David blanchett casey weade David blanchett casey weade
Podcast 55

055: How to Navigate The Changing Retirement Landscape with David Blanchett *

Lots of retirement research comes from people who are trying to sell you products, but David Blanchett is not that kind of researcher. A CFP, CFA, and PhD, David is Adjunct Professor of wealth management at The American College of Financial Services, a leading contributor to the Wealth Management Certified Professional® (WMCP®) designation program, and the head of retirement research for Morningstar Investment Management, LLC.

For his authentic, impartial research, David has been called one of the brightest minds in financial planning by Money. He made InvestmentNews’ inaugural 40 under 40 list in 2014 and has had his work featured in the New York Times, PLANSPONSOR, and the Wall Street Journal, among many others.

I’ve been following David’s research and sharing it with colleagues and clients for years. Today, he joins the podcast to discuss the uncertainties that can set a financial plan awry, how to build a plan to protect you from the worst case scenario, and why changes in life expectancy have done more to reshape retirement planning than anything else in recent American history.

In this podcast interview, you’ll learn:

  • Why people who are about to retire are so concerned about inflation – and how financial planners and pre-retirees should incorporate inflation into their plans.
  • Why healthcare shocks – and not healthcare costs – are the problem – and why there isn’t an easy way to hedge the risk of healthcare costs in retirement.
  • The importance of saving more – and why market outcomes are far less important to plan for than potentially having to retire several years before you plan to.
  • The reason David doesn’t completely hate annuities – and why annuities have gotten such a bad name.
  • Why David believes that many active investments are actually passive ones – and the importance of knowing what you’re buying and why you’re buying it.
  • The reason David said Roth 401(k)s are bad for so many retirees – and why he now recommends a mixture of traditional and Roth assets for most people.

Inspiring Quotes

“I think figuring out what that next step means and how you’re going to spend it is incredibly important. It’s worth thinking about for many, many years.” – David Blanchett

Interview Resources

Estimating the True Cost of Retirement
The Retirement Mirage

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Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results expressed or implied.
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Read Full Transcript


Casey: David, welcome to the podcast.

David: Thanks for having me.

Casey: Really excited to have you. We have been utilizing your research here in our office and in my practice for years. I have talked about your research on our television show. I’ve illustrated it to clients and on radio. We've talked about it on the podcast. I’ve written about in different books. I'm such a big fan of the way that you authentically and impartially are able to do this research and share it with the world. Many times a lot of the research says that people are receiving are coming from people that want to sell them something. You don't have anything to sell them. You're just doing it because you're truly interested in it. So interested in it that you've done some of the most extensive education you possibly could for your very self in getting to where you're at, whether it's CFP, CFA, getting your PhD as well. I know that you're a PhD. You've got a PhD in financial planning. I read in your 40 under 40 that you were always interested in the field of financial planning, wanted to be a financial advisor from a young age. Is that true?

David: That is. It's an interesting goal in life to be in the financial planning field. I don't know what it was. When I was in high school I got a subscription to Fortune. I had a mini mutual fund. I convinced two of my friends and three of my parents' friends to give me money and I invested it. At a young age I always liked the profession. I actually passed the CFP exam when I was 21 years old. I always loved the idea of helping folks make better choices. I think that my parents were both teachers. They didn't get the best financial advice. Seeing the power of financial planning really motivated me to embrace the profession.

Casey: Were you ever actually in the field of offering people financial advice as a profession, or have you always been in this research field? Is that really where you wanted to be?

David: I make the joke that I've been climbing the Ivory Tower now for about 20 years. My very first job actually was I sold insurance for Northwestern Mutual in college for three years. I would cold call. I would do all this kind of stuff. After that I actually did financial planning for individuals for a number of years. That was enjoyable but I always was asking questions about “Does this make sense? Is this the right thing to do?” I started doing more and more research. The more research I've done the more I wanted to kind of build what I would say are solutions for other planners or other retirees at scale versus the individual advice.

Casey: Do you ever miss sitting down one on one with those consultations and actually helping people one on one? Or are you able to do things on such a bigger scale now that that's more fulfilling?

David: I still get some of that informally. Unfortunately, people that I know know that I'm kind of good at financial planning so I get the opportunity to help them for free. I do get a lot of great discussions with academics, with individuals that work at a variety of financial planning firms. I guess I'm engaged in a different way. I still get some of the taste of helping individuals make better choices, but at the same time what are truly best practices for helping someone accomplish their goal? I like living in both worlds. I really do, at the end of the day, like the at-scale perspective of building tools that lots of folks can use versus helping someone individually. That's obviously where things actually matter. I hope that a lot of the stuff that I'm doing makes sense for individuals and planners. I think that it does. I get that refresh all the time with interactions with other academics, planners et cetera.

Casey: I'm just one of probably tens of thousands of advisors that follow your research and share it with their clients, share it with the world. I know I've probably shared your research with thousands of people over the years. There's one piece of research that I want to dig into a little bit further because it's one that seems to come up in almost every single meeting that I've ever had with a prospective client as we're building their retirement plan. There's a lot of concern about inflation.

People are concerned about what inflation's going to do over time. They question, “Should we be using 1%? 5%?” Inflation rates in the past have been double digits. They feel that there's a bit of this money that's been printed off at these printing presses that reserve banks around the world and they go, “What's that going to look like and what's that going to do with my purchasing power over time?” I often go back to a study that you did on retirement spending. That was titled Estimating the True Cost of Retirement. Can you tell us a little bit about that research and how it came about?

David: Sure. I always like to make the point that retirement is the most expensive purchase you're ever going to make. As much as your fancy new iPhone, your nice new car, your fancy home costs, retirement is over a million dollars. It really makes sense to think about the assumptions that we use to figure out the cost of retirement. With that research I actually used a data set called the health and retirement study that tracks individuals throughout retirement, so over time.

One of the really unique things that came out of that was this idea that retirees actually don't tend to increase their spending every year with inflation. They tend to spend a little bit less of inflation every year, especially households that a lot of their spending is discretionary items. I think what happens there is a variety of things. Effectively, as you grow older on average you care less about things. You’re less likely to travel. You don't spend that much on clothing et cetera. You actually tend to spend about 1% less of inflation on average as you age. If you think inflation is going to be 3% a year, the average retiree spends about 2% more per year, which is 1% less than inflation, throughout retirement. There's obviously exceptions to the rule. Health is a big issue we can talk about, but most people actually don't increase their spending every year by inflation.

Casey: I can attest to that because we've been working with clients since the late ‘90s. I've got families that we've worked with for the last 20 years that are spending less today than they did 20 years ago. That's really counterintuitive. If you just say, “It's a 3% inflation rate,” they should be spending well more than 60% more today than they spent 20 years ago. It just doesn't seem to be the way things work out. However, you always want to play defense against these things that you can't control. I take a look at your research and I say, “Okay, it looks like maybe we should factor in really a 1% inflation rate.” Or, “Maybe we need to analyze each one of the individual expenses that you're going to have and put different inflation rates on each one of those things and maybe reduce one of those things over time.”

How do you think financial planners and pre-retirees should go about incorporating inflation planning into their overall plan? Should they use a flat inflation rate? Should they analyze things individually?

David: Here's a few things. First off, whenever I've done a webinar with individuals where I can do polling questions I’ll often ask, “What should we assume your spending in changes in retirement? It will grow faster than inflation, it grows with inflation or less than inflation.” Most people want to say, “It grows faster than inflation.” Healthcare costs are a really big deal. You’ve really got to ramp things up.

To me this is a hold-off on that thought. Let's actually think about it a bit differently. We still actually use inflation as the base estimate for the change in spending in retirement for some of our models. There's a few different reasons for that. To me, what this does or should do is give you alternative perspective. You can assume inflation is the primary scenario. You should say, “Hey, wait a minute. We know that a lot of people that retire don't actually increase their spending with inflation. Let's do another scenario that’s probably more representative of what's likely to happen.” Assume that you spend 1% less in today's dollars every year in retirement. What does that mean for what you have to save for retirement? To me this is more about scenario planning versus kind of a single hard and fast rule.

Casey: Okay. If we're going through these different scenarios obviously, as you said, healthcare is going to come up a lot. When you mentioned that healthcare expenses are one of the biggest concerns… I've heard it's the number one concern of retirees, the number two concern of retirees. What effect does the increase in annual cost of healthcare have on overall spending for the average retiree?

David: For most people healthcare is actually not that big of a deal. Let me explain for…

Casey: Yeah, you’ve just got a bunch of people to this guy, “I’m not going to listen to this guy anymore.”

David: Hold on. For the average 65-year-old household they devote about 10% of total spending to healthcare costs. The average 85-year-old household it's only about 20% to healthcare. The thing about healthcare that is scary is a few things. One, you've got Medicare premiums increasing rapidly. You've got general health expenses increasing considerably. To me, the scary thing with healthcare is what I would call a health shock. It’s “I need to go to the nursing home and it costs $100,000 a year or three or four years.” Most people though don't experience those. Healthcare for most people is a risk that won't be realized. It's not something that you can really easily plan for because, again, most folks don't have significant health expenses but those that do it can be overwhelming.

I think that healthcare isn't a normal kind of risk in that I know not everyone's going to have health shock, but those that do it's really big deal. There's not really a good way to solve the problem. People say, “Long term care insurance.” Of course long term care insurance, but it's becoming incredibly expensive. A lot of folks can't get it. There's not really an easy way to hedge out the risk of having that healthcare shock at some point in retirement.

Casey: It might not be easy to necessarily figure it out, but as we're putting together our strategy you said healthcare shocks are the problem. That's not necessarily the rising cost of healthcare itself because you've got good coverage for that. If we make sure we get good Medicare coverage, get good supplement, get a good drug plan and incorporated a long term care strategy now at least we can hedge against those healthcare shocks assuming we can afford the basic healthcare, the long term care incorporated into the plan. A lot of people are just going to have to take some risks. I guess that's the thing about retirement planning. It's imperfect. Everyone wants to go into retirement saying, “I’ve got all of my bases covered,” but it's really impossible to absolutely know you have everything figured out, right?

David: Right. I'm a research guy. I run all these simulations. I'll do a 5,000 run simulation and I’ll feel really good about myself. You only get one chance at retirement. When it's just your retirement lots of things can happen. That's why I don't know that … Financial plans are incredibly useful for clients but so many things can happen that really cause them to break down or fail. Health is one example.

There's other things that can happen too. The best financial plan can go awry if you retire three years early. There are so many uncertainties in life that we have to think about, but it's hard to plan for unless they happen. I need to be aware of what happens, so “If I retire early what does this mean for my spending?” If you actually do retire early that could be really bad. I think that a good plan you’ve acknowledged the possibilities, but you can't possibly plan for all of them.

Casey: Jumping to that talk about potentially retiring early. You had written and did a study titled The Retirement Mirage that had to do with it. It said why investors should focus less on timing and more on saving. You focused on a study in there. There was a study listed. The EBRI states that nearly half, 47%, of current retirees were forced into early retirement. That's a huge number. 47% of current retirees forced into early retirement. You went on to say this may be the case, but retirement plans are often wrong and a number of Americans retire earlier than they plan to wreaking havoc on finances. Someone who expects to retire at 65 may be more likely to actually retire at 63 and the impact can be severe.

David: Yeah, it’s kind of depressing. What's funny is a lot of people aren't very good savers. America as a whole are pretty terrible savers. People always say, “I'll make it up at the end. Maybe I'll work a few years extra. I'll save a bit more.” In reality, that's not going to happen for a lot of people. In reality, a lot of folks retire because they have a health issue, because their spouse has a health issue, because they lose their job. The implication is kind of dire. The only thing you can really do to protect against that is to save more, unless you're willing to live off less in retirement. A lot of financial planners talk about rate of returns. “We're going to account for different market outcomes and scenarios.” From my perspective, a much more real outcome that's more likely, that’s more severe is “What if I retire a lot earlier than I expect?” You just need to be aware of the implications if that actually does come to pass.

Casey: The implications for savers I think are very clear. You just need to save as much as you can because… That was something my dad always instilled in me. He said, “You may lose everything tomorrow. You may lose your house tomorrow.” Everything can change in a moment and you have to be prepared for that. Don't think that you're going to continue to earn X amount for the rest of your life because anything can happen. For someone that's getting close to retirement, say they're five years out from retirement. I sit down with families all the time. We just had a couple in here the other day. They're now three years out from their planned retirement date. They came in and started working with us three years ago.

When we first sat down I put together a plan assuming they would retire the year they came in to visit with us. They said, “We're not going to retire for six years.” I said, “Yeah, but you don't know that.” Is that what we should do when we look at retirement plans is go ahead…? If we're within, say, f5-10 years of retirement let's just assume an earlier date prior to that date that is maybe our goal date. How much earlier do we actually plan on that occurring? Is it right here, right now what are we going to do? Or is it two or three years less?

David: There's no one kind of easy answer. I think that one benefit that you have as you approach retirement is you approach certainty. I'm 37 years old. I have so many unknowns ahead of me. I've got hopefully 30 years until retirement. I'm making assumptions today about how much I have to save based upon that retirement date. As I move closer and closer to retirement I'm going to have a better idea of where things stand. Even someone that is five years away from retirement can still have that unfortunate shock where they could say, “Okay, I'm going to retire in five years. Things are looking good.” In two years they get laid off and they can’t return to work at all.

One thing I found in that research is that a good approximation is the average person retires a half a year early for every one year past age 61. If you say you’re going to retire at 65 you're going to retire- that's four years past age 61- about two years earlier than you expect to on average. Again, I really hope that people can make it there but the EBRI statistics pretty clearly show that actually in the data that they looked at about half of the people retire early. It's true that some folks retire late but that's an anomaly. If I had to guess, a lot of the folks that are retiring later it’s because they have to, not because they want to.

Casey: Yeah. Actually that couple that I spoke about we had originally planned for a six year retirement. Now what's happened is he's struggling with some psychological issues. Stress. Also the work has changed. They've put him in a different position. He doesn't like his new position and it kind of feels like they're pushing him out. He said, “I don't know if I can physically take it much longer.” Now we're planning on retiring about a year from now. That's two years earlier than his planned retirement date is where we're actually ultimately going to land.

That's why I always encourage people to plan for the worst case scenario. A lot of those worst case scenarios that you've tested over time have had to do with really the longevity of retirement. The safety in income strategies. This is something that's been talked about in research extensively since the late ‘70s, early ‘80s when retirement really came to be a thing. A lot of that talk has been about safe withdrawal rates. How much can we safely withdraw from a retirement portfolio and expect it to last a lifetime? I love your research in this world. You've also done a lot of this research in conjunction with another one of our guests, Dr. Wade Pfau. We might actually think about these things a little differently now that we've got the other half of the brain here.

One of the things I want to go back to though is when we talk about safe withdrawal rates. I wonder how your research on the true cost of retirement… The research on how retirees are actually spending once we factor in inflation and their decreases in spending over time, how did that affect safe withdrawal rates, and assumptions that are used in planning, and the way retirement planners are planning today?

David: It definitely bumps that up. I think that the piece that you mentioned earlier, the true cost of retirement. The goal of that was to question a lot of these fundamental assumptions we use when you’re figuring out how much you have to save for retirement or the inverse, the safe withdrawal rate. One example of a common assumption is that you increase your spending every year by inflation. If you don't increase your spending by inflation it reduces the money you have to save for retirement. Thinking about things like safe withdrawal rates, I think that there's a lot of interesting research out there but I think a lot of it is somewhat misguided for at least two reasons.

One are the key assumptions about, for example, returns. What do you assume the markets will earn in the future? I think that most researchers use historical long term averages. That's incredibly problematic because while bond yields have risen recently, we're still really low by historical standards. The U.S. historical returns are better than almost any country in the world for the last 115 years. I'd love for the good times to continue. I just don't know that they are.

The second thing is the metrics we use to quantify an outcome. A common metric that's used by advisers is what's called the probability of success. It's a pretty good first approximation of what is a good or bad event? You just run a bunch of scenarios and you figure out what percent of the time does someone accomplish what they're trying to do? I want $50,000 a year for 30 years. In this simulation how often do I achieve that goal? The problem with that metric is it ignores the magnitude of failure. It treats going broke in year two as the same as going broke in year 30. I think that when you tack on things like guaranteed income in the ability of retirees to make adjustments and everything else. I think that a lot of talk about safe withdrawal rates are probably a bit conservative. You probably take out more money because you can make an adjustment if you have to. You have this kind of base level of income.

It's a really, really complex problem. It would be a 100,000 word paper to even tackle part of it. We take away at these pieces, but there's so much to think about that it’s really hard to put it all together in one great piece of research.

Casey: One part of this, what you're saying is that we're focusing on how much we can safely withdraw when we put together these retirement plans, run different simulations. We're looking at historical returns of bonds and stocks. Now with interest rates near all-time lows we've got stock market valuations near all-time highs. We say, “Can we really expect those returns over the next 30 years?” It might make sense to incorporate a different type of strategy versus this static withdrawal rate, I think as you referred to it in your papers, which is “Let's start at 4%.We'll adjust it for inflation every year.” Let's assume that it's more dynamic. There's this dynamic withdrawal strategy, a static withdrawal strategy. You could also incorporate a guaranteed withdrawal strategy in there. Let's talk about the difference between a dynamic and a static withdrawal rate. What's the difference there?

David: Sure. A static is what we assume in research. Dynamic is what happens in real life. For better or for worse, we have a lot faster computers today than we had, say, 20 or 30 years ago. A lot of financial plans and models assume that you make decisions at retirement and then you follow those decisions with some kind of basic adjustment for the duration of retirement. I take out $50,000 when I retire. That amount is increased by, say, inflation every year for 30 years. That's a static model. A dynamic model is what will actually happen in real life. Where I take out a certain amount when I first retire and then next year I come back and I ask the question, “How am I doing? Is this sustainable?” Then I make adjustments.

I think that static models tell us a lot about what is safe but they don't reflect reality. I know that some people have expenses that they can't change. It's a nondiscretionary expense. For most people you can make changes over time. I think that over the last decade or so there's been what I would call better research exploring our savings levels based upon this idea that, hey, people can make changes over time. How do you make those changes and how does it affect that initial withdrawal decision?

Casey: When you talk about dynamic we're talking about taking a look and revisiting the retirement plan every single year and saying, “Okay, I did well last year so I can increase my withdrawal this year.” Or, “I didn't do real well last year. Let me go ahead and reduce that withdrawal rate for the next year.” Right?

David: Yeah. I think fundamentally this is what a financial planner should be doing. The danger of retirees if left to their own devices is they're going to take some amount of money out and then just keep doing that for some period of time. A really important value of advice is telling someone, “Hey, wait a minute. I know that you want this much money but this is the implications of that.” I spend all this time doing research and modeling and the goal of all this is just to form expectations. “Mr. or Mrs. Client, you can do whatever you want but I'm here to let you know that this is probably a better path to take. If you don't do what my recommendations suggest this is where things could end up.” I think where the biggest disconnects are is when someone doesn't understand the implications of what they're doing. I think that advisors help bridge that gap and help them understand, “Hey, if you keep doing this, this is the implications of that.”

Casey: I think this goes along the lines of what we call our flexible withdrawal strategy. When we implement a plan we're going to take a look at it every year and try to figure out periodically where should we be taking our withdrawals from, and separating things out into both paychecks and play checks. Making sure that those paychecks, those nondiscretionary expenses, that income that we have to have every single year is going to be there forever. Then we accept some flexibility or a dynamic approach with those discretionary expenses. Is that an approach that you're advocating here?

David: Yeah. I think that in reality there's all these different types of buckets people use to think about spending. There's needs, wants and wishes. There's discretionary and nondiscretionary. Fundamentally retirees usually have some amount that they want to have every year. I think you call it a paycheck. Then there's some amount they can choose to adjust over time. That's the play check. I think that the problem with a lot of research is it assumes that all spending is effectively the paycheck. That it’s not adjustable over time. Anyone that's worked with people know that that's not usually the case. That we all have different levels of adjustments we can make if we have to. The key is the ability to make those changes has a huge impact on what that safe withdrawal amount or rate is when you first retire.

Casey: One of the things that I push back on in this realm sometimes when we talk about paychecks and play checks is I find when a retiree, especially in those first 5 or 10 years they just stepped into retirement and they want to go on vacation next year. Maybe the market has been real good. They shouldn't take that distribution to say, “Hey, I'm going. I have to. I've earned it. I'm going no matter what.” I think we have to exercise some caution as well in saying, “Okay, these are our play checks.” I think a lot of those what we think of as discretionary expenses while we're working become nondiscretionary psychologically during retirement.

David: I would say, “Okay, you can take the vacation, but here's the thing. The markets have to behave themselves for the next five years for you to keep doing that. You can do it, but just know that there's implications down the road of doing so.” I'd be hesitant to tell someone no based upon, again, how their plan is just because maybe they can't take that vacation five years from now. There's this idea of people over time have health issues. Things happen that limit their ability to be able to travel. You want someone to enjoy their retirement within their means. If they want to accept the possibility that “Hey, if the markets misbehave this is going to be it,” that's good. If they say, “Hey, I'm doing this every year,” that's the problem.

Casey: All right. Then we're trying to figure out how long we should project that they actually spend in retirement as part of this. That was a good part of your research over time. I think you actually said at one point that we’re looking at it the wrong way. We shouldn't assume any period of time, even 20, 25 or 30 years. It should be something different. What do you think about that time period we spend in retirement? How should we make those assumptions? It seems like we need to in some way.

David: Yeah. You have to have a time horizon. I think one thing that is really critical for probably all your clients to understand is that there is a growing divide in America today based upon how long you live in retirement based upon income. For better or for worse, individuals that have higher income levels are living a lot longer than the average American. I think that when you see statistics about the life expectancy is 76 today that's for a newborn. That's not for someone who's 65 years old and is in the highest income decile. I think that retirement decisions are affected by how long retirement lasts. I'm going to use the annuity word, but I think that in reality income for life is a really vital thing to be aware of.

I think it's that uncertainty about retirement that creates a lot of difficulty for retirees. You don't know how long to plan for. Do I plan for 2 years or for 50 years? I think that what you want to do is make it manageable but also realistic. I think that in reality it's going to be an excess of 30 years for a lot of people that are retiring today that are 65 years old just because of the advances we're seeing in healthcare and medicine, especially among wealthy Americans.

Casey: You’re saying you don't adhere to “I hate annuities and you should too”?

David: I do not. Here's the thing. I don't love generalizations. I understand that there's a lot of really crappy annuities out there. I could use even worse words to describe them. Here's the thing, they've been around for thousands of years. Much longer than these things we call mutual funds. The reason is, is because people… I go to Las Vegas all the time for conferences. I love Las Vegas. I love to go gamble and play blackjack and whatever the… Whoever I'm with, I don't care. It's just a good time. I'm a very rational person though. I know that every hand of blackjack I play I lose about 2% whatever I'm gambling because the house has an edge. I still love playing blackjack. I’m guessing a lot of your listeners go to Vegas, they go to casinos, they have a good time. You go because you enjoy it.

An economist might say, “David, you're irrational. You're playing this game that you're losing money.” I don't care. It's the same thing with insurance. I have life insurance. Insurance is not a positive expected value item. No one buys life insurance thinking, “Hey, I'm going to beat the insurance company.” They've got these things called actuaries. Those guys are really freaking smart. An annuity is not an investment. It's a risk transfer mechanism. I'm talking about annuities as income vehicles, not necessarily the accumulation versions. I think the problem is that a lot of annuities today are viewed through the investment lens versus the income lens. From the income lens they can make a lot of sense.

That being said, there are lots of really crappy annuities but there are also some great ones too. I don't think you should dismiss the value of a product just because there are some bad apples.

Casey: That being said, why do you think…? There's probably 10 times as many bad mutual funds out there as there are annuities. You know this being at Morningstar as long as you have, how many annuities there are in comparison to how many mutual funds there are. Why is it that annuities have gotten such a bad name? You even said it yourself. You said, “I'm going to use that word, annuity.”

David: You’ve got to warn people if you're going to use the word annuity. I don’t know. I think that part of it could just be that a lot of the folks that sell annuities aren’t financial planners. They're not fiduciaries. They don't have your best interests at heart. There's also the issue of transparency. I think that what we see… The worst annuities are the least transparent. You just can't understand them.

I'll never forget, I was trying to understand a relatively complex variable annuity. I called up the insurance company and I got this answer. I read their prospectus. It's like 110 pages of… It’s just a terrible experience. I called up the insurance company. I called up their customer service and I got an answer. I was like, “That doesn't seem right to me.” Then I called them back the next day, a different person and I got a different answer. If me, Mr. PhD, CFP, random designation guy cannot figure out how these products work, how does the average person? If I am sold something I don't understand how do I understand its value? How do I know that it's working for me?

I think that it isn't always that the products are even bad. It’s that they’re so complex you don't understand what they're actually doing for you. There's all these reasons why I think that they have a bad name. I'm hoping that there's things that we can do initially to clear that up. At the end of the day, knowing you have a guaranteed source of income for as long as you're alive, that's pretty valuable.

Casey: I think your advocation of annuities hasn't been in the realm of accumulation, long term growth. It hasn't been in the area of creating a death benefit or a long term care benefit or tax deferral. It's been very much focused on guaranteed income.

David: Right. I think that annuities can work as accumulation vehicles as well. To be fair, if you're talking about a tax advantage vehicle to grow money in, a 401(k), an IRA is a better place to start. If I am a wealthy individual who’s at a very high tax rate, annuities can be a really solid way to think about growing wealth. I just think that for accumulation there’s usually better vehicles at least as a starting place to grow wealth with.

Casey: Especially if you have a higher risk tolerance. If you have the ability to go through some ups and downs then you're probably going to make a better long term return with equities. However, if you're going to panic when the market’s down and you don't have the risk tolerance for it, you might actually do better making 4% to 5%, 4% to 6% in sometimes a fixed indexed annuity rather than taking on the risk of the market. It's all unique to the individual.

I guess that right there makes me want to jump down to a question that we had from one of our fans. I want to get back to this topic, but I've got to interject this because I think it has to do with being along those lines of what's right for you might be different for somebody else. It's difficult to make these general assumptions or give general answers. Sam Robinson asks, “Does David think active or passive investing is the way to go for a 39-year-old?”

David: The answer to the question is yes.

Casey: That's kind of what I thought.

David: Here’s the thing. There's lots of research that says that passive is better than active. Here's what it really says. It says that fees matter. I actually did a paper, I don't know, seven years ago looking at Vanguard's active mutual books. Here's the thing. They have absolutely rocked. They have beaten… I had seven different tests of “Did they outperform?” Almost all of them were positive. Here's why. It was a relatively low cost that I would call high quality active investment. I'm not anti-active. I'm anti high cost investments that aren't truly active. I think most active funds are closet passive. They’re replicating an index and they're charging high fees. I think that portfolios can definitely have both. If I had to pick one I would just pick passive because it's easier. If you could identify high quality active managers that are low cost, do that. I think it's more complex in the taxable space. There's tax implications.

There's no one right answer here. I think that the key is to understand what you’re buying and why you’re buying. If active excites you and it gets you to save more then do that. If you just want to buy something and never look at it, active is probably not the right place to invest. I think, again, it depends upon the investor, the account type, the goals et cetera.

Casey: Good. That goes on to say everybody's unique. It might take a diversified approach of both active and passive depending on where you're at and the type of market you're in in any given time. Back to this topic of annuities, you said that annuities can make a good allocation for guaranteed income during retirement. You had some research on the appropriate allocation of annuities, bonds, equities. How does somebody determine how much of their assets should be allocated to an annuity as they step into retirement?

David: This is kind of the theme of today's podcast. There's no one right answer for everyone.

Casey: That’s the difficult part about a personal financial planning podcast.

David: Especially for retirement. I think retirement is the one area… If you're 30 years old, save 15%, buy some life insurance, generalize. Retirement is really unique. It really boils down to all these irrevocable decisions you make about how you fund things. To your earlier point about paychecks and play checks, how much do you want to have as absolute certainty for life? What is the number that you need to feel comfortable that if the markets go crazy that you're good to go? That to me is a great starting place to answer the question “How much should I annuitize?” We have much more complex models we use to figure it out but, again, what do you need to feel comfortable as a retiree? Some people might say, “I want to annuitize all of it,” and that could be totally fine. Someone might say, “David, I've got social security. If I have to I can live off that.” That could be enough. It's really a question for each person based upon what you've got when you retire and what you want to accomplish.

Casey: Let's talk about what you want to accomplish in that realm because you're balancing some things there. I think there's two main things that you're balancing. Let's make sure I don't miss anything here. As far as two primary things you're balancing the idea of “How much do I want to leave behind? What's the legacy I want to leave behind?” and “What degree of certainty do I want to have in my income?”

David: Right. In reality you could say there’s a 10-dimensional chart you could use to figure out what each person needs. Fundamentally what you're buying with an annuity is insurance over your life. Every insurance you lose money on average. The cost of that is the wealth you leave behind to heirs. You can do things to reduce the loss to heirs. You can add a 10 year period certain payment or a cash refund provision. What that does is it reduces the benefit. You can accomplish both though. If you want income for life and you want to have money for your heirs, tack on some of these riders. I think that it's okay.

Annuities can be rational, for lack of a better term, if it makes you comfortable in retirement. I don't care. If the best portfolio in the world keeps you up every night worried about retirement, what's the point? Again, it's how do you want to experience your retirement? One thing that there's lots of research on is that people, retirees, are terrible at spending down their accumulated wealth. It's very painful for a retiree to spend down their nest egg. “Oh my God, I have to make this last for as long as I'm going to live. I don't know how long it’s going to last. What if something happens?” It's so much easier to spend income. Even if it's a “bad deal” to buy an annuity, what you see is that it can really help someone better enjoy their retirement because it gives them a paycheck that is automatic, that doesn't require that kind of constant pain of spending down their lifetime savings.

Casey: It goes back to this concept of focusing not on return on investment but your return on life. If that guaranteed income, that certainty helps you really enjoy your life that much more, that's what you created it for in the first place. Maybe you give up a little flexibility, a little growth, a little legacy but you get to really enjoy the here and now.

That also leads us into some of your research on the optimal equity allocation glide path. That means how much should we have in equities when we step into retirement, and what should that look like over time? I think the traditional research has shown us… Why don’t we just take the rule of 100? You're 60 years old. We're going to put 40% in equities and 60% in fixed income. Over time we're going to start to reduce that equity allocation as you age. It seems like some of the research out there is starting to show us the opposite, and maybe even that equities aren't really needed.

David: You have to have equities, I think. There's been some research that talks about the idea of a rising glide path, taking on more risk as you age. I think that’s just shenanigans. I think about my grandma. I'm not going to say, “Hey grandma, let's make your portfolio more aggressive as you age.” That doesn't fly with me. I think that like everything else, it's a personalized choice.

When I talk about risk today there’s obviously all these different definitions of risk. One definition of risk that us investment nerds talk about is standard deviation or the volatility of your portfolio. Here's the thing. Right now there is risk that the portfolio that's in equities we could have another market crash. Here's the other risk. If you have a very conservative portfolio you're going to earn less than inflation potentially. You're going to have a shock if interest rates rise. I think that for most people the smart place to be is a diversified, boring portfolio. Let's call it half stocks, half bonds and retire that adjusts over time. If, for example, the markets behave nicely and it goes up, you can maybe take on more risk because you want to maximize the bequest or money you're going to leave to your heirs.

I don't know that retirees should be that aggressive. I think a lot of folks want to dig themselves out of a hole if they’re behind with aggressive returns. I think safety really is more important for retirees but *safety is not having no equities. You have to have some equities. If you don't you're not going to have that portfolio last more than probably 20 or 30 years. You’ve got to take on some risks. Just be smart about it.

Casey: Of course I think we have to mention a disclaimer. That's a generalization. There could be someone that's spending $10,000 or $20,000 a year. They've got $5,000,000. They get a 4% fixed rate and they put it all in a fixed account. Heck, in a CD at the bank paying 2%. They don't need equities but it doesn't mean that that's not an appropriate allocation. I think research shows us that pretty much everyone should have some type of equity for the best statistical proven allocation, I guess I want to say.

David: Yeah. I think that to your point, there's two different drivers of the right equity allocation. There's what I would call risk capacity and risk preference. Capacity is the risk that you should take given your funded status, given your years to retirement, given the risk of your total of all these different definitions. It's based upon you as an individual.

The other piece is your risk preference. How do you feel about taking risk? If you're someone who has the capacity to take on whatever risk you want to you can do whatever you want. If you're that person who’s overfunded, what makes you the happiest? I think that where most people are though is they're kind of in the middle. Where they're trying to figure out “What is the right level of risk for me given my situation?” I think for them it's taking just enough so when the markets go south I don't panic. I think that's a place where advisors can really, really help. You've seen a lot of investors left to their own devices. They panicked back in 2008 and they realized these losses. Staying invested and having someone to help you do that I think really leads to a better long term outcome.

Casey: We all like to use an acronym along those lines which is CAN. Do you have the capacity for the risk, the attitude for the risk, and the need for the risk in the first place? I think that's something that everybody needs to analyze. More people a day seem to be getting concerned with equity valuation, especially those that were investing during 2008 or during the tech bubble crash. They start to wonder, “Should I really be holding this much in equities?” Now they look at interest rates potentially rising in the future and they go, “Boy, should I really be holding onto bonds at this period of time?” Now we've seen quite a bit of research by different researchers, even professors saying that we should be looking at replacing our bonds with annuities. Is that something you adhere to? What are your thoughts on that?

David: Yeah. I've actually done some research that suggests the same thing. I think the key there is the effective return on an annuity, like an immediate annuity, is higher than a bond. The reason is this thing called mortality credits. We don't have enough time to go through the math here completely. Long story short, when a bunch of folks get together and pool their risk together, you earn a higher return if you survive because you're taking money from the losers.

I wouldn't recommend the extreme of that where you replace all of your fixed income with annuities, but you're going to earn a higher rate of return buying an annuity than buying fixed income. If you're someone who's very, very conservative a logical extension of that is you're going to have more wealth in retirement if you annuitize a good portion of it. I think that you need to think about, “How am I going to invest?” If you're going to invest in CDs you're better off buying an annuity with a good portion of your wealth.

Casey: Some people are going to say, “Yeah, but they're too expensive and I don't want to pay that much.” I want you to explain a quote I was able to pull from you. You said, “Many few guaranteed income benefits is expensive. However,” you said, “it is a relatively inexpensive form of longevity insurance, especially from a behavioral finance perspective.” Are they expensive or inexpensive? Can you explain that?

David: It's kind of like the insurance that they want to sell you at Best Buy. That's really expensive insurance. When you buy that TV you don’t know… You always should say no to that. There's not a good reason to say-

Casey: Always say no.

David: Right, because that's not priced appropriately. Even if you look at things like immediate annuities there's big differences in pricing. If you go online you can get lots of quotes. There's websites you can go to that give you lots of quotes. If you get the best one it's a pretty good bargain.

The behavioral comment just gets to the fact that while, again, on average you're not making money, it provides a peace of mind you cannot achieve through a normal bond mutual fund. I have a grandfather. He is in his 90s. He gets a call every day from someone trying to get him to buy something or just trying to scam him for a host of reasons. He's still with it. He knows what's going on. He's not going to fall victim to that. At some point though he could. Here's the thing. With an annuity you don't have to worry about that. Even myself, Mr. Investment Planner, at some point I will annuitize a large portion of my wealth because I just don't want to deal with it. Someone might say, “David, you could earn a higher return with an efficient portfolio.” I'll still have some money invested but I like the idea of a paycheck for life. You can do that artificially through a portfolio but that's not guaranteed. I want a guarantee. I want to know that no matter what happens I've got money even if there is a cost.

Casey: Let's move on from this ‘A’ word and move on to maybe another controversial subject as well. I really wanted to get your thoughts on this because this is something you wrote about back in 2006. I want to see how your thoughts have changed, if at all. It was in the Journal of Pension Benefits titled Roth 401(k)s are Wrong for Most 401(k) Participants. Have your views changed as you've aged here, or do you still think that everyone should be traditional 401(k) tax deductible and not Roth 401(k)?

David: I’ll tell you how they've changed. The math there isn't all that complex. Unless your tax rate changes between now and retirement it doesn't matter if you do Roth or traditional, assuming you save the same amount of money. What we see though is most people when they retire have incomes that are lower than they were when they were working. There's more benefits to taking the tax deduction when you're working. You get the child tax credit and other things. For most people, the vast majority, traditional really is a better way to save for retirement.

That being said, it makes sense to have some of both. I do some of both because we don't know what's going to happen in the future. I am predominantly traditional but I have some Roth as well just because you can use it to manage marginal tax rates and do different things. I still believe that, again, for most people traditional makes the most sense. You want to have a little bit of both because things change. Life happens. It's good to hedge.

Casey: I think in your research it said something like tax rates have to increase 10% or something along those lines in order for it to make sense. As you step into retirement they have to be 10% higher than when you made that contribution. That's pretty significant but I think they could be significantly more than that. I really don't know. I think one of the things you pointed out was somebody that’s 30 years out from retirement maybe it makes more sense for them, but as you near retirement it makes it even more difficult to be making Roth contributions versus traditional. I do both as well. I advocate all my advisors and everybody we sit with… We’ve got to diversify our investments. We need to diversify our tax buckets at the same time because we just can't predict the future. It's really a policy diversification or protection or an in-policy insurance, if you will.

David: If you're someone who wants to save gobs and gobs of money you should probably do it in Roth. There's limits of what you can save in a 401(k) plan. I think that there's definitely reasons why to do Roth. It probably won't matter that much at the end of the day. Again, for most people the deduction is going to be worth more now than it’s going to be worth when they lose their jobs.

Casey: Great. I've got just a couple of things really want to make sure we get to before we run out of time. We're going to jump around here towards the end on some questions that I want to pull some really good answers out of you. A lot of them have to do with things that I hear from people all the time.

One of them has to do with renting and owning and retirement. Should we own a home? Should we rent a home? Some people are just dead set and say, “You've got to own a home. You can't be throwing all that money away on rent. You're better off owning a home. You've got an asset there.” Others say, “No, I don't want all the headache and I don't want to deal with utilities, maybe maintenance outside and things like that.” What are your thoughts? Should a retiree rent or own in retirement?

David: First I would say whatever makes them happy is probably a good-

Casey: Return on life again.

David: Return on life. Homes are terrible investments. Let's not kid ourselves. They're very expensive to maintain, to operate. They're actually very risky as well. People think that homes are safe. They are not safe. Homes are unique and they're both an investment good and a consumption good. You derive a consumption from living there and they can also increase in value. I think that if you're going to be there for a long time, say minimum of five years, you're probably better off buying versus renting. The actual differences aren't that significant. If it really matters to you to not mow your yard and not to repair things renting is probably fine. The implicit cost of the decision varies over time, but when you really account for all the costs of ownership it's not nearly as attractive as it seems.

Casey: Right. I think it's just having that hard asset for some. Feeling like, “This is mine. You can't take it away.” The value can still fluctuate quite dramatically. You could still have the asset, but the risk that you mentioned there is in the value of that asset changing over time. Just as quickly as the stock market can shift direction so can any area of the real estate market, farmland or homes and other assets.

David: Right. If you're willing to move the risk is significantly less. If you live somewhere and rents increase dramatically and you can move somewhere else, you’re in great shape. I think we'll always be homeowners. My wife would not be okay renting, but that's my personal choice. It's not a recommendation for everyone.

Casey: One of my questions I have to ask, because you're one of the most well-educated individuals in the retirement research field. You find a lot of financial advisors don't have any designations behind their name. They don't have maybe even a college degree for that matter. Then you find the advisors at the other end of the spectrum that have CFPs or CFAs or a variety of different designations. What are your thoughts on the state of advisory education today?

David: Some colleagues that I work with they don't have PhDs, they don't have CFAs and they're brilliant. They do an excellent job building strategies. There is a definite positive correlation between designation, especially core designations in advisor ability. I think that other similar professions like accountants and law there's minimum standards. For better or for worse in this industry… If you take the Series 7 that doesn't teach you almost anything about being a financial planner. I think as an industry we need to focus more on education because our clients rely on us for a lot of important decisions. Unfortunately the bar to work in this industry I think is far too low. I’d love to see more mandated education requirements as important in the future.

Casey: If you are in the process of looking for a new financial planner or financial advisor, you said there should be some type of minimum education requirement. What do you think that minimum education requirement should be if you're searching for a new financial planner?

David: In theory you want them to be a certified financial planner. There's other designations that work as well, but that to me is the most accepted and most well-known. Just because you have designation though doesn't mean you actually know what you're doing. There's lots of designations that you can get in like two hours today. I think that the key is… CFP it requires I think three years now of experience, a college degree. I think that's a pretty good early signal that this person is serious about this industry and knows at least the basics of financial planning. I say the basics because you can learn a lot more than they teach you in the CFP. That just shows the commitment to, “Hey, this person should know what they're talking about.”

Casey: Along those lines, and maybe we already hit on it, but if you could change one thing in the world of financial advice, what would it be?

David: I think I just mentioned it. I think requiring a higher standard of care as a fiduciary potentially and then education. I’m not all that concerned about how people are paid, if it's a commission or it's a fee. I think there's conflicts any way you slice it. I just want this profession to be more knowledge based and less sales based, and that requires education. I think that, again, a lot of folks will do a great job without a mandate, but there's a whole swath of folks that I think need to get the education but just choose not to do so.

Casey: I'm very passionate about that myself. You said the bar is set too low today. I've often said the bar is set disgustingly low in this industry, especially when you compare it to what you see in the field of medicine. You wouldn't work with a doctor that didn't have formal education in order to operate on your knee or your heart. I'd argue your finances are just as important.

We've got one last question from one of our fans. Julia Wilder has a question that goes, “After years of research, what are a few of the surprising facts that have been unexpected during the past few years? Is the retirement landscape really changing over these 20 years? If yes, what are a few of the most surprising facts?”

David: There’s a lot of potential questions in there to answer.

Casey: We can go with, “Over the last 20 years what's changed and what's been most surprising?”

David: I don’t know if this is surprising but what surprised me the most is changes in life expectancy for households based upon income. It's not that I don't care about all Americans, but most people have nothing saved for retirement. Those households that do, I think longevity is going to become a significant issue in the next five or 10 years because they're living so much longer. Nothing has quite shocked me when I saw some research a year or two ago about how it's been changing over time. If you have to add on five years of retirement expectation that is incredibly expensive. Just being aware of that I think is important when thinking about “How much do I save? When can I retire?” All those different things.

Casey: What about the financial advice landscape as a whole?

David: I think that it's like this really, really big ship. It's hard to move but it's been moving in the right direction. I think that we had that fiduciary role that got mixed in. It wasn't perfect- nothing is- but it was directionally correct. I'd like to see us get somewhere along those lines but we're moving there collectively anyway. I think that as an industry we're doing more and more knowledge based planning, more folks are getting designations. It's just taking an awfully long time.

Casey: Yeah. I hope we continue to move that way in the future. My last question I’d like to ask as we wrap up most of these conversations. I've asked this question to thousands of people over the years. What does retirement mean to you?

David: I'm 37 years old. Retirement to me is something I research but I haven't experienced yet. I think that when I look at my parents, my wife's parents, my grandparents, it's a time to enjoy everything that you've worked hard for for the last 30 or 40 years. It should be and could be the most enjoyable part of your life, but you have to plan for it. That means more than just the financial aspect of retirement. You and I talk a lot about the financial aspect of things. I think figuring out what that next step means and how you’re going to spend it is incredibly important. It's worth thinking about for many, many years.

Casey: Thanks so much for joining us here on the podcast. I've been wanting to have this conversation for a really long time. I had to be very selective about what questions I was going to ask today because, oh boy, we probably could have talked for another hour. I know you've got other things to do there at Morningstar’s office so I'm going to let you go. Thank you so much for joining us.

David: Thanks for having me.