for retirement income and comparing, well,

00:33:27.480 | what sort of approach where I'm going

00:33:29.960 | to have a limited amount of savings each year

00:33:31.840 | and I can allocate that between investments, term insurance,

00:33:35.000 | and whole life insurance?

00:33:36.840 | What can lay me the best foundation

00:33:38.640 | to get the most spending and legacy in retirement?

00:33:43.800 | And finding there were a number of different ways

00:33:46.200 | that whole life insurance can fit into that puzzle

00:33:49.080 | to support more income and/or more legacy in retirement.

00:33:54.440 | And I found it compelling enough to actually begin

00:33:57.320 | implementing this for myself.

00:34:00.680 | We just had the discussion about the annuity,

00:34:02.720 | that the simple income annuity often

00:34:05.400 | has the most downside income.

00:34:07.920 | And that's true, like a single life-only single premium

00:34:11.240 | immediate annuity would have the highest payout rate.

00:34:14.360 | And then if you have two spouses with annuities,

00:34:17.440 | the way you protect the spouse would be you get a joint life,

00:34:20.240 | or you get a cash refund, or you keep

00:34:23.600 | the liquidity for the underlying contract value and so forth.

00:34:27.600 | And then that's your life insurance, in that case.

00:34:29.640 | You get a lower guaranteed payout rate

00:34:31.760 | because you're building in more protection through the annuity.

00:34:35.480 | And I compare that to, well, what

00:34:37.000 | if I just had the death benefit to back up the annuity premium?

00:34:41.320 | So in retirement, you could get a single life,

00:34:43.720 | life-only income annuity backed by the life insurance.

00:34:48.240 | And I found that that sort of approach

00:34:50.080 | could work much better than by term and a vested difference,

00:34:53.740 | and then doing systematic distributions,

00:34:56.000 | or even by term and a vested difference,

00:34:58.720 | and then by a joint life income annuity at retirement.

00:35:01.880 | And then the other approach, it's

00:35:03.240 | really about the sequence of returns risk.

00:35:05.120 | And it's this buffer asset, which I first really learned

00:35:08.720 | about on the reverse mortgage side.

00:35:10.560 | But cash value life insurance is the other major example

00:35:14.760 | of a buffer asset.

00:35:16.040 | It's this idea you have something

00:35:18.640 | outside your investment portfolio that's not

00:35:21.520 | correlated with the portfolio that

00:35:24.040 | can be a temporary spending resource

00:35:26.040 | to help avoid having to sell assets when they're

00:35:29.640 | at a loss, or in trouble.

00:35:31.240 | The rule that I found worked best

00:35:32.560 | is whenever your remaining investment assets are

00:35:36.520 | less than the amount they were at the start of retirement

00:35:39.000 | in nominal terms, draw from the buffer asset if you have it.

00:35:43.440 | And that can really help manage sequence of returns risk

00:35:46.840 | and help to preserve the portfolio in a way

00:35:49.920 | that the gains in the portfolio can more than

00:35:52.600 | offset the fees associated with the buffer asset,

00:35:56.720 | whether that's the expensive reverse mortgage,

00:35:59.600 | or whether that's the life insurance that has, of course,

00:36:04.160 | the insurance fees, but you're getting the death

00:36:06.360 | benefit for that, but also just anything else related

00:36:09.160 | to the complexity of the contract

00:36:11.600 | and how that can lead to commissions or fees that

00:36:14.400 | are otherwise hard to tease out what exactly they are.

00:36:18.040 | But looking at real policies, finding

00:36:21.600 | that you can support more spending and/or more legacy

00:36:25.680 | at the end of retirement as well with these more

00:36:28.640 | integrated strategies.

00:36:30.760 | But it's the same idea again.

00:36:32.000 | It's not that you're selling stocks to buy the insurance.

00:36:35.560 | It's you're selling bonds to buy the insurance.

00:36:38.600 | Try to keep the same amount of stocks,

00:36:40.320 | but you just position bonds so that they're not

00:36:42.520 | all held in bond funds.

00:36:44.560 | They're also held in income annuities

00:36:47.960 | or in whole life insurance.

00:36:50.520 | And I just found the results to be really compelling

00:36:53.400 | and tested many different variations on it.

00:36:56.920 | I agree it's counterintuitive and surprising,

00:36:59.120 | because I do come from the investments only world,

00:37:01.560 | but I found it compelling enough to actually implement

00:37:04.560 | for myself.

00:37:05.680 | So just a couple of clarifications.

00:37:08.720 | When you're talking about your buffer assets,

00:37:12.120 | you're talking about if you have a downturn in the market

00:37:15.320 | and you don't want to have to sell stock in order

00:37:17.680 | to take the money to live on, that you

00:37:20.360 | go to one of these buffer assets like the cash

00:37:22.720 | value in a whole life policy or like a reverse mortgage.

00:37:26.920 | And that's where you get the money from in the year or two

00:37:29.440 | in which the markets are down.

00:37:31.160 | And then when the markets come back up,

00:37:33.280 | then you can go back to selling stock.

00:37:36.000 | And this is the concept of a buffer asset.

00:37:39.880 | Yeah, that's the idea.

00:37:41.360 | And that because sequence of returns risk

00:37:44.480 | works in such odd ways, the synergies

00:37:47.720 | of being able to avoid having to sell at a downturn or at a loss

00:37:52.240 | are really compelling and really then lead to a much better

00:37:55.400 | outcome for the portfolio.

00:37:57.400 | In both cases with the reverse mortgage or the cash value,

00:38:00.440 | you're treating it as a loan.

00:38:02.480 | The reverse mortgage, you're borrowing

00:38:04.120 | from the home equity and the cash value.

00:38:06.280 | You structure it as a loan from the policy.

00:38:09.240 | So there's going to be a loan balance that

00:38:11.160 | grows with interest.

00:38:12.960 | But the benefits to protecting the portfolio

00:38:17.080 | can more than offset the costs of the growing loan

00:38:20.400 | balance associated with the buffer asset.

00:38:22.560 | So yeah, that's the idea.

00:38:24.440 | We're going to talk about reverse mortgages.

00:38:26.320 | But I think that before we do that,

00:38:29.680 | we need to kind of clear up a couple of things.

00:38:32.080 | And that is, I live in a retirement community

00:38:35.240 | in an over 55 community.

00:38:37.760 | And I get these invitations to go to dinners

00:38:41.240 | where they're put on by retirement specialists

00:38:45.080 | talking about giving me guaranteed retirement

00:38:48.200 | income for life.

00:38:49.600 | So I went to one of these free chicken dinners.

00:38:52.600 | I'll tell you, it was the biggest farce

00:38:54.280 | I've ever been to in my life.

00:38:56.040 | The guy used all kinds of emotional things

00:39:00.360 | to try to get--

00:39:01.760 | particularly targeted the woman in the audience--

00:39:04.200 | to say, you're never going to see your grandchildren again

00:39:07.120 | if your husband dies unless you come and see me.

00:39:09.400 | And I'm going to make sure you get the income that you get.

00:39:11.840 | I mean, it was a real sleaze.

00:39:14.680 | And this is sort of the impression

00:39:16.120 | that people get about insurance and insurance salespeople.

00:39:20.360 | So all of this stuff gets lumped under, don't do it.

00:39:23.640 | Don't go there.

00:39:24.680 | It's just high commission garbage.

00:39:28.440 | Yeah, and I mean, as a starting point default assumption,

00:39:31.880 | that's probably a good rule to live by.

00:39:34.600 | Because as annuities get more complicated,

00:39:37.800 | they're not transparent.

00:39:39.160 | So that can allow costs to be internalized in ways

00:39:42.800 | that are not at all obvious.

00:39:45.400 | I mean, so the starting point is the simple income annuity.

00:39:49.600 | And just the reason all these more complicated annuities

00:39:52.560 | developed was because the simple income annuity is

00:39:55.320 | you pay the premium, and then that asset disappears

00:39:58.560 | from your balance sheet.

00:39:59.560 | But you now have this protected monthly paycheck

00:40:02.640 | for the rest of your lifetime.

00:40:04.800 | People were not comfortable giving up that liquidity.

00:40:07.560 | And then also, they were not comfortable with giving

00:40:09.680 | an upside for that asset once you have the income annuity.

00:40:12.600 | You can't strike it big in the stock market and so forth.

00:40:16.280 | And so that's where these other types of annuities developed.

00:40:19.880 | And these are deferred variable annuities or fixed index

00:40:23.640 | annuities.

00:40:24.720 | And I think a lot of those chicken dinner type

00:40:26.680 | events are going to be for the fixed index annuities, where

00:40:30.080 | they might even portray them as get

00:40:32.000 | the returns of the stock market without the risk.

00:40:34.280 | And that, to be clear, is also not how they work.

00:40:36.800 | But it's easy to get misled about that.

00:40:39.720 | But at a basic level-- and so the idea

00:40:42.880 | is there can be good competitively priced versions

00:40:45.400 | of those.

00:40:45.880 | That's not necessarily what you're

00:40:47.340 | getting at one of the chicken dinner events.

00:40:50.080 | But it's a way to still have the liquidity.

00:40:53.440 | You don't have to annuitize the contract.

00:40:55.440 | So you can still get your money back.

00:40:58.120 | Now, there could be surrender charges and things.

00:41:00.160 | But you still have access to the funds.

00:41:02.560 | And then you still have some degree of upside exposure.

00:41:05.960 | And the variable annuity usually would provide more upside

00:41:09.000 | exposure than a fixed index annuity.

00:41:12.200 | But you have the underlying contract value.

00:41:14.320 | You have the upside exposure.

00:41:15.800 | And then you have this optional rider

00:41:19.840 | that really was developed just in the 1990s initially,

00:41:23.040 | this guaranteed living withdrawal benefit

00:41:25.720 | that will provide you that guaranteed lifetime income.

00:41:28.400 | And you're spending your own money

00:41:30.120 | as long as there's money left in the contract.

00:41:32.200 | But the idea is if the contract depletes,

00:41:34.920 | that's when the rider kicks in.

00:41:37.120 | And you'll continue to receive that guaranteed income

00:41:39.760 | for the rest of your life.

00:41:41.040 | So it works as a source of guaranteed lifetime income.

00:41:44.360 | But the companies have just made these things so complex.

00:41:48.000 | And every company uses different terminology.

00:41:51.520 | And especially with the variable annuities,

00:41:54.440 | they have the guaranteed roll-up rates

00:41:56.200 | that people misunderstand to mean

00:41:59.040 | a guaranteed rate of return.

00:42:01.360 | And so the point of those two chapters in the Safety First

00:42:04.520 | book was to just try to step back and describe

00:42:07.880 | how the annuities work.

00:42:09.360 | So that if somebody is thinking about them,

00:42:11.160 | they at least know the basic underlying structure

00:42:13.720 | and know what questions to ask and know

00:42:16.000 | what they need to understand to determine

00:42:18.600 | if that's the right type of product for their situation.

00:42:22.480 | But yeah, I mean, otherwise, the default

00:42:24.400 | is you do want to be quite cautious.

00:42:27.080 | To me, the transparency of, say, an index mutual fund--

00:42:31.480 | here's the fee.

00:42:32.320 | Here's what you get.

00:42:33.520 | Here's the performance of the index.

00:42:35.160 | Here's the performance of the fund.

00:42:36.580 | It's very clear.

00:42:37.960 | Even if you're doing a treasury bond, here's the interest.

00:42:41.160 | This is what you're going to get.

00:42:42.920 | Here's the bond.

00:42:43.960 | If you go to a bank and you buy a CD,

00:42:46.120 | this is the annual percentage rate that you're going to get.

00:42:48.600 | This is for how long.

00:42:49.920 | If you turn it in early, there's a penalty.

00:42:52.920 | And it's all very simple and very clear.

00:42:56.080 | And a lot of people can figure it out on their own.

00:43:00.440 | And they'll end up buying index funds and CDs

00:43:04.320 | and keeping it simple.

00:43:05.840 | But when it comes to insurance, boy,

00:43:07.600 | things can get really messy.

00:43:09.320 | I mean, how do you know you're working

00:43:11.720 | with an agent who actually cares about you?

00:43:16.600 | Well, that's a good question.

00:43:18.480 | And since I'm not actually involved in selling insurance,

00:43:21.920 | these kinds of more practical issues--

00:43:25.520 | it's a good question that I don't necessarily

00:43:27.440 | have a good answer for.

00:43:29.000 | Because you can't just go by on who has the nicest personality

00:43:32.280 | or who's a member of your church and so forth.

00:43:34.480 | Because a lot of people can use these types

00:43:36.760 | of civic organizations to gain trust in inappropriate ways.

00:43:42.960 | So yeah, I mean, I don't have a good answer.

00:43:45.200 | I think you probably want to just do more--

00:43:47.200 | especially like bogleheads who are

00:43:49.280 | more involved in this process-- do

00:43:50.760 | the research about the actual annuity products themselves,

00:43:54.640 | figure out what annuity is right for you,

00:43:57.840 | and then just, as necessary, use an agent to get what you want,

00:44:02.640 | rather than having to rely on that agent to give you

00:44:06.440 | the proposals about what they want to sell you, I guess,

00:44:09.120 | would be the real starting point with that.

00:44:11.760 | But do you see why there's kind of an aversion

00:44:14.280 | to doing the whole concept of the safety first?

00:44:19.160 | Not that it wouldn't work.

00:44:21.060 | It all sounds good, and I'm sure that there are good companies

00:44:24.400 | out there to do it.

00:44:25.320 | It's a question of how does an individual actually

00:44:27.960 | go out and decipher which are the good people to work with,

00:44:31.720 | and whoever's out there selling chicken dinners trying

00:44:34.520 | to capture a 10% commission and on to the next person?

00:44:38.520 | Makes it very difficult to, say, adopt

00:44:41.360 | your strategy, which probably should

00:44:43.320 | be adopted by more people.

00:44:45.480 | The question is the process of how you actually ferret out

00:44:48.800 | all this stuff out there and actually come up

00:44:50.720 | with what is the way in which you do this.

00:44:55.680 | Yeah, and probably staying away from those chicken dinners

00:44:58.680 | is another sound bit of advice.

00:45:00.920 | But increasingly, the annuities are now

00:45:02.880 | being offered on a fee-only basis, where

00:45:05.800 | they don't pay commissions.

00:45:07.520 | And so the traditional financial advisors

00:45:10.400 | who don't accept commissions and who just charge

00:45:12.640 | a fee from their clients to provide the advice

00:45:15.440 | are able to offer annuities to their clients as well.

00:45:19.000 | And with the fee-only version, since it

00:45:21.040 | doesn't bake in a commission, it can have lower fees

00:45:25.600 | and also even perhaps not have surrender charges,

00:45:29.080 | or at least have dramatically lowered surrender charges

00:45:32.200 | as well.

00:45:33.440 | But yeah, your point's valid that it's

00:45:36.480 | hard to know who you can trust in the world of annuity

00:45:39.720 | purchasing.

00:45:41.520 | Let's talk about another buffer asset

00:45:43.120 | that you mentioned a few times now called a reverse mortgage,

00:45:46.440 | which you wrote a book about.

00:45:48.040 | In fact, it was your first book.

00:45:49.360 | You wrote it in 2016.

00:45:51.400 | Some of the rules and regulations

00:45:52.760 | have changed since the book has come out.

00:45:55.520 | So could you go over reverse mortgages

00:45:57.880 | and how reverse mortgages could work

00:45:59.760 | into this whole retirement plan?

00:46:01.840 | Right.

00:46:02.360 | So it's another tool that you can

00:46:04.720 | have as part of the toolkit.

00:46:05.920 | And indeed, as people are starting

00:46:08.520 | to really figure out the value of reverse mortgages,

00:46:11.400 | and it was possible to set one up for $125

00:46:14.600 | in some circumstances, in August 2017,

00:46:18.400 | there was a rule change introduced

00:46:19.840 | that got implemented October 1, 2017, that effectively,

00:46:24.440 | by increasing the initial mortgage insurance premiums,

00:46:27.640 | raised the initial cost of setting up a reverse mortgage

00:46:30.600 | quite dramatically.

00:46:32.000 | I wasn't planning to do it, but I

00:46:33.320 | had to write a second edition of my book

00:46:35.440 | to redo all the analysis under the new rules.

00:46:38.800 | Found the new rules did weaken the case for reverse mortgage,

00:46:41.920 | but didn't completely overturn it.

00:46:43.560 | So the second edition of my book accounts for today's rules.

00:46:47.840 | And it's the same idea.

00:46:50.280 | If you can be strategic, and you open the reverse mortgage,

00:46:54.400 | and then use it strategically alongside the investment

00:46:57.320 | portfolio, in any number of ways,

00:47:00.960 | it can help lay a foundation for a better retirement outcome

00:47:04.400 | in terms of either supporting more spending

00:47:06.640 | and/or the same spending, but having more legacy

00:47:10.080 | at the end of retirement as well.

00:47:11.600 | Where legacy in that case would be

00:47:14.320 | what's left in your investments plus the value of your home

00:47:17.200 | minus the loan balance due on the reverse mortgage,

00:47:20.400 | where it's the buffer asset, same as we were just talking

00:47:22.800 | about with life insurance, that you have the reverse mortgage

00:47:26.280 | line of credit, and it's growing over time,

00:47:28.680 | and it can't be canceled or frozen.

00:47:31.640 | And then rather than having to sell from your portfolio

00:47:34.280 | at a loss in a troubling time, you

00:47:36.960 | could tap into the reverse mortgage as a source of funds.

00:47:41.200 | Again, it proceeds from a loan, so it's not taxable income.

00:47:43.840 | It doesn't show up as part of your adjusted gross income.

00:47:46.960 | And it can provide that bridge for spending.

00:47:49.560 | You could also just set it up as a contingency fund

00:47:52.520 | as a way to have liquid contingency assets

00:47:55.000 | for any sort of spending shock.

00:47:57.400 | So there's a lot of ways reverse mortgages can be used.

00:48:01.600 | Wait, a lot of these ideas seem to make sense.

00:48:04.200 | What stops people from doing it?

00:48:07.480 | In terms of annuities, there's this whole academic literature

00:48:10.640 | about the annuity puzzle, just trying

00:48:12.880 | to explain why people are not comfortable with annuities,

00:48:17.760 | and that we've talked already about the lack of liquidity

00:48:20.720 | and upside potential in a traditional income annuity.

00:48:24.360 | Another thing is just people, they view it as the gamble,

00:48:27.640 | like we discussed, that if I buy the annuity

00:48:30.600 | and then I die early, the insurance company

00:48:32.560 | wins at my expense.

00:48:34.280 | And people aren't always comfortable with that.

00:48:36.240 | That's not strictly how the annuity works.

00:48:38.280 | It's a long-lived in the risk pool

00:48:40.200 | that win at your expense rather than the insurance company.

00:48:43.760 | But that can certainly be an impediment.

00:48:46.480 | And so there are things as well like charitable gift annuities

00:48:49.480 | where you can--

00:48:51.560 | usually the payout rate would be less

00:48:53.120 | with a charitable gift annuity because it's

00:48:54.920 | trying to build in something for the charity.

00:48:57.520 | But in that case, you can frame it more as, well,

00:49:00.360 | the charity would win at my expense

00:49:02.120 | rather than the insurance company.

00:49:04.240 | So that can be a potential solution to that annuity

00:49:07.280 | puzzle.

00:49:08.480 | Could you explain what a charitable gift annuity is?

00:49:12.480 | It's a way for charities to receive charitable contributions

00:49:16.440 | from individuals, but to link that as well to a lifetime

00:49:19.960 | income.

00:49:21.440 | Now, charities have different approaches.

00:49:23.640 | The safest approach for the charity is they take your gift

00:49:27.560 | and they purchase from a commercial insurer

00:49:30.240 | an annuity for you to pay you.

00:49:32.400 | But because they're offering a lower payout rate

00:49:35.440 | than a commercial annuity, they're

00:49:37.720 | able to then keep part of that as a gift.

00:49:40.240 | The riskier way for a charity to manage that

00:49:42.440 | would be to actually become an insurer themselves, so to speak,

00:49:45.600 | and to pay out the annuities through the collections

00:49:49.480 | that they receive.

00:49:50.840 | But either way, the idea is they're

00:49:53.480 | paying below market rates as annuities.

00:49:56.560 | And therefore, on average, are able to receive

00:49:59.960 | a charitable contribution so that people

00:50:03.120 | can make that gift sooner, but still receive a lifetime

00:50:07.120 | income connected to it.

00:50:08.240 | So that they can also be thinking of it

00:50:11.000 | as it's like a way to mix their retirement

00:50:13.720 | spending and their charitable giving together

00:50:16.440 | into one overall strategy rather than keeping them separate.

00:50:20.560 | How do the taxes work on that?

00:50:22.320 | In other words, you give a gift to charity

00:50:25.040 | and they buy you an annuity.

00:50:26.520 | I mean, how much of a deduction do you get on the gift?

00:50:28.840 | And how much do you have to pay in taxes on the income

00:50:32.200 | that you get from the annuity?

00:50:34.400 | Well, you're not going to necessarily get the full tax

00:50:37.640 | deduction right away.

00:50:38.840 | You probably do want to indeed talk to a CPA

00:50:41.520 | to make sure that you're getting all those specifics right.

00:50:44.560 | Because indeed, part of a charitable gift annuity payment

00:50:46.840 | can be taxable income.

00:50:49.440 | And as we talk as well about this annuity puzzle

00:50:52.240 | and kind of why don't people seem to like annuities,

00:50:56.120 | another idea that's been offered is

00:50:57.720 | it's been called the Scrooge McDuck effect.

00:50:59.880 | Yeah, from the old cartoons.

00:51:02.480 | He loved to jump into his money bin

00:51:04.920 | and swim through his money.

00:51:06.240 | And it was like people want to see their money.

00:51:09.840 | They may not have a money bin like Scrooge McDuck.

00:51:13.000 | But when they look at their portfolio statement,

00:51:15.800 | if they see a lot of funds, they feel wealthier.

00:51:18.800 | And if you purchase an income annuity,

00:51:21.280 | you can lose that phenomenon.

00:51:22.800 | The annuity has a present value of its lifetime future payments.

00:51:26.760 | And that can be substantial.

00:51:28.560 | But that's not usually reported anywhere.

00:51:31.040 | And so people may feel poorer after purchasing an income

00:51:34.720 | annuity.

00:51:35.600 | Because instead of having this pot of assets to look at,

00:51:39.280 | they do have a valuable asset.

00:51:40.800 | They just don't get to see it.

00:51:42.440 | And they don't appreciate it as much for that reason.

00:51:46.560 | Let's jump into one topic that you

00:51:48.200 | talk about a lot that is not insurance related.

00:51:51.000 | And that is using tips in a portfolio.

00:51:55.320 | Well, so interest rates are very low now.

00:51:57.800 | But that's true across the board.

00:52:00.640 | If you're going to hold bonds in retirement,

00:52:03.680 | I think the case for tips would be much stronger

00:52:06.040 | than for traditional treasuries.

00:52:08.400 | But at the end of the day, I don't just

00:52:10.480 | simply know how many different types of bond

00:52:13.640 | holdings a retiree needs.

00:52:15.640 | I would lean more towards using that income annuity approach

00:52:19.840 | instead.

00:52:20.560 | But yeah, I mean, if you want inflation protection,

00:52:23.480 | tips and I-bonds are the bonds that can provide that to you.

00:52:28.280 | Let's end with what you call the Retirement Research Manifesto,

00:52:32.360 | where you have eight points.

00:52:34.280 | You put this in the beginning of all your books.

00:52:37.240 | And I just want to go through them with you.

00:52:39.760 | And comment quickly on each one.

00:52:42.000 | The first one is play the long game.

00:52:47.040 | You occasionally hear somebody say,

00:52:48.880 | oh, I don't need a retirement plan.

00:52:50.640 | I'm going to be dead by 70.

00:52:52.640 | And that's not really the way to think about retirement

00:52:55.280 | planning.

00:52:55.760 | You've got to assume you're going to live a long time.

00:52:58.520 | That's the foundation of how we mostly think about retirement.

00:53:03.240 | But it's just important to have that reminder.

00:53:06.480 | Number two, don't leave money on the table.

00:53:09.960 | The idea there is to just be efficient with your planning.

00:53:12.840 | And there's so many parts of retirement income

00:53:15.920 | where a small short-term expense can

00:53:18.320 | lead to a big long-term benefit.

00:53:20.280 | And that's what I mean about not leaving money

00:53:22.840 | on the table in that regard.

00:53:25.240 | Use reasonable expectations for portfolio returns.

00:53:30.400 | I think that one's really important.

00:53:32.200 | A lot of financial planning software

00:53:34.160 | just plugging in historical averages for everything,

00:53:37.160 | assuming bonds are going to average 5% or 6% returns when

00:53:40.480 | we see interest rates in the neighborhood of 1%.

00:53:43.760 | You've got to be realistic, and especially with sequence risk.

00:53:47.880 | Which leads into number four, be careful about plans that only

00:53:50.680 | work with high market returns.

00:53:54.040 | So much of the simple stuff you'll see online

00:53:56.720 | is assume an 8% rate of return, and this or that happens.

00:54:01.440 | And sure, it's easy to fund retirement with 8% returns.

00:54:04.560 | But the probability of getting those

00:54:06.440 | is not necessarily all that high.

00:54:08.400 | You've got to make sure you have a plan that can work,

00:54:10.960 | even if you don't get 8% returns.

00:54:14.280 | And that leads us to what we talked about today, number 5,

00:54:17.160 | build an integrated strategy to manage various retirement

00:54:20.680 | risks.

00:54:22.320 | Bonds are a starting point.

00:54:23.720 | And the way to try to spend more than just a simple bond

00:54:26.600 | portfolio, you have the diversified stock portfolio,

00:54:30.520 | aggressive portfolio, and get risk premium

00:54:32.400 | from the stock market.

00:54:33.440 | Or you use an insurance approach and get risk pooling.

00:54:37.080 | And either way, you have the potential to spend more,

00:54:39.480 | and they can manage these different risks, the longevity,

00:54:42.920 | the market risk, and the spending

00:54:44.360 | shocks in different ways.

00:54:45.960 | So integrating tools together is important.

00:54:49.040 | And number 6 is the reason I wanted you on the call today,

00:54:52.560 | because of what's going on in the financial markets

00:54:55.640 | with very low, historic low interest rates,

00:54:58.520 | negative interest rates all over the world.

00:55:01.360 | Approach retirement income tools with an agnostic view.

00:55:05.860 | Yeah, that's the important one, because if you

00:55:13.000 | come from a particular area, you think

00:55:14.880 | that's the solution for everything,

00:55:16.680 | whether it's investments, whether it's insurance.

00:55:19.440 | Even people who think that reverse mortgages are

00:55:22.160 | the solution for everything.

00:55:23.480 | And at the end of the day, just keep an open mind

00:55:26.680 | about any sort of tool.

00:55:28.080 | Think about how it can contribute to your plan.

00:55:31.200 | And think about things that way.

00:55:32.720 | Don't just exclude things without a deeper investigation.

00:55:37.320 | Number 7, start by assessing all retirement assets

00:55:41.080 | and liabilities.

00:55:44.480 | The retirement balance sheet, it's

00:55:46.360 | about asset liability matching.

00:55:48.360 | And so you figure out your goals.

00:55:51.060 | They lead to your liabilities or expenses.

00:55:53.720 | And then you map your assets to those goals.

00:55:57.200 | And you try to match up the risk characteristics.

00:55:59.280 | So you don't want a lot of stock market investments

00:56:01.600 | for your basic expenses, that sort of thing.

00:56:04.760 | But you need to think about the whole picture,

00:56:06.600 | about matching assets to liabilities.

00:56:09.960 | And finally, distinguish between technical liquidity

00:56:13.800 | and true liquidity.

00:56:16.240 | An investment portfolio can be technically liquid,

00:56:18.720 | but with asset liability matching.

00:56:21.480 | If I believe in the 4% rule, and I have $1 million,

00:56:25.160 | and I want to fund $40,000, that money, though technically

00:56:30.120 | liquid, is not true liquidity.

00:56:32.400 | It's earmarked to meet my future spending.

00:56:35.120 | True liquidity is when you have assets that are not

00:56:38.320 | earmarked for something else.

00:56:40.520 | And then they became the source of reserves

00:56:42.760 | that can fund your contingencies in retirement.

00:56:45.680 | - Wade, thank you so much for being

00:56:47.040 | on Bogleheads on Investing.

00:56:48.360 | You gave us a lot to think about.

00:56:50.080 | And I very much appreciate you being on the show today.

00:56:52.800 | - Well, thanks, it's been a pleasure.

00:56:54.720 | - This concludes Bogleheads on Investing, podcast number 24.

00:56:59.080 | I'm your host, Rick Ferry.

00:57:01.280 | Join us each month to hear a new special guest.

00:57:04.600 | In the meantime, visit bogleheads.org

00:57:08.000 | and the Bogleheads Wiki.

00:57:09.760 | Participate in the forum, and help others find the forum.

00:57:13.960 | Thanks for listening.

00:57:16.160 | (upbeat music)

00:57:18.760 | (upbeat music)

00:57:21.360 | (upbeat music)

00:57:23.960 | (upbeat music)

Bogleheads® on Investing Podcast 024 – Dr. Wade Pfau, host Rick Ferri (audio only)

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