499: Retirement Income Strategies to Quell Inflation Fears and Spend Comfortably with David Blanchett

[INTRODUCTION]

Casey Weade: The economic environment the retirees find themselves in today is dramatically different than it was just six years ago, even just two or three years ago. And how do we view the future of interest rates? How do we view the future of inflation, and what impact will that make on retirement spending patterns and ultimately, your retirement income strategy?

Hey, this is Casey Weade, and welcome to the show. Where does my mission to deliver clarity and purpose and elevate meaning in your life? And if you’re new to the show, I want you to know what to expect. We do this in a variety of different ways. We bring you both financial and non-financial conversations on a variety of different topics. Week in and week out, we’re bringing you a variety of these conversations with world-class guests, like we’re going to have today.

This is one of those long-form interview-based podcast, and I’m excited about this one because we’re bringing someone back that was originally on the podcast back in 2019. We have David Blanchett here with us today. He is currently the Managing Director and Portfolio Manager, Head of Retirement Research at PGIM DC Solutions. He was previously, when we interviewed him back in 2019, he was the Head of Retirement Research at Morningstar. He is still the professor of wealth management and was my professor of wealth management at one point at The American College of Financial Services.

And if you’ve been a Weekend Reading subscriber for some time, then you’ve read some of his work. We regularly include his writings in our emails that we send out to the families that rely on us for their retirement advice, and we also bring a lot of that research into the conversations that we’re having with you week in and week out.

He has won many awards for that research. He has received awards from the Academy of Financial Services, the CFP Board, the Financial Analysts Journal, the Financial Planning Association, and many more. What I’m really excited about today is we’re going to be revisiting some of the discussion that we had six years ago. That was episode number 55. If you want to go back and listen to that episode, we’re going to be bringing some of that research forward and taking a look at how it’s evolved over the last six years.

[INTERVIEW]

Casey Weade: With that, David, welcome back to the show.

David Blanchett: Thanks for having me.

Casey Weade: Well, I’m excited to have you back, buddy. I think I probably read something that you put out almost every single week. There’s maybe no other retirement researcher that I admire more than yourself. I love the content that you put out. You have a very academic, unbiased approach. These are the things that I believe we need in the world today. And I think in a lot of your writings that you put out, a lot of your tweets and posts on LinkedIn, I think we share some of the similar frustrations at the same time.

And I want to start with something that I saw that seemed to be one of your frustrations. And you posted on LinkedIn recently with some frustration around news headlines, often throwing out the word crisis to describe the state of today’s retirement, the retirement crisis. And you felt and you said that you believe that challenge is a better descriptor. How do you compare and contrast between crisis and challenge?

David Blanchett: Well, I think, to start, one of the complications here is we all define crisis differently, right? Crisis is a very kind of personal term, but I view a crisis as a really dire situation, right? So, things are just not good. And people will often suggest or say, we have a retirement crisis. And I push back pretty strongly because if you look at retirees, they are a very content bunch and they tend to have incomes that are at least equal to or above where they were when they were working.

We, as America, have a very robust retirement system, Social Security, that is far more generous than other developed nations. And so, if you look kind of collectively at retirement, we’re actually in pretty good shape. Now, I’m sure we’ll talk about issues around the Social Security trust fund at some point today. But overall, I think that the challenge is a better word than crisis because there are things that we should be doing to improve retirement. But I think the notion that kind of we’re in this crisis state where Americans are destitute at old age doesn’t reflect reality. Now, if we were to all of a sudden lose Social Security, I think that would be a crisis. But if you look at collectively how much Americans save, how much they spend, how they feel, retirement is actually, it’s a pretty good place today, at least in America.

Casey Weade: Some of what we’ve heard over the years, and you often hear this from the oldest generation at any given point throughout history, talking about just how bad it’s going to be for their kids or how much worse it is today than it was in years past. But when you look at the numbers, look at the research, we’re living in a much better place than we were 100, 200 years ago, even 50 years ago.

Now, if we go back to when we originally had our first interview back in 2019, there was something that often hit the headlines, which was the war on retirees. There’s this war going on on retirees. And that was really an emphasis on the 0% interest rate environment that we found ourselves in for many years. Now, it’s kind of flipped, almost. The war is a little different. You don’t hear about the war on retirees being framed up as an inflation problem today. But I wonder how you view that. Has the challenge gotten any easier over the last six years? We have much higher inflation than we had six years ago. But we’ve seen an easing of inflation coupled with higher interest rates.

Now, if we go back six years ago, we still had these persistently high market valuations. Market valuations haven’t shifted that much, are still really high. And so, if we consider all of these things, we have inflation that’s higher, but we have interest rates that are higher. And then we’re still on the same market valuations like that. Has it changed really all that much on a relative basis, or is it kind of a wash?

David Blanchett: So, it’s really tough. I don’t think retirement is ever going to be easy. But I do think that interest rates have an interesting dynamic in our society, right? Older investors invest more conservatively. And so, when interest rates drop they earn a lower return on their investments. Alternatively, higher rates are really negative for younger Americans, individuals who want to buy a home today. You’re looking at a 6.5%, 7% interest rate on a 30-year mortgage. And so, I think that higher interest rates, higher expected returns do help retirement, right? It makes it a little bit easier.

But to your point, inflation is this really kind of new risk that hasn’t been a concern among Americans when it comes to retirement for a long time. But if you look at surveys today, we just did a survey at the end of last year, we asked older Americans to select the number one threat to retirement security. Among things like market returns, health care, longevity, and inflation, inflation was selected number one and then all the others combined. And that’s pretty new. Like, I’ve been doing surveys on, like, what are you afraid of? What are your key threats for retirement for at least a decade? And it’s usually longevity or health care risk. But I think that inflation is this risk that’s top of mind today that is somewhat new. So, think about how you actively address it as part of a retirement income plan is more important than ever.

Casey Weade: And what I continue to revisit, I go, but has relative inflation changed that much? If our interest rates are so much higher, the risk-free rate is so much higher today that we might actually be in a better position than we were six years ago from the difference between inflation and the risk-free rate.

David Blanchett: It is. And so, I think to me, this is more of that behavioral angle of like how do you feel in retirement. And so, it’s this really interesting dichotomy where people talk about a retirement crisis and how Americans don’t have enough money save for retirement and all these things. But retirees don’t spend down their money. There’s this massive disconnect, right? So, people say, oh, we have this crisis and retirees are in rough shape. Or like, if that were the case, you’d think they would leverage their savings more than they are.

And so, I think that to me, inflation is a risk more in terms of people’s willingness to enjoy retirement and consume. When you’re nervous about inflation, maybe use to get vacation, things like that. And so, I don’t view it as a risk in the same way I view like longevity risk as a risk. I view it more as a risk that needs to be addressed as part of a plan that someone can kind of more effectively enjoy their retirement.

Casey Weade: So, let’s talk about how we address this. And as we get into this, I want to go back to, the reason I brought you on 2019, I want to talk about retirement spending patterns, because that was kind of the groundbreaking research that I think has probably been the pinnacle of your research that more people have leveraged and talked about more than anything else. Doesn’t mean it’s the best work you’ve ever done, but boy, I don’t think there’s any other piece of your research that has been more widely spread and things that we’ve talked about. And so, I want to take for saying, I would like you to kind of revisit retirement spending patterns as research was originally laid out, that impact. And then I kind of want to bring that forward. Now, we’re in a much different inflationary environment than we were back then when you did this research. Has that impacted the research? So, take that where you will.

David Blanchett: There’s a lot to unpack there. I guess, going back, so I used to be a financial advisor like a long, long time ago. And when you do a financial plan, what you typically assume is that an individual will have a retirement period last, say, 30 years, and that every year retirement, they’re going to increase their spending by inflation. And if you talk to advisors, if you talk to retirees, you don’t often see them calling you up and saying, “Hey, the CPI went up 5.9% last year. I need a 5.9% raise.”

And there are some kind of models that were used like this. This is idea of the slow go, like, the go go, the slow go, the no go years. It’s a book by Michael Stein called The Prosperous Retirement. It’s over 20 years old. And it’s a really kind of clever way to think about how individuals or households change in retirement. When you’re young, you can be active, you can go out and do things and spend money. But what we typically see is as individuals age, they tend to kind of slow down their consumption.

And so, in this research, it was titled Exploring the Retirement Consumption Puzzle. It was published back in 2014 in the journal of Financial Planning. And they use the data set from what’s called a health and retirement study that observes the same households over time. So, it goes back every two years and asks them all these questions, like 100 questions. It’s a really intense survey. But what I looked at was, well, how do people actually adjust their spending over time? And what I found is that most Americans don’t increase their spending by inflation. So, it’ll go up, but it won’t go up with the full amount of inflation.

So, if, for example, inflation is 3% a year, people might spend 1% more on average. And why this is really important is that you kind of pull out retirement. If you think about retirement lasting 20 or 30 years, this notion that you’re going to spend less over time, what it can do is it can free up money you could spend earlier in retirement. And so, to me, one of the kind of the key assumptions we use in retirement planning, which is individuals increase their spending by inflation, doesn’t tend to track reality.

Now, to be fair, some individuals do spend even more than inflation. Some spend even less. The key is the kind of the average trend is that spending tends to decrease in today’s dollars as we move through retirement, and so, in our earlier talk about inflation. So, inflation is still very much a risk. But I do think that it’s worth revisiting this notion that, hey, I’m going to increase my spending every year by inflation, because again, what it does is maybe would allow someone to spend more early in retirement when they can better enjoy their savings.

Casey Weade: So, I think what’s getting harder about this, we used to have this conversation, I mean, for many years in different mediums and with clients and prospects on the radio shows and TV. We talk about this research and how we’re planning for retirement expenses to go up at 3% a year, or you’re planning for them to double over 20 years. But I’ve worked with clients for 20 years and I’ve never seen any of them double their expenses over 20 years, let alone even spend anymore 20 years into retirement.

And I think that was easy for people to stomach and accept when inflation was 1%, 2%, even 3%. They started seeing inflation rates over 4%. And then they go, I think it’s harder for them to accept that that could possibly be reality. And how do you battle that? Or how do you think about that? How do you address that question?

David Blanchett: So, to me, there appears to be just some active choice in this. And so, yes, like if inflation is higher, you are going to spend more, but the odds are, you’re not going to increase the full amount with inflation, right? And there’s reasons for that. I mean one is just the substitution effect. If things start costing more, you might choose to do something else, right, as opposed to, I don’t know, going to Florida for a vacation. You’ll go somewhere closer. And so, I think that the key here is that retirees have varying levels of flexibility.

And I think what’s really important is retirees who have the most wealth typically have the most flexibility. Most or a good portion of their spending or consumption is in things that they can change. They can choose to not eat out. They can choose to do things. And when you have that level of flexibility, it allows you to have more choices. And to me, the key here is not that you have to spend less. It’s how can I free up more money for you earlier in retirement so that you can actively enjoy it.

The last thing I want someone to do is to start retirement super conservative, not spend as much as they possibly could, then have a health issue at 75 and then they’re kind of stuck. Yes, they have this large pool of money. But saving in 401(k)s is not fun. I don’t enjoy saving for retirement. I’d rather go, blow the money on a vacation. But I’m not going to do that. I want to be responsible. What I don’t want to have happen is individual save, be really good savers for 20 or 30 or 40 years, get to retirement, be afraid to use their savings, and then all of a sudden, they realize 10 years in, they’re 75 years old, that, “Oh, I could have spent a lot more money and done a lot more things.” So, to me, it’s about this balance of understanding that, yes, we want to prepare ourselves for a long possible retirement, but we also want to enjoy retirement as much as we possibly can.

Casey Weade: In order to do all that, we have to factor in an inflation rate. You’re going to have them factor in a lower inflation rate that shows that they can spend more today. So, brass tacks is what inflation rate should the average retiree be using in their retirement projections?

David Blanchett: So, I think a long-term inflation rate between 2% and 3% is pretty reasonable, right. And so, now, like a fun point here is technically when you do a retirement projection, there’s different ways that you can treat inflation. Okay? You can treat inflation as a static variable, so it goes up a constant amount per year. More advanced modeling tools treat it as random. So, some years, it goes up 4%. Some year, it goes up 2%. Some years, it goes up 1%, etc.

I think the key is, one, using a reasonable long-term assumption. The best way to do this, typically, if you’re thinking about a retirement plan, is to have two different sets of assumptions, kind of like a near-term assumption, like what’s going to happen in the next 1 to 10 years, and then say, like years 11 to 30? And why that’s so important is, if we go back to 2019 and we had super low interest rates, okay, you might want to assume the lower interest rate on your investments, a lower inflation rate for that period.

But longer term, I think things tend to move back to the long-term average. Now, like what’s important, too, about inflation is, is that every American has Social Security, so you have a lifetime income indexed to inflation. If you have investments that are invested in a way that benefit from inflation, inflation doesn’t have to be that big of a risk. The key is, is how are you thinking about managing as part of your overall retirement income plan. If you’re ignoring it, then yes, it can become an issue, but I’m less concerned about inflation if it’s higher, again, if you have that flexibility, if you’ve built a portfolio or retirement plan that actively considers what would happen if inflation is above average.

Casey Weade: So, if we take, for instance, let’s say the long-term average of inflation is 3%, we know it’s around 3%. And we say the average retiree is going to spend about 2% less per year. So, does that mean that they should be using a 1% inflation rate in that strategy?

David Blanchett: I still think it’s totally fine to just assume it increases by inflation, right? There are some big elephants in the room, like, where health care cost is going. So, while it is true that Americans tend to spend less in total as they age, they allocate more of their spending towards health care, right? So, about 10% of total household expenditures goes to health care at 65. It’s closer to 20% at age 65. It’s very possible that that could increase further in the future, right? No one knows what’s going to happen. Long-term care is this huge risk.

And so, I think to me, where that assumption around spending less comes into play is maybe helping someone that is a bit constrained when they get to retirement. Yeah, they haven’t saved enough, how do I free up money, stuff like that. So, I think, one, it’s totally fine to use for all financial plans. But people, in my experience will often say, whoa, I don’t want to assume I’m going to spend less. And so, I think that’s fine. But having like a secondary plan to kind of let someone know, hey, there’s a really good chance that you’re not going to increase your spending every year by inflation, especially when you’re older. And so, what would that mean in terms of you doing more today and understanding just the trade-offs, that’s where I think this kind of modeling is really important. Just to give someone a better perspective on, hey, it’s probably okay to spend a little bit more now because you’re probably not going to spend more later.

Casey Weade: And I think what I’ve seen, I mean, if I look at the clients that have been working with us for 20-plus years, if you just build a level income strategy, and so, from their portfolio, they’re getting a level income, but then they still have typically half of their income and retirements coming from Social Security, say, well, they’re automatically getting those costs of living adjustments and Social Security. And so, their overall net income is still increasing by, say, 1% per year on average. And so, I think that’s what gets built in there.

We go, hey, let’s plan on 1% or let’s plan on 2%. And most of those costs, I mean, adjustments are going to be taken care of by your Social Security benefits, but then, we still need to guard against a worst-case scenario. It’s much like guarding against a down mark in the first 10 years of retirement. I mean, you want to guard against the worst-case scenario and we can say, hey, David’s research looks really good, looks really solid. However, what if he’s wrong? What if inflation is substantially higher than it’s been in the past? We need to have a strategy for that.

So, then do you encourage retirees to create some type of hedge in their portfolios, set a portion of assets aside in a bucket that can outpace inflation, such as equities or TIPS or real estate alternative investments that we know will keep pace or outpace inflation so that we can make adjustments if we ever need to. And if so, how much do they set aside, specifically for that purpose?

David Blanchett: Yeah. So, this is kind of difficult because there’s a risk spectrum here, right? If you want a really good inflation hedge, you should buy TIPS, right? TIPS are one of the few investments that exist today, treasury inflation-linked securities that provide a guaranteed return plus an inflation hedge. The problem is, is that there’s no risk premium there beyond effectively inflation. So, they might keep pace with inflation, but long term, you might be better off investing in equities.

And so, to me, the key is allocating part of the portfolio to these real assets. And so, that would include TIPS. It would include maybe commodities, maybe real estate, but also equities and more traditional asset classes, because I think that if you look at– so I just had some research come out and looks at, how do different investments do over different time horizon? So, there’s lots of ways that, I’m a portfolio manager, you can build portfolios. You run these kind of fancy optimization routines. We generally assume in these models is that returns are effectively independent or random over time, right?

So, the return of the stock market last year is not related to the stock market next year. That’s actually not true, right? Stock markets kind of move in a cyclical way. They go up and they go down. They go up and they go down. And one thing, if you see, if you look at historical data, is that certain asset classes become more attractive inflation hedges the longer that you hold them. And so, I won’t get too into the research, but I think to me, what the key, for retirees especially, is a very well-diversified portfolio with explicit allocations to asset classes like TIPS to commodities to real estate, maybe infrastructure, because those asset classes, they aren’t going to be as efficient for someone who’s in accumulation.

Because when you’re young, your human capital, which is your ability to go out and work is your most effective inflation hedge. But as you age and you deplete your human capital, you often need different investments in your portfolio to kind of think how it will most effectively help you accomplish your goal. And so, I wouldn’t lean all into equities, I wouldn’t lean all of the TIPS. I think it really does take a diversified portfolio that’s thoughtful to address inflation risk.

Casey Weade: What I feel that people should take away from this is build a strategy that’s based on a conservative inflation rate and then set assets aside that can be there to hedge the risk that inflation’s higher than you expect it to be. And I appreciate that. And I think that’s going to be very valuable to a lot of folks. Now, let’s shift our focus specifically to interest rates.

And now, we’re in a higher interest rate in period. And we’re seeing a lot of folks that are coming in and saying, “Hey, I’ve got these CDs, they’re coming due, or interest rates. I’m not getting the same interest rate I was getting 12 months ago. What should I do?” Is now the time, I guess, and you can take this and even discuss kind of the future of interest rates and how you see interest rates changing here over the next, say, 5 to 10 years, but I think people are asking themselves, should I start locking in these interest rates for a longer period of time? I was going in the bank and getting a 6-month, 12-month CD that was paying 5%, 5.5%. Now, as interest rate is coming down a little bit, should I be locking these funds at higher interest rates for 5, 10, 15, even 20 years?

David Blanchett: Yeah, I mean, I think it’s really difficult to predict where rates are headed, right? I think last year’s a great example. Early in the year, there was significant predictions about rate cuts. We didn’t see those materialize. But I think there’s still one or two more rate cuts forecasted in 2025. But that could all change, right? If inflation becomes an issue because of tariffs, whatever else that happened, we could see interest rates rise.

And I think that one thing that is still kind of novel today is this high interest rates that you can get on cash. That’s not historically– hasn’t lasted very long. And so, I understand why some investors may want to lean more into cash today, but typically, what’s happened is when we get a more normal yield curve and you’re seeing cash returning 2% to 3% less in intermediate bonds, that happens pretty quick.

And so, again, I don’t know where things are headed. I think we could have rates go way up or way down in a year or two, a lot of variability right now, I think. And I think that’s why kind of locking it in to at least part of the portfolio into something that’s more intermediate or long term in nature is just a smart play. Like, yes, it’d be great if you could earn 5% on cash forever. Probably not going to happen.

And when interest rates move, the cost of the move, if or when they decline, especially for cash, can be pretty significant long term. So, I’m not a big fan of market timing. I think, things were different when the curve was more inverted. Now, we’ve seen more of a normalization. I do believe kind of addressing what you’re doing with your cash is really important because if rates fall, there could be a pretty big opportunity cost.

Casey Weade: Well, and I think most retirees, I mean, and traditionally, my grandparents would have said, “Well, I’m going to buy a five-year CD then.” So, we go out and buy a CD. What is the best way, if we’re thinking, yes, I do want to lock in some of the current interest rates on my cash at a higher rate of return, do we look at CDs? Do we look at annuities? Do we look at bonds? What are the best tools to do so?

David Blanchett: I mean, I think it depends upon on everyone’s unique situation. So, I think that CDs can be great if you can get a good rate. There’s an annuity that’s called a MYGA, a multi-year guaranteed annuity. It’s like a CD that offers a guaranteed rate for a fixed term. Those can be attractive. Just your more traditional core bond funds, I think, can work as well.

So, I don’t know that I have a strong preference. I think that things like taxes can be really important. So, for example, if I’m going to own this in a taxable account and I have a relatively high income, well, an annuity that offers a guaranteed return might be more attractive because I don’t have to pay tax on that gain every single year.

If it’s in a qualified account like an IRA or 401(k), maybe just a more traditional core bond fund could be fine too. So, I don’t know that I have kind of a strong preference about where individuals get that fixed exposure. It really depends upon their overall situation, their preferences, their tax situation, etc.

Casey Weade: Now, there was an article you wrote in February of last year. So, almost exactly 12 months ago, it was exactly 12 months ago. You had an article in Kiplinger and you expressed that in comparison to cash yields, cash yields were, I think, higher than they were today. And you said equities are still a better long-term bet. And I look at that and I said, isn’t it kind of– well, when you think about that, I just think it’s hard for people to justify still, to allocate to equities when they can– the risk premium isn’t there, right? They go, well, when interest rates were 1%, then I was looking at long-term averages of equities at 7% to 10%. Yeah, I’m better off in equities. If I can get a risk free 4% to 6%, then well, is it really worth allocating equities for another 1% to 2%? How do you think about that?

David Blanchett: So, I think 2024 is a great example. But if you looked at market predictions, Jan 1, 2024, I think most people had S&P like flat or down, right? S&P was up 25%. And so, it cannot do that forever, right? That’s just not realistic, I mean, maybe it could happen, I don’t know. But I think the key is understanding your risk tolerance and maintaining that diversified exposure. I think what we’ve all seen is someone is convinced that the market is due for a crash and they exit too early and they miss years like 2024, and then...

Casey Weade: Or they look at it and they’ve got 80% inequities and they go, I’m going to go ahead and set 20% aside in fixed income because I’m making– it’s only 2% difference because I’m making 5%.

David Blanchett: And so, I think to me, like that’s where diversification is so important for retirees. I really like, I don’t want to say like 50/50 is right for everyone, but like a really well, I mean, the diversification matters the most in retirement. And so, I do think that having equities is really important as a long-term structural inflation hedge. And so, equities do become– the risk of equities actually declines in relative terms the longer that you hold them because of the cyclical nature of market.

So, if you can stay invested for a 5 or 10-year time period, equities become relatively safe or safe-ish compared to fixed income. The problem becomes, if you’re going to trade out of the market, if you’re going to react to market volatility, or if you need the money, then it becomes more of a no-brainer. Yes, you should invest most or all of your money in cash or bonds. But I do think that retirement is an unknown period that could last 30 or more years. And so, having equities, I think, is a really good kind of long-term hedge against longevity risk and its inflation risk, things like that. So, I wouldn’t go overboard because a lot of people have a hard time with the volatility, but I do think maintaining, especially if you’re a younger retiree, half-ish of your portfolio in equities is a smart long-term play.

Casey Weade: Do you think that today, given a much tighter risk premium than we had in the past, yeah, I mean, combine that with market valuations that have been sustained, do you expect that that will impact at least near-term future equity returns?

David Blanchett: Yeah, I think everyone does. If you look at– I love to look at capital market assumptions, we do them at PGIM, other asset managers create them, they are probably at or near their lowest, they’ve been in an awful long time, right? Again, like I think there was the expectation in 2014, the markets wouldn’t do well. They did quite well.

And I think that when you kind of factor all this in and just suggest that valuations are really high. So, I mean it’s very possible that tomorrow or next week, we enter a massive bear market that markets go down 50%. I think it’s also possible that our economy booms and we see more years of plus 25%. And so, I think that to me, the key is looking myself in the mirror if I’m a retiree doing an honest assessment, hey, like how much can I afford to lose here before I start to panic? And that should have a big impact on the portfolio because I have done research.

And what I have found is that older retirees, without a doubt, or older Americans react the most to market volatility. I’ve looked at multiple market cycles, multiple groups of investors, participants, and overwhelmingly, older Americans respond more to volatility. I think that’s because, like the impact of the drop is a lot more silly. if I’m 40 years old, my portfolio goes down, it’s like, whatever, it’s for retirement. I don’t need it. But I think that people, the older risk more when they’re older. And so, that’s why being all in equities might sound great, but if you can’t sleep at night and you’re worried about it, then it’s not the right portfolio for you.

Casey Weade: Let’s shift a little bit over to the 4% rule, because there was some recent research that you did at PGIM regarding the validity of the 4% rule. You found that the 5% might be a better starting place. And that’s changed so much over the last 5 to 10 years. It was 2.5%, then it was 3.5%, and some people said it was 1.5%. And now, you have research saying, well, it’s 5% today.

And I think that’s hard for retirees to go, how do I plan for this when it’s always in flux? Like, when it was, and are you saying, I guess this part of this research is probably where we need to go first, when you say it’s 5% today, is that a factor of retiree spending patterns or is that a factor of current interest rates? Or is that a combination of the two?

David Blanchett: It’s a factor of that and a holistic retiree balance sheet. And so, maybe just to define terms, right, the 4% rule came out over 30 years ago, research by Bill Bengen. And all it really tells you is, when you retire, if you were going to assume a 30-year retirement period, you can take out 4% in the first year of retirement and then increase the amount every year by inflation. Okay? What I’ve been looking at more is what are the assumptions that we used to determine that?

And so, for example, the 4% rule, in most retirement financial planning calculators, use success rates as the outcome metric. Okay? Success rates, how it works is what you’ll do is you do what’s called a Monte Carlo simulation. You’ll just kind of treat some variable like market returns as random, because we don’t know what’s going to happen to markets. Okay?

And then what it does is it looks at, did I accomplish my goal in its entirety? And if so, I will kind of assume that that’s a one, like, you got that amount. If not, if you don’t accomplish the goal in its entirety, it’s a zero, okay? And the success rate is the percentage of runs or trials that you accomplish your goal. A huge problem with success rates as an outcomes metric is you could fall a dollar short in the 35th year of retirement, and it would suggest that you failed, right? And that’s not a failure.

And so, when we think about how we define outcomes, it can have a huge impact on what we do, right? In reality, what we need to think about is, well, what is the actual impact on a retiree if they have to make a change? And in that context, let’s think about the holistic balance sheet, there’s the assets and the liability. Okay? We think about funding retirement. Households have guaranteed lifetime income, probably Social Security, maybe a DB plan, public pension, whatever. And they have their savings, so their 401(k), their IRA.

The liability is this idea of essential expenses and then flexible expenses. If you mash those together, think about the role of the portfolio, we actually talked about this earlier. The role of the portfolio for most retirees is to fund more flexible expenses, things that they’re more okay to cut back on. So, we think about the role of the portfolio, how we quantify outcomes, what we’re doing here, I think that 4% is overly conservative. It’s resulting in outcomes that overwhelmingly suggest that you could spend more than initially.

But there are lots of important variables here. Like, how flexible are you as a retiree cutting back on your spending? What is your existing amount of guaranteed lifetime income? But if you mash all this together and build a better kind of way to think about, how do we feel about accomplishing goals? What does it mean to cut back? I think that 5% today is a better starting place. Now, the idea behind that, though, is that you’re going to come back every year and reassess what that number should be, right? Because here, it could go to 5.5%, if all of a sudden, interest rates go way up and valuations improve, it’ll go up. It could also go down.

But to me, 5% is just kind of like generalized average. So, the average retiree, given their average situation, that’s a good place to start. But now, there are going to be some retirees that don’t have a lot of guaranteed lifetime income, that have a lot of flexibility, where 4% is the right number for them, the key is kind of understanding where you sit in terms of your situation, and then picking the right withdrawal rate based upon what’s best for him.

Casey Weade: In general, I think, the application of the 4% rule is a rule of thumb for those that are a ways out from retirement, at least 10 years. Now, 20, 30 years out, 40 years out, been trying to figure out how much you should save, then 4% is a great starting point. Are you suggesting that even those that are really far out from retirement should start thinking more about 5% instead of 4%, and the 5% just becomes a universal standard?

David Blanchett: I do, I mean, I think so, again, like it really should have been called the 25 times rule. So, some quick math, 1 divided by 4% is 25. And that’s really all it tells you is how much you have to have saved in the first year of retirement. The 4% only applies to the year one withdrawal. That amount is then increased by inflation.

So, after the first year, the percentage becomes irrelevant. Okay, it really should have been called like the 25 times rule, where whatever income you need to generate from your savings that you don’t get from Social Security, you need 25 times that value. I think that 20 times the value is probably a more realistic starting place. But I fully acknowledge that that’s going to change over time. And then it’s really hard to kind of think, oh, I’m going to exactly hit my savings goal at age 65. People tend to retire early. A lot of things happen.

But if you look at the range of recommendations out there, you see withdrawal rate recommendations between like 2% and 8%. I think 2% is way too conservative. If you do 2%, there’s a really, really good chance you can have a massive pot of money when you die. I guess that’s okay if that’s your goal. If you use 8%, there’s a really good chance you have to cut back significantly during retirement. To me, 5% is this kind of better balance.

And again, like the key, like what’s the deal between 4% or 5%? Well, I think what’s really important is, is where we start when we first retire kind of begins this trajectory that we go down. Like, those initial spending amounts become kind of sticky over time. So, people kind of get used to a certain lifestyle. What I want to do is kind of balance this need to possibly cut back if they need to and enjoy as much as they can today.

Casey Weade: A couple of things there, and one is, I think for those that started retirement years ago, maybe you’re using a 2% or 3% withdrawal approach, make sure you’re readjusting and reassessing where you stand every single year and changing that number potentially. Also, another thing you mentioned there was having flexibility in our spending in retirement. And there’s just been kind of a proliferation of income strategies, I feel like, especially over the last five years.

I mean, when I started, it was the 4% rule. And then there was kind of this bucket approach that kind of came into play. And now, there’s a litany of other types of strategies we could be using. And I think it gets a little bit overwhelming. One of those is the kind of a flexible spending approach. You have guidance, kind of guardrails. And you just kind of said something there that I don’t want to get overlooked. You said people get used to a certain level of spending.

So, if you’re pulling $40,000 out of your portfolio, you’re probably not going to adjust that. I think the things we define as discretionary become not so discretionary when rubber meets the road. Yeah, I’m going on that vacation with the kids. I’m keeping the country club membership. And so, that’s where I kind of struggle with the guardrail approach, saying, oh, well, we’ll just adjust your spending by $5,000 this year and you’re going to spend less this year. And in practice, in reality, I mean, I don’t know that that strategies had to make much in the way of adjustments since it’s come to be. What’s going to happen when people that are on the strategy all of a sudden get hit with this reality that this was a strategy you chose, now you’re going to have to take a pay cut?

David Blanchett: So, I think, realistically, no matter what you do, you’re going to apply guardrail to whether you take out 3% and it becomes $1 million, that’s $30,000 a year, or it’s $80,000 a year, right? In theory, you’re going to guardrail. To me, what I “worry” about, and you can use air quotes about worry, is that like, if you picked $30,000, you picked 3%, there’s a really good chance that you could guardrail up every single year. And so, maybe they all end up at a similar place, the $80,000 end up dropping significantly to, say, $60,000. The 30 makes it way up to 60.

Well, you didn’t do a lot of the things that you could have done when you first retire. So, I mean, I think that there’s this implicit assumption that you’re going to make dynamic adjustment to some extent. To me, it’s balancing, how much can you spend when you first retire, knowing that you don’t want to cut back unless you have to, but you also want to do as much as you possibly can. So, to me, those are all kind of things that we’re balancing.

And that’s where I do think that 5% is just a more realistic starting point because a huge problem with the 4% rule is it assumes that if you fall a penny short, you’re like destitute. Well, like every American effectively has guaranteed lifetime income. So, even if your portfolio went to zero, you’d still have something. And realistically, you’re going to make dynamic adjustments over time. So, to me, this is about kind of finding a better starting point for retirement than just saying 4% is the number for everyone. It’s not. I think it’s probably a bit too conservative.

Casey Weade: Well, then, let’s say we’re trying to find the right strategy at the inception of retirement and you point there were some research that you had that about 50% of retirees planned to live off portfolio income exclusively. So, is it living off dividends or living off portfolio income? Is that the guardrails approach? Is it the flooring approach? Is it the bucket approach? How does a retiree digest all this and land at the right strategy for them?

David Blanchett: I think that’s where having an advisor to kind of do a gut check every year is really important. I think a really good rule of thumb to ask yourself, like, hey, is my withdrawal rate or amount correct from a portfolio, is just to kind of go online and do a good online calculator for life expectancy? So, how long do you think you’re going to live? One divided by that number is a pretty reasonable approximation of what you should be taking out. Now, that’s the RMD rule, right?

But don’t use the government table. Use a calculator that’s based upon your situation. Use one that incorporates your health, your income, your wealth, things like that. And that’s not a terrible benchmark for what should I be taking out. So, when you first retire, your life expectancy might be 23, 24 years. Well, that suggests like a 4 and a half-ish percent withdrawal rate. That’s a good gut check because what I worry about is as you move into retirement, people have this fixation of 4%. It’s not 4% when you’re 75 years old. It could be like 7% or 8%, and that could be too high for some folks.

But to me, a gut check on spending from a portfolio is this kind of dynamic updating process. And the easiest rule of thumb, it’s called the modified RMD rule. It’s just one over some period where ideally, that period is defined based upon your kind of longevity period for retirement.

Casey Weade: So, I want to see what your strategy would be here. So, specifically, I mean we’ve talked a lot about this 4% rule or 5% rule today, but there’s lifetime guaranteed income. There’s an RMD approach. There’s dividend approach. Is this bucket approach or a flooring approach? I mean, I know we’re about the same age, but let’s say that you were about to retire tomorrow and you may be a little biased as a portfolio manager and feel free to explain that. And I carry my own bias as well. We all do. What would be your bias that would lead you to a specific strategy? And why would you choose that strategy for your own retirement?

David Blanchett: Well, I think that there’s some important things that we should all acknowledge when it comes to planning for retirement, like one is that we are going to change and things are going to happen, right? So, you could suffer cognitive issues. We could suffer from the host of issues, right? And so, within our household, I tend to take care of most of the investment stuff. And I think that, I strongly believe that most Americans should have lifetime income that is at least equivalent to their essential expenses.

So, what do you absolutely need to have covered and then get a paycheck for that? For most Americans, you can get that from delay claiming Social Security, right? For other Americans, you might need to go out and buy some kind of lifetime income annuity. There’s lots of options there. We won’t go down that road. I think what I’ll be looking at doing is delaying claiming Social– well, I guess we’re assuming as of today. Today, I would want to delay claiming as long as I possibly can, I would likely even buy more lifetime income via some product. I might even buy a longevity insurance. And then I would invest the rest.

And I mean, I’m pretty good at managing portfolios, but I also don’t have to worry about it. What if I live a long time? What if that happens to me? I want it to be easy. So, I do think there’s an important role for lifetime income, because it is this kind of ultimate easy button on retirement. That being said, like you shouldn’t probably have all of your money in lifetime income. You should have a good portion of this in a portfolio, but I think that understanding what your spending profile looks like is just so important in thinking about how to structure lifetime income versus pulling money from a portfolio.

Casey Weade: Well, that’s a great transition to your License to Spend research that you did alongside of Michael Finke, who discussed it with us briefly back in episode number 451 of the podcast. But I want to kind of revisit this from your perspective, and maybe you need to rewind, kind of define License to Spend too. Feel free to do that. As we get started, the question here is really, when annuities become a license to spend for retirees, meaning that they tend to spend twice as much every year in retirement if they hold guaranteed income versus investment wealth, is that an inherent license to spend, or them spending more in retirement, is that simply an element of them having that guaranteed income every month? Or is that an element of portfolio optimization, more optimal portfolio allocation, and that’s why you’re able to spend more?

David Blanchett: So, there’s a lot there. Like, maybe taking a step back like, for those of us that like actively research retirement income, lifetime income annuities are usually deemed to be relatively attractive, right? This collective movement in our society towards defined contribution plans, 401(k)s, 403(b)s, IRAs. I think it makes a lot of sense for companies. If I had a company, I’m not going to offer a defined benefit plan, but it’s really inefficient for every American because we have to all of a sudden plan to live to age 95, age 100, age 105.

And so, there’s like 50-plus years of research from tons of economists that have suggested that, hey, in retirement, it is much more efficient to pool longevity risks via some kind of product or strategy or solution than it is to have each individual having to worry about living a really long time in retirement. And so, if you look at the body of research team, everyone’s like, wow. Like, lifetime income annuities make a ton of economic sense. Okay?

That’s the more kind of like classical economic perspective on why allocate to lifetime income. And to be clear, that includes the likelihood of Social Security. I think the first place that every American should look when it comes to lifetime income is delay claiming Social Security, okay? It could also mean allocating savings to buy a lifetime income annuity. Okay, this new research, I’ve been with Michael, the original piece was called Guaranteed Income: A License to Spend.

We have a new piece that came out a few months ago, very much along the same lines. And what it looks at, what both these look at is how do retirees actually deploy their wealth when they retire in terms of spending? Are they more willing to spend from certain assets than others? And to be clear, like we can’t ask them questions. We can’t say like, hey, what are you doing? Well, we can’t do that. We have thousands of retirees. What we know, we know how much they have in their IRA, how much they have in their taxable account, how much they get in terms of lifetime income, capital income, and wage income.

We can run these sophisticated regressions, these mathematical models, whatever. And what we can look at is, well, how are these different assets, and assets as being defined as both is like the 401(k) balance and income sources, how do households use these different potential sources of income to actually consume in retirement? What we find is there is significant evidence that retirees are much more likely to spend lifetime income than any other income source or asset, roughly by double.

And so, for every dollar, let’s just say every dollar that they get of lifetime income, they spend about a dollar. Okay? For every dollar they get of wage income, they spend about $0.50, every dollar of capital income about $0.50. If you look at withdrawal rates from the portfolios, they’re about half of what you would even generally recommend is optimal based upon the household structure.

So, what the evidence suggests is that households are far more willing to spend lifetime income than other sources of wealth when they retire, and why? I think this is a bit different than what I’ve done before is before, I love to do these complex routines focused on, how much should you withdraw from your portfolio? Was it 5% or 4.7%? Like, whatever, okay? This is looking at actual retiree behaviors. And so, what this suggest is that not only is there kind of academic evidence for the value of lifetime income, there’s also this behavioral evidence that you’ll actually be more willing to spend money in retirement the more you have in lifetime income.

Casey Weade: One of the things that I thought about where we’re at today, in higher interest rate environment, are annuities more attractive? Is now a better time to own an annuity? Or should we be looking more towards lifetime income if we were owning annuities that weren’t lifetime income based because of higher interest rates locking in those higher interest rates that we have today? But going to an insurance news article that you had, it had a little research around the misunderstanding of annuities.

What I found interesting was that 60% of respondents in their 40s were interested in annuities, 20% of those in their 70s. And I mean, you would expect that to be inverted at the very least, I mean, typically, and I think it’s pointing to saying that the older individuals misunderstand annuities. I kind of point out that research something, sounds like younger individuals misunderstand annuities too.

David Blanchett: Well, it’s funny. If you look at those surveys, it’s kind of persistent over time. Like, if you ask people like, do you want to buy a product that provides guaranteed lifetime income? And they’ve been asking these questions for like decades. And younger people are like, “Yeah, that sounds really, really great.” Older Americans are kind of like, “Ah, I don’t want to do that.” And so, I think that that happens for a...

Casey Weade: And you’re saying that the numbers have been very persistent, right? Over time, that hasn’t shifted.

David Blanchett: There has been a slight increase among older Americans, but that’s kind of like a fact where it’s like 60% of 40-year-olds are like, “Yeah, that sounds awesome.” But only like 20% of 75-year-olds. Like those numbers, because I think, oh, well, when those 40-year-olds get older, there’s going to be this massive increase in interest. Well, no, it’s just as people have aged into it, as they age, they have the same perspective, like I don’t do that.

So, my issue is that, I understand the issue, like a lot of the products, they’re irrevocable, it’s really hard to kind of make this transfer. And so, I think there’s a possibility, like we could see some future legislation here. One thing that I kind of like is this idea, all employer contributions would need to be annuitized upon retirement or something along those lines. I think it’d be really hard to kind of make people “annuitized.” The simple ways you can do it, their savings.

But getting more Americans to allocate more of their wealth into lifetime income, which again, delay claiming Social Security, buying a lifetime income annuity, I think it would actually make, as a country, like better off because we’re going to spend more, we’re going to enjoy retirement more, things like that. So, I think there are some interesting societal issues here that we could see some legislation on eventually. But long story short, I think that the actual behavioral benefits of lifetime income are more than the economic benefit. So, even if you don’t buy the benefits of mortality pool and all that, like just the fact you don’t have to worry about what you need to spend because you’ve got income guaranteed for life, that, to me, is probably the bigger justification to consider them today.

Casey Weade: When you look at this and how it shifts, so these 40-year-old respondents, all of a sudden, they go from 60% or likely and they love the idea of getting guaranteed income, then that goes down to, I don’t know what the numbers are in their 60s, maybe it’s around 30% or something like that. Yeah, but the number is going down. Do you think that what’s happening, how I kind of think about what’s happening over that period of time is, well, they didn’t have that much when they were 45.

Now, they’re 65. And you go, “Man, I’ve got quite a bit today.” Now that they have more in assets, there’s two things that have happened. One is now, that’s kind of become part of their sense of worth, that net worth has become part of their sense of worth or their identity even. And they’ve also spent 20 years now, 20 more years focusing on accumulation. And it’s harder to shift to income.

David Blanchett: Right. And that’s why I think, we don’t have many of these products today. But again, I’ll use the word annuity generally here, like annuity is the kind of wrap portfolios that allow them to exist, like wherever you manage them. Like, we don’t have to transfer money to the internally. I think those are going to be a huge area of growth in the future, right? People want longevity protection. Advisors want to keep assets in the native custodial environment. So, I think that having solutions that kind of blend together like, yes, I’ll pay an extra 1% a year for this annuity, but I want to manage the portfolio my way and do it how I’ve been doing it, not have to move it all over to Prudential or whomever. So, I think that we are seeing more innovative products being created that will make individuals more interested in utilizing annuities as part of their retirement income strategy.

Casey Weade: That’s interesting. That’s a new one for me. And maybe this is the answer to a couple of– I’ve got a couple wrap-up questions for you. And maybe you just stated this one. But maybe you didn’t either. And so, my question as we bring things to a close is if you could change one thing about how financial planning is practiced today, what would it be?

David Blanchett: Yeah, I mean I think that like, to me, it’s somewhat siloed where we have advisors that focus their value/profitability portfolios. Other advisors just sell products. I really wish that we would all kind of come together and provide more holistic retirement income planning, right? And I have all these people randomly email me, like friends, like strangers. And usually, what happens is, is they meet with a “financial advisor.” We’ll just use air quotes there. But they’re not really an advisor. They’re selling a product. They’re building a portfolio. And it’s not really a holistic solution.

I remember one time, it was someone and it was actually a pretty good product. But my question is, to my friend, I was like, “Well, how did he determine this for you?” He’s like, “Well, he just presented this.” I’m like, “Well, even if it’s the right product, it wasn’t the right process. Like, he didn’t ask the right questions.” And so, like maybe eventually, it’ll make sense, but why would you buy something if this is most of your retirement savings and you can do a full discovery on what is your actual situation?

So, I think that, and we’re already seeing this, but I just want our industry to evolve more into more of a comprehensive financial planning/advising domain where advisors are actively using all the solutions that exist. So, they’re talking about building efficient portfolios. They’re talking about lifetime income that really help, especially retirees get the best plan for them.

Casey Weade: Absolutely. And I think we’ve been heading that way. If you rewind it back to the early 2000s, I mean, the only people that were talking about guaranteed income were those that had an insurance license only and they were selling annuities. Everything needed an annuity. And I think now, you’re seeing certified financial planner practitioners, true financial planning firms going, all of these tools are valuable. We just need to go through the right process to find what the right tools are for you and your unique situations.

I hope we’re headed in the right direction. I think we’re headed in a much better direction. And now, I have a selfish question for you. I know you have four kids. They’re about the same age as my children. And being someone that is always around the money, always thinking about finances, and we have a lot of listeners that have grandkids, a lot of listeners have kids, and they want to know, what are some things that I can do to ensure that my children are going to be equipped financially in order to operate in this world? What are some unique things or methods or strategies that you use with your kids to ensure that they’re on that right path?

David Blanchett: Well, so my kids are between the ages of, effectively, like 6 and 12. So, I guess I’m doing things that I think will help them, but it’s far too early in the game to see if it’s actually going to work out. So, that question will be better served to ask parents that have older kids. I mean, I think what we’re trying to do is make them very aware of what things cost, what an allowance is, what they want to spend money on. And I’m not making them save money for retirement today. It’s just more kind of general awareness around the importance of saving, what you’re spending on, things like that.

So, to the extent that we’re successful, we’ll see. I do have some more kind of colorful initiatives planned in the future about saving money to buy a car, like how we’re going to kind of split the cost of college. But that’s a few years away, so.

Casey Weade: Well, if we continue to do this every six years, the next time we get together, you’ll have an 18-year-old, we’ll see how it worked out.

David Blanchett: Perfect.

Casey Weade: David, thanks so much. I know that there’s so many, they’re going to find value in this conversation, and I look forward to doing it again. Hopefully, we shorten up the time between interviews.

David Blanchett: Yep. This is great.

Casey Weade: We’ll see you, my friend.

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