The 4% rule may not work, says this pension expert. Here’s his strategy for a downturn.
Economist Wade Pfau has been thinking about retirement since he was 20 years old. But not just his own retirement.
Peacock began studying Social Security for his dissertation while completing his Ph.D. at Princeton University in the early 2000s. At the time, Republicans wanted to divert some of the Social Security tax into a 401(k)-style savings plan. Pfau concluded it could provide retirees with ample retirement income — but only if markets cooperate.
Today, Pfau is Professor of Retirement Income at the American College of Financial Services, a private college that educates financial professionals. His most recent book, Retirement Planning Guidebook, was published in September.
While many retirees are counting on stocks continuing to rise to keep their portfolios growing, Pfau fears markets will collapse, jeopardizing this “overly optimistic” approach. He has embraced often-criticised insurance products such as variable annuities and life insurance that retain their value in a stock market crash, and has done consulting work for insurers. He wrote another book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement, because these loans can also be used as “buffers” during market downturns.
Peacock, 44, is already playing with spreadsheets to analyze his own retirement savings. He recently developed a model to determine when it’s best to move money from tax-deferred accounts to tax-exempt Roth accounts, in part because he wanted the answer for his own retirement accounts. We reached Pfau at his home north of Dallas. An edited version of our conversation follows:
Barrons: The 4% rule states that a retiree is safe to withdraw that percentage annually from a portfolio, adjusted for inflation. Why don’t you think it will work?
Peacock: It’s not that I don’t think it will work. I think the probability that the 4 percent rule will work for today’s retirees is around 65 to 70 percent, rather than being a near certainty.
It’s a debate. Just stick with the historical data or make the adjustment to say, “Wait a minute. With interest rates low, you can’t predict bond returns as high as we’ve had in the past, and maybe you can’t predict stock returns as high as we’ve had in the past?
What percentage can people safely withdraw?
I think 3% would be much more realistic to offer the same odds of success that we usually think of with the 4% rule.
Will the people with a lower withdrawal rate still have enough money to retire?
One of the unrealistic assumptions of the 4% Rule is that you don’t have the flexibility to adjust your spending over time. Someone could retire with a 4% withdrawal rate if they’re willing to cut their spending a bit when we hit a bad market environment.
One more thing?
People need to be smart about their decisions about applying for Social Security. It’s okay to spend fixed assets in the short-term so you can defer Social Security benefits until age 70, at least for the high-earning couple. The boost you get from waiting through Social Security benefits will really reduce the need to take investment payouts after age 70.
People might also be looking at ways to use home equity to support retirement spending, whether by downsizing their home or considering getting a line of credit through a reverse mortgage.
Isn’t tapping into home equity to avoid selling stocks a duplication of a losing bet?
Using a buffer-based strategy like home equity is consistent with the idea that the stock market will perform at reasonable levels over long periods of time. If there is no market recovery, it becomes all the more difficult to have a sustainable retirement savings strategy.
Why are the early years of retirement the most dangerous?
It’s the idea of sequence-of-return risk. I’ve estimated that if someone plans a 30-year retirement, the market returns they experience in the first 10 years can explain 80% of the retirement outcome. If you experience a market downturn early and markets recover later, spending from that portfolio doesn’t help that much because you have less left to benefit from the subsequent market recovery.
What is the solution?
There are four ways to control sequence-of-return risk. First: Spend sparingly. Second: spend flexibly. Being able to reduce your spending after a market downturn can manage yield risk because you don’t have to sell as many stocks to meet spending needs. A third option is to strategically approach volatility in your portfolio, even with the idea of a rising stock glide path. The fourth option is to use buffer assets such as cash, a reverse mortgage, or cash value life insurance.
What is a rising stock glide path?
Start with a lower equity exposure early in retirement and then work your way up. Later in retirement, market volatility doesn’t have as much of an impact on the sustainability of your spending path, and you can accommodate by having a higher stock allocation later.
Why do pensions make sense when interest rates and pension payments are low?
Well, because the fact that interest rates are low influences every strategy. But the impact of low interest rates on pensions is less than the impact on a bond portfolio.
Most pensions are not adjusted for inflation.
An income annuity will not be the source of inflation protection in the retirement strategy. That has to come from the investment side. However, the annuity allows for a lower early withdrawal rate from your investment portfolio to mitigate sequence risk. Most retirees naturally spend less as they age and may not need inflation protection
Medical costs increase with age.
Right, that’s the only balancing factor. Medical expenses are going up, but everything else tends to go down fast enough that overall spending falls into old age, when people may have to pay for more care at home or in a nursing home, or some other type of long-term care needs.
Does long-term care insurance make sense?
When I look at traditional long-term care insurance, I have a bit of a problem because you typically use insurance for low-probability, high-cost events. And the problem with long-term care is that it’s a high-probability, high-cost event.
There are other hybrid approaches where you can combine long-term care insurance with life insurance or an annuity, and that’s where most of the new business goes, and that has some potential.
How is your own money invested?
At my age, I’m still mostly into stocks.
Do you own pensions?
I’m interested in variable annuities with housing benefit, but I’m still too young. We don’t usually talk about getting pensions until you’re in your mid to late 50s.
Variable annuities get a bad rap. You think it’s undeserved?
Mostly undeserved. They get a bad rap for having high fee resistance, and when I think of retirement, I don’t think so much of fee resistance as of how much wealth you need to be comfortable in retirement. Variable annuities mean you believe the markets will outperform, but you also don’t want to put your entire retirement on the market, so you need some sort of backing.
You have been a proponent of products sold by insurers, such as annuities, and you have done consulting work for insurers. How can we be sure that your research is not contradictory?
Whenever I write some kind of research paper, I fully outline the methodology to give people a complete understanding. Nothing is in a black box. The assumptions are all listed and if people want to try other assumptions they can.
When I conclude that annuities can be helpful, I try to decide in my assumptions of the doubt not to use the annuities, and still find that a strong case can be made for the annuities.
Social Security is more generous than pensions. Shouldn’t people max out before buying an annuity?
Yes. Insurance companies have to live in the real world. When interest rates are low, it affects pensions. In fact, when thinking about retirement, step one is that at least the high earners in a couple should defer Social Security until age 70. And then if you want more pension protection beyond that, fine. It generally wouldn’t make sense to apply for Social Security early and buy a commercial pension at the same time.
Does it ever feel odd to focus on an event that won’t happen to you for a few decades?
Mostly no. It just comes up sometimes when someone says why this young person is telling me how to retire.
For me, it’s not so much retirement as pursuing the ability to be financially independent. It’s still relevant for me to think about when I might be able to retire, even if I’m not necessarily ready. I have a personal interest in it.
A personal interest in what?
Playing around with spreadsheets and analyzing my own retirement savings. This is what primarily motivated me to do this tax planning research in order to be able to incorporate Roth conversion strategies into my own planning.
Barron’s Retirement: Q&A Series
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