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Podcast 121

121: The Safety First Approach to Retirement Income with Wade Pfau

Today’s guest is Wade Pfau, the Retirement Researcher. He’s the author of The Retirement Researcher’s Guide Series, a collection of books in which he’s explored investment-based strategies, ways to use reverse mortgages to secure your retirement, and much more.

Wade has dedicated his career to helping retirees answer tough questions, understand their options, and build financial plans that will truly serve them.

In his new book, Safety-First Retirement Planning, he provides highly insightful, valuable information for anyone considering making annuities a part of their retirement portfolio.

Today, Wade returns to the podcast for a deep dive into this topic. You’ll learn how you can utilize the many financial products available to reduce your risk, the different approaches you can take as you create your retirement plan, and the intentional strategies that will help you live the life you spent your career aspiring toward.

In this podcast interview, you’ll learn:

  • Why modern portfolio theory doesn’t apply to households and doesn’t apply to the unique challenge of retirement.
  • Why the holy grail of retirement income planning is enhancing efficiency – and why it’s so rare to find planners who choose to work with a blend of investment and insurance tools.
  • What makes bonds the least efficient way to fund retirement spending goals, what you should do with them, and what not to sell along the way.
  • How to use life insurance to live at a higher spending rate.

Inspiring Quote

  • “You really have to make sure you’re thinking carefully and building an efficient strategy, a strategy that will get the most spending power out of your asset base in retirement.” – Wade Pfau

Interview Resources

Read Full Transcript

[INTERVIEW]

Casey Weade: Wade, welcome back to the podcast.

Wade Pfau: Thanks, Casey. It's great to be here.

Casey Weade: Hey, I'm excited to have my favorite retirement researcher back to talk about your latest work. And something that's pretty unique has gone on over there at the American College. We've got David Latele coming up here to be interviewed on a podcast here pretty soon and we're going to be discussing his retirement transition. I know he's preparing for his own retirement and it's going to be a unique conversation. We decided to have it just because how many retirement researchers do you see transitioning into retirement and going through this process themselves? A lot of us even financial advisors, financial planners, we might spend a lifetime working with clients, helping them plan their own retirement, not realizing the difficult questions that we're asking, those that are sitting across the table and the amount of work that goes into it or the stress that's created during that transition period. And I was just wondering if being that David and yourself have done a lot of work in the retirement income planning space, tax planning space, work with a retirement income certified professional designation. Has he been leaning on you in any of this? Have you and him been discussing his own retirement plans?

Wade Pfau: It does come up from time to time but, yeah, he's had this great opportunity now where he's even writing a Kiplinger's column about his own retirement, and it's kind of this retirement expert is now retiring and so what lessons does he take from all that academic work to make it more practical? And he's looking at different kinds of annuities and different approaches and, yeah, it's really been a long process for him probably at least the last 5 or 10 years where everything he does with the RSVP program, he's also in the back of his mind thinking about how that applies to his own retirement.

Casey Weade: Yeah. That's pretty neat. I'm really excited to have that discussion. Someday that's going to be you and you're going to be transitioning in retirement. We’ll be having this discussion again. And the thing that I think David's brought up, you've brought up many times is that this whole world of retirement it's a little new, and you stated in your book that retirement income planning is relatively new. And if it is so new, I wonder what are the dangers for retirees today given the relative newness of the field?

Wade Pfau: Yes, it's really about how retirees face these different risks and I think something that really put that and really highlighted that point was just Harry Markowitz. He's the founder of Modern Portfolio Theory and just the idea of building a diversified investment portfolio and asset allocation. And it's the foundation of everything taught to investment managers about how to invest for households. And then after he won the Nobel Prize for that, he was asked, "Well, how does this apply to households?” And he said he never thought about it before and after just reflecting on it for an evening, he recognized that it doesn't apply to households that it's a fundamentally different problem where modern portfolio theory is just how do you invest for one-time period when all you're doing is managing assets and retirement is about you don't know how long the money needs to last so you don't know how long your distributions will be going.

And the act of taking distributions from your investments actually fundamentally changes the impact of investment volatility. You become much more exposed to the downturn in financial markets in the early retirement years can permanently disrupt that retirement. And so, simple investment-based models don't really account for that because they're not accounting for any distribution. They're just accounting for you're trying to grow your pot of assets while you're growing assets because you want to spend them and you don't know how long you need to continue to spend them for. So, that's the heart of what makes retirement different, just along with as well, long-term care and different health shocks and things that could, of course, you could always have a big surprise expense throughout your lifetime but you get more vulnerable to major expenses for health and long-term care later in life as well. So, that’s what makes it different.

Casey Weade: If you've been using this accumulation investment approach as modern portfolio theory, you just got this portfolio of stocks and bonds that you've been watching grow or mainly probably mostly stocks throughout your working life, that can be a difficult psychological transition to go, “Oh, this isn't going to work anymore.” Or you might hear somebody say, "Well, this isn't going to work anymore. You need something different.” They go, “Ah, they're just trying to get my business.”

Wade Pfau: Right. If you haven't thought through the problem, you may have that idea that this has always worked in the past. Why would you need to change anything? But I mean, even in that regard, target-date funds that have become so popular and 401(k) plans recognize that as you get closer to the retirement date, you have to start scaling back on the amount of financial market risks that you take. Now, they might not really do that as thoroughly as is needed for retirement income. But I think we do at least have this idea that you should be taking on less market risk in retirement.

Casey Weade: Well, and if you're not familiar with what a target-date fund does, it basically just allocates more of your equity. You have more equities in the front end and then as retirement date gets closer, they just shift more of those equities and they automatically rebalance towards fixed income as you get closer to retirement. So, we're just talking about stocks and bonds. And in your book, I think that's a good transition point, you say the holy grail of retirement income planning is finding strategies that enhance retirement efficiency. And with equity is reaching more volatility, equity prices getting higher and higher currently, as we record this here in February, we're at a pretty high valuation when it comes to the equity markets, and we have interest rates still near all-time lows. And so, if retirement efficiency is the holy grail of retirement income, is that even more important today? Is just efficiency in retirement income strategy more important today in this economic environment than it was 10, 20, 30 years ago?

Wade Pfau: It is because with high market valuations and low-interest rates, people who want to have relatively conservative planning assumptions really need to consider this idea that market returns may be lower in the future, not necessarily that we'll have a big financial market collapse or anything. But at least instead of expecting double-digit type returns on their investments, at least thinking about single-digit returns, there's not as much capacity for prolonged continued big financial market gains. And so, when you're getting lower market returns or when you're planning for that, it requires more assets to fund the retirement. And so, if you're pushing up against the amount of assets you actually have, it really pushes you to - you don't have any capacity to waste, be wasteful in that regard. You really have to make sure you’re thinking carefully and building an efficient strategy, a strategy that will get the most spending power out of your asset base in retirement.

Casey Weade: Well, if I'm wrong about this, let me know but I think as we have this wave of baby boomers stepping into retirement, we have interest rates falling, we have market valuations rising, and predictions of future returns and equity is going down. We require a more creative, more intentional approach, and is that what has led to you really focusing your career on thinking about these income strategies more intentionally and looking at more creative strategies? So, you've had this evolution of the books that you've put out from talking about reverse mortgages to talking about the investment-based approach to talking about the safety-first approach. Why did you choose to write these books in the order that you did? Last time you're on, we talked about reverse mortgages quite a bit. And then the next book after that was investment-based from a retirement planning standpoint and safety-first here. So, maybe you can kind of talk us through those three books and why you chose to write them and why you chose to write them in the order that you did.

Wade Pfau: Yeah. So, getting into that issue, I do come from the investment side of financial services and got my start looking at investment-based retirement income strategies. And then with these issues of lower interest rates, higher market valuations, people living longer than in the past, really becoming concerned about that investment-based approach and so looking for alternatives to that. Now, the Reverse Mortgages book was first and that was a little bit indirect in terms of I was just working on what I thought would be a chapter of a longer, general retirement income book. That chapter kept getting longer and longer. So, it actually looked like its own book, and it was a shorter book. And I just thought, well, it's more of an experiment.

Casey Weade: Well, I noticed when I was reading it. Yeah.

Wade Pfau: It became an experiment.

Casey Weade: I’m reading reverse mortgage and I go, "This is about income planning.”

Wade Pfau: Yeah. So, let's just effectively do an experiment. Let's publish a book and learn the process because that's more of a niche market as well. I thought it's not going to sell as many copies. So, let's just learn about the book publishing process by going through the process of an actual book. That explains why that one came first. But I had already at that point was halfway through writing the book about investment-based strategies and so I picked up again with that to get that one finished. And then ultimately, as a part of that process, looking beyond just investments and that's where that safety-first approach comes into play where you're going to integrate investments with other tools such as insurance, and so then spending the time to fill in the gaps there and then that became the third book in the series.

Casey Weade: From my experience, and most families at first come in to work with us they've been utilizing an investment-based approach their whole lives on the way to retirement and most people that are in retirement they're working with a financial planner that exclusively uses investment tools. Every once in a while, I run into somebody that is working with a planner that's exclusively working with insurance tools, but very rarely, if ever, are we going to run into somebody that's using a blend of investment and insurance tools to create this comprehensive strategy. And I know the question of the day is, well, you've done all this research. You've got the investment-based approach. You've got the safety-first approach. Which one's better?

Wade Pfau: So, the conclusion that's come up time and again and just approaching the research, but doing it in different ways, but it's always to really simplify things. Bonds are the least efficient way to fund the retirement spending goals. So, if you can shift some of the bonds over to annuities, leave the stocks alone, that's going to help you move towards a more efficient retirement income strategy where you look to meeting those core spending goals with protected lifetime income through an annuity but you don't necessarily sell stocks to do that. As much as possible, you're shifting from bonds into annuities. And then what that leaves you with is a more aggressive asset allocation for your remaining investments. And then that can be a source for more discretionary types of goals related to legacy or just having more lifestyle discretionary type spending if markets are doing well and also just providing a resource to help cover any unanticipated expenses as well.

Casey Weade: So, when you say efficiency, what does that mean exactly? Is that spendable income? Is that growth? What does efficiency mean when it comes to retirement income planning?

Wade Pfau: So, I'm really thinking of it in the same sort of way if you go back to like a principles of economics class because my background is economics. So, like Economics 101 where if you have two goals, and then the goals I'm looking at here meeting your spending goals even if markets aren't cooperating while at the same time preserving as much as possible for legacy or for spending shots, so meeting spending goals and having money left over. Strategy A is more efficient than strategy B. There's a tradeoff between the two like if you want to leave more behind, you have to spend less or if you spend more, you should anticipate leaving less behind. But strategy A is more efficient than strategy B if it lets you spend more and/or leave more behind at the end as well. If one strategy just leaves lower spending and lower legacy at the end, it's less efficient than a strategy that helps you to do better in both regards.

Casey Weade: So, we're saying efficiency, using a safety-first approach, utilizing a strategy of planning investment and insurance products. Efficiency means that strategy, that blend is going to allow you to spend more, have more spendable income, and ultimately have more assets leftover than an investment-only approach. Is that what I hear you saying?

Wade Pfau: Right. Or I mean both that's true and then also, it could just be meeting the same spending goal, and then also having more money left at the end to make it more efficient.

Casey Weade: Okay. So, we've got a more efficient strategy if we're using the safety-first approach over the investment-first approach. And if that's the case even if we have some biases, right, I think there's still some individuals are going to go out there say, "Yeah, I'm never going to use any insurance tool ever. I just want that investment-only approach.” But even those individuals, even if they're still by say, “No, I don't think I want to use an insurance tool,” they should still be presented as an option. I mean, in my belief when you go through my book, Job Optional, I am sharing investment approaches, right alongside insurance-based approaches and blends of the two because I think we all need to understand what the option is and we picked the best one for ourselves.

However, how can a consumer determine if the financial planner they're sitting with most identifies with or operates within one of these two realms? Because we all have the same sign above our doors. How do we know if we're sitting with an advisor that maybe is going to only present us with investment approaches? Maybe he has a bias towards other approaches. We all have our own bias. How does that consumer just interact with a financial planner, recognize the type of person that they're sitting across the table from and the biases they might have?

Wade Pfau: Yeah, that's a great question. And it probably really can just relate to just asking a couple basic questions like asking them about annuities and seeing what their reaction is. There are a number of investment-only type financial advisors who just have a very negative perception of annuities. You see it in like the Ken Fisher commercials out there of, “I hate annuities and so should you,” and so any sort of advisor who has that kind of gut reaction that annuities are never helpful for anyone, they're going to be investments-only type of an advisor. It might be a little bit harder to see in the other direction but if they are mostly proposing insurance and if you ask them about, "Well, what about the stock market? I want to invest for growth in the markets,” maybe if they talk about, "That's not such a great idea. The stock market is like a casino or something like that,” then that might just suggest that they're not really open to these sorts of integrated strategies. There's a role for both.

Casey Weade: I think you'd made that reference in your book and if they're referring to the stock market as a casino then they're probably expressing some bias towards the investment world because it's not technically what it is. It's just higher risk, right? We've got a higher risk situation and we're utilizing investment-only tools and it sounds like we're getting less efficiency at the same time, leading a less spendable income, less assets, ultimate leftover and that kind of brings us to the origination of the safety-first world, the investment-first approach. You'd said in your book that the safety-first school of thought was originally derived from academic models of how people allocate their resources over a lifetime to maximize lifetime satisfaction. And I said how does the origination of the safety-first approach, how does that contrast with the origination of the investment-first approach?

Wade Pfau: So, the safety-first approach is really part of the academic research and the investment-based approach really is more of based on rules of thumb developed by financial advisors. I kind of say that the investments-only style approach really goes back to Bill Bengen’s research that led to the 4% rule in the 1990s. There's just, "Well, let's look at historical data and see how much you could have spent over different periods in history and kind base our guidance on retirement around that.” Whereas the safety-first approach is based on academic research. And really the conclusion of the academic research is you build a floor so that your basics are going to be covered with some sort of contractually-protected income. And then from your remaining assets, you can spend it's more for the upside in the lifestyle so kind of the rules around required minimum distributions provide an example of what you could do with your remaining investment assets. It's, as you get older, you spend an increasing percentage of what's left every year for upside. And that's really the core academic approach, build a floor to cover the basics and then be more aggressive and spend with an increasing percentage to cover more discretionary types of expenses beyond that core floor.

Casey Weade: I think that's what I read in David's article that he was going to go with an approach, a flooring approach as we've written about in the past, but I think saying that what you're going to get greater spending than the sustainable wall withdrawal rate from an investment portfolio with a retirement income strategy, incorporating insurance is just contrary to what we might believe. I mean, if the stock market averages say 7% a year and an insurance product is going to pay me 3% to 5%, how could an insurance product provide me with a greater spending rate than an investment strategy?

Wade Pfau: So, it really boils down to and there was an article I wrote in 2017, where I really tried to lay this out because this is a great question. There's three basic ways you could fund a retirement spending goal. You could build a ladder of bonds, and that's sort of the starting point, the baseline. I just buy bonds that will mature each year and cover each year spending and then the more worried I am about living a long time, the longer I'd have to build that ladder of bonds and so the less I can spend, but I'd have bonds maturing every year supporting my retirement spending. Now, in a low-interest rate world, that's not going to support a whole lot of spending. And if I want to try to spend more than that, I've got two options. The whole investment-based idea is build an aggressive diversified investment portfolio. That original Bill Bengen 4% rule style research about investments said, "Try to use 75% of stocks in retirement and don't use less than 50% stocks because you need enough exposure to the stock market. And then you have to just be comfortable with the idea that stocks will outperform bonds and that's going to let you spend more in your retirement.”

So, you can spend more if that strategy works and historically, it did tend to work. In the US stocks did tend to outperform bonds supporting a higher level of spending. But the third approach is this risk pooling idea of an annuity, which is when you buy an annuity, a simple income annuity that premium goes to the insurance company, they invested in a bond-like portfolio. So, in that regard, it's like owning bonds, you can spend your original principal as well as interest on the bonds. But then you get this risk pooling feature. There's mortality credits. Those in the risk pool who don't live as long help to subsidize those who live longer. And so, that becomes a source of spending power for those who live longer than average that investments don't provide. Of course, if you live longer, it helps you to own the annuity. And then if you don't live as long in hindsight, you maybe wish you didn't buy the annuity. But what the annuity is doing is it's allowing for a higher standard of living throughout retirement because you know that if you end up living longer than average, you'll get these contractually protected subsidies from the risk pool that investments don't provide.

And what you're trying to do with an investments-only strategy is get more than bonds as well but relying on the stock market to give you those outsized returns. Well, for people who are worried about outliving their money, the investments-only approach the logic of it is you have to behave conservatively. You have to plan for a long retirement, you have to plan for a below-average market return, and you quickly get to the point where your sustainable spending rate will be less than an annuity because, with risk pooling, the annuity can pay you like you're going to live to an average life expectancy and get an average bond-like return on your underlying asset base. So, that's the difference. If markets do great, what happens with the investments-only approaches? You ended up having to spend less and then you have a much larger legacy at the end versus with the annuity, you can more efficiently spend at a higher rate from your assets because you have that risk pooling feature.

Now, if markets do absolutely wonderful throughout your retirement, you might end up with a smaller legacy with the annuity, although it depends because integrated strategies, you still have stocks in your portfolio. So, you might actually have a larger legacy at the end as well, it depends but if markets don't do well, that's where an investment-only strategy will deplete. But the integrated strategy is going to allow you to continue receiving some protected lifetime income through the annuity, no matter what the markets do, and no matter how long you live in retirement.

Casey Weade: But really there are some out there that can afford an annuity approach. I do see it as a more costly approach with less risk. I mean, we say yes, you'll have greater spending efficiency if you follow the guidelines. So, if you're going to stick to a 4% withdrawal rule, investment-only approach only they say, 4%. If you were to follow, say, a blended approach, maybe you're getting a 5%, 6% cash flow that you're able to create with that blended strategy. But what if I'm someone that says, “I've got a couple that I worked with a number of years ago, and they wanted about an 8%, 9% cash flow, and they wanted a lot of income by way above what you would consider a safe withdrawal rate. And it was either you cut your spending, and we go with a more safe approach. We can integrate this strategy utilizing investments and income-based annuities and/or provide you say 5%, 6%. But if we want to get 8%, 9%, we're going to have to go with an investment-based approach. Your odds of success are going to go down. Are you willing to accept that or do you want to continue working?”

And they said, "Well, we're not going to cut our income. We're not going to cut our budget, and we hate our jobs so we're going to retire no matter what.” So, in that circumstance, that's someone that has to take on that risk and go with an investment-based approach because an annuity is just not going to provide the level of guaranteed income or the income at all that they need.

Wade Pfau: Right. If your spending goal is more aggressive than what an annuity can pay, then indeed the annuity will ensure that you can't meet your spending goal. But the problem is if your spending goal is more aggressive than the annuity can provide through risk pooling, you don't have a very realistic spending goal. So, yeah, if you want to spend 8% or 9%, your best bet is to go completely in the stock market and roll the dice and hope it works. But it may only have a 20% chance of working and that's where maybe the annuity will ensure it doesn't work, but at least it will provide you some lifetime income versus maybe there's a 20% chance that the investments-only strategy will work. But in that other 80% of the time, you're going to run out of money well before the end of your lifetime and that can be very problematic.

Casey Weade: Yeah. Luckily, there’s a couple they were ultimately willing to cut that budget but they needed to get into retirement and get some bucket list stuff out of the way. And now we were able to transition them over to a blended approach. But it took a couple of years of real high spending before we were able to make that transition. And another thing that I think that some they hear, well, a safe withdrawal rate say 3% or 4% and they say, "Well, how can a safe withdrawal rate be 4% when today we can go get fixed annuity multiyear guaranteed annuities that act a lot like a CD with insurance backing at a fixed rate of 4%?” If we can get 3.5%, 4.5% fixed, then how could a 4% withdrawal rate not be 100% certain?

Wade Pfau: Right. It's a great question and it’s because and even like in the context of the 4% rule, it's assuming 30 years of inflation-adjusted spending, so I could go buy TIPS today, Treasury Inflation-Protected Securities, that give a real yield plus inflation to match that spending and that yield curve has gotten really low in the last month. So, it might only be about a 3.4% withdrawal rate but nonetheless, even if I bought 30 years’ worth of TIPS looking at a 3.4% withdrawal rate, but at the same time, if I'm looking at that aggressive investment portfolio, well, if I want a 90% chance for success, for example, that's where the withdrawal rate could be 3% or even less and it's a lower withdrawal rate because it's not that you ensure you're going to have a lower withdrawal rate, but you have to make it low enough so that you'll feel sufficiently confident that you won't outlive your wealth.

And that's where if I want a 90% chance that the plan will work, I have to assume I'm going to be getting a lower rate of return. And it could be lower than if I just bought bonds, but it's a tradeoff. 90% of the time, I'll do better than that. So, I may beat just the bond portfolio because the bond portfolio will ensure I run out of money at the end but 10% of the time, I could do even worse. And that's where, well, if I want to draw the line there that I want a strategy that can work 90% of the time. That's why the withdrawal rate from an aggressive diversified investment portfolio can be below that withdrawal rate on bonds or, as you said, like a deferred fixed annuity or something else that would imply a higher yield and a higher spending level because you have to be extra conservative.

Casey Weade: Yeah, an investment strategy, we've got a 3% withdrawal rate showing a 90% chance of certainty. It's all about the inputs, right? It's all about the assumptions that are made. And so, that 10% chance of failure, is that due to the assumption that, hey, the market’s overvalued, we're just going to see lower returns in the future? Is it the projection of lower returns and equities and bonds into the future or is it the volatility of equity markets that’s going to hurt us? So, was it the returns or the volatility that's the biggest risk today?

Wade Pfau: Well, it's a combination of the two and those are actually the two assumptions you have to choose when you do the test to determine what these success rates are. You have to pick an average market return. So, you don't have to be conservative with that number, just what you think's going to be the average return. But then you also have to pick the volatility, how much volatility will there be around that average. And so, if you believe returns will be lower, on average, that's going to hurt your withdrawal rate or if you believe markets will be more volatile, that's also going to hurt the withdrawal rate. And the volatility side, it's a little more subtle, that if something goes down, it becomes a lot harder to come back up if you're spending from that asset. So, a higher level of volatility makes it easier to fall in this sort of death spiral with an investment portfolio where you get caught by a downturn. You're selling assets because you're trying to fund your spending and then you just have less than that portfolio to recover. The market can recover and the market average could be fine over that retirement but if you get hit by an early downturn, it can really disrupt the ability for that retirement portfolio to recover with the overall market.

Casey Weade: It seems like a lot of the research out there is telling us that it's going to be more volatile and lower returns in equities moving forward. And there was something you wrote about in your book, the Paradox of Wealth by William Bernstein. I think that is something, you know, some are going, "Well, how could returns be lower? I mean, since Trump got in, it's been going nuts. We've been on this great bull market.” If we look at the long term, we've had great 7% to 10% average returns in the market over the last hundred years. Can you just talk to us a little bit about this paradox of wealth by William Bernstein? I think a lot of times we talk about market valuations, pricing, and statistics but this is a little different.

Wade Pfau: Yeah. He's actually really going back 1,000 years to calculate like the returns on capital so that people who own the wealth and then they're trying to match up their wealth, they're saving it. So, they're investing it in something and seeking a rate of return. Well, he just noticed that over the past thousand years, the best that you can estimate the returns on capital have just been experiencing a gradual decline. And so that paradox of wealth is as societies become wealthier, the underlying returns on that wealth decline. And he looks into reasons for that. Ultimately, it's just a matter of supply and demand that ultimately there becomes more like a glut of wealth. There's too much wealth chasing investment opportunities. And so, to get that balance between those demanding assets because they're investing businesses or they're building businesses and so forth and those supplying the assets to make those investments, you have to accept a lower rate of return. There's more wealth, seeking fewer opportunity, well, not necessarily fewer opportunities, but there's more wealth seeking the available opportunities for investment and to balance the two, you're looking at a lower overall return on the assets.

Casey Weade: Yeah. That's an interesting way to look at things today. It’s a little different than some of the ratios and things that we look at. I think many times we forget that the number one driver of the markets is our demographics and our demographics are shifting quite dramatically. And with that demographic shift and the wealthier society has gotten, if we just don't look at last hundred years, but we look at maybe more relevant time. Let’s look at the last thousand years, and then we can start to see some of these long term trends that can lead to lower equity returns and in return, the need for alternative strategies. You writing that book on reverse mortgages and how we incorporate a reverse mortgage and retirement plan was just it's pretty interesting to see that. If you haven't listened to that discussion that we had about that, then I would encourage you to go back and listen to that episode Wade and I did a while back.

But today, I really want to focus on this insurance discussion because that in the safety-first book that you have here, and this was not a small book, by any means. We had quite the research book that was put together here 350 words, a small print, and it's one of those things that I really nerd out on and I just enjoy getting into and many of our advisors do as well. So, they always get excited when I have you on because they know we can get into some of the nitty-gritty details that many times we do and address some of the concerns that families have regarding things like annuities. And in the first couple chapters of your book, you get into annuities and I thought one of the things that was really interesting, you kind of have this discussion around liquidity. And this discussion around liquidity has to do with true liquidity. And how many of the families that will work with they'll say, “Okay, I like the idea of some guaranteed income, but I don't really want to give up the liquidity.” No, I don't want to take 200,000 put it someplace, yes, I'll get say 12,000 a year the rest of my life but I don't really like giving up the liquidity. But you say that that liquidity is an illusion.

Wade Pfau: Right. Well, it can be. Right. And that's like, for an example of this, well, retirement it's about matching assets to your goals. And if an asset’s been matched to a goal, it's not really liquid anymore. I mean, you could use it for something else, but then you jeopardize meeting that goal. So, if you believe in that 4% rule, and then to just keep math simple, if you had a million dollars, you believe in the 4% rule and you want to spend $40,000 a year so you put that money into a brokerage account, and you use that in a 50% to 75% stock allocation. Well, there you go. That's your financial plan. You could say that's liquid because brokerage account is liquid. You have a million dollars of liquid assets, but in the meaningful sense of retirement, that money is not really liquid. It's earmarked to meet that $40,000 spending goal. And if you use it on something else, you're directly jeopardizing your ability to meet that future spending goal.

And that's where it gets back to this discussion again, where if you're using an investment strategy, it's forcing you to be more conservative. In other words, you're going to need more assets to make sure your retirement works because you have to assume that you live a long time and that you get bad market returns. And the annuity can pull that risk across a large number of individuals and allow you to meet that spending goal with less assets. And even if the annuity is not liquid, that simple income annuities don't have that liquidity feature. But if you can earmark less assets to meet that goal, then what's leftover becomes a source of true liquidity, its assets that are not earmarked to another goal and that can be used for anything without worrying about not meeting your other goals.

Casey Weade: Well, if I may set up an example for those that don't do retirement income planning every day, let's say that we had a million-dollar portfolio and we wanted to generate $30,000 a year in retirement income. We could take that whole million dollars and allocate it to a, let's say, a 60/40 stock-bond mix or something. Yeah, we blend stocks and bonds in there. Alternatively, we take that million and we said we want to create $30,000 a year. Let's say that we carve out 500,000 of the million to guarantee all of our income needs rest for life. Now we've got another 500,000 that really lets if we look at this in a vacuum, don't talk about health care needs or emergency needs with that remaining 500,000, the only reason those excess funds are really going to be utilized is for inflation protection. And so, we start to look at the best tools to allocate assets and two for inflation protection. It’s probably not an annuity. Annuity is meant for creating stable retirement income, not to guard against inflation.

And some of David Blanchett’s research you wrote about this with changing spend patterns that we have in our spending and retirement, we may not even experience inflation. However, this is defense. We have potential of a hyperinflationary environment at any time. So, why don't we set some funds aside for long-term growth in the right assets. They're going to help us outpace inflation and ultimately, that can also be our legacy if we don't use them for inflation. That's how I would describe it. And if you can offer any further depth to that, I welcome it.

Wade Pfau: No. I think you explained that very well. I don't think you need the inflation protection from the annuity because if you can just put less assets into it at the start, it helps to reduce your distribution need from your remaining investments. And so, it's another way to manage these risks. If you're spending less from your investments, you're also less likely to get into that downward spiral of heading towards asset depletion. And so, you have more opportunity for those assets to grow and that can be the source of inflation protection as needed. But also, as noted in national research about people spending patterns, not everyone's spending grows with inflation. People tend to spend less as they age. And so, you might find you don't even need additional inflation protection. If you do need it, you have the assets, you could ladder in additional annuity purchases or just take it from the investments. But you might also find that you don't need that as well. So, you have that flexibility either way.

Casey Weade: Well, you've talked about risk pooling here as one of the ways that they're able to generate more income and insurance companies able to generate more income than you could on your own and that's someone to buy a life insurance policy, right? People will say, "Well, how can they give me $500,000 if I die tomorrow, and I only gave them $10,000?” Well, you gave them $10,000 and so did a bunch of other people also gave that $10,000 and they're expecting that this is average life expectancy. In the end, they're going to win overall. You may win because, one, you're going to get your money back. Your return may be higher than that, but that's ultimately how life insurance works. Its risk pooling and that's the same way that you're going to see guaranteed income strategies work with an income annuity is to have that risk pooling feature.

And I think, really quickly, most can grasp that. However, then when you go to, let's say, a fixed annuity that's paying just a fixed rate a lot like a CD that's paying say 4% per year, and they say, “Well, why can they pay me 4% but I can't get a guaranteed insured bond that's also five years long to pay me 4%?” And so, you mentioned in your book how insurance companies are able to attain a higher rate of return on fixed-income assets, bonds than we are as individual investors. I have my own theory on why that is. How would you explain that?

Wade Pfau: Yeah. And so, to be clear about that discussion, annuities now in the US really, going back to the 1950s, get used two different ways. The original way is to talk about lifetime income or getting a set number of payments. But with the changes in the tax code where annuities provide tax deferral, they're often also treated as just a tax-deferred, a way to get tax deferral and to treat them more as an investment. And so, with the example you're saying, that's more about tax deferral and also about the idea that, yeah, maybe the annuity can offer a higher yield than the household can earn if they tried to just invest in bonds themselves. And that relates to a few factors. The insurance company has this general account and they're doing this asset-liability matching where they know every year they don't know who's going with life insurance. They don't know who's going to die with an annuity. They don't know who's going to live or die, but they have a good sense of how much they need to pay out each year.

And so, they can purchase bonds that are matched to these expenses and that allows them to generally hold longer-term bonds than a household could afford to do because longer-term bonds offer higher yields, but also create more interest rate risk that if interest rates go up, you'll experience a bigger capital loss. So, insurance companies can invest in longer-term bonds. They can also invest in - because they're bigger, they can diversify more and so invest in a variety of corporate bonds to have more credit risk or more just riskier bonds but diversifying that and as well they can invest In less liquid bonds, which also offer a premium because they know they're going to be holding these for the long term and holding them to maturity, so they can invest in the types of less liquid bonds that households would struggle to try to their own. And then as well just because of their size institutional pricing on their trades. So, with all that considered, that's where quite realistically an insurance company can expect to yield more on their portfolio of bonds than a household can necessarily earn trying to build a bond portfolio on their own.

Now households surely have access to mutual funds. So, they could get that, for example, credit risk diversified through a mutual fund. But for the retail investor, you then also have to consider the expenses on those mutual funds. And the insurance company can be better positioned to just yield more than the household when it comes to investing for fixed income.

Casey Weade: I often think of a company like Allianz that it owns PIMCO, right? They are buying billions of bonds at a time. They can name their own price a little bit better than the individual investor that's got $100,000 and wants to create a diversified portfolio, buy individual bonds, a couple of thousand dollars at a time, you're not necessarily going to be able to throw your weight around quite like a PIMCO or an Allianz or another major billion-dollar insurer could.

Wade Pfau: Right. Yeah, retail investors have to pay a markup. And it's hard to know what those markups are because they're not always transparent. But, yeah, at the end of the day, the insurance companies buying those bonds at a discount relative to the household.

Casey Weade: Now, it's interesting, you use the word transparency there and said you're buying bonds. It's not always transparent. I think what a lot of times you read online that annuities aren't always transparent. So, is there just a lack of transparency in the financial industry? Do you think that that is more of an investment bias where they say, "Well, annuities they lack transparency,” but then they don't talk about their bond portfolios lacking transparency. So, it's an interesting dichotomy you offered us.

Wade Pfau: Right. Yeah. I mean, annuities can be complex and fixed annuities because it's just like a bank account. They're spread products. So, like if you open a checking account at the bank and it's a no-fee checking account, well, the idea is the bank can earn more on the funds than they're paying you in any sort of interest. And it's the same concept with any sort of fixed annuity where the insurer is able to invest that money and it's earning a higher yield than they're paying back to you at the end of the day. So, that's the non-transparent part.

Casey Weade: Wade, you talk a lot about a lot of different types of annuities. In the book, you cover income annuities and fixed annuities and variable annuities, indexed annuities, and I don't see you anywhere throughout this discussion saying variable annuities are bad or fixed annuities are bad or income annuities are bad. Do you think it is truly possible to make any overall conclusion for or against annuities?

Wade Pfau: I think any type of annuity can have the potential to play the role and that's in the book. I spend a lot of time just explaining how income annuities work, how variable annuities work, and how fixed indexed annuities work. And noting, at the end of the day, when you add a living benefit to get lifetime income, the variable annuity gives you the most upside potential, but maybe the less amount of downside guaranteed income, but of course, it can vary from product to product and so to just understand how the different types of annuities work. But in the media, when they talk about annuities, they often create an annuity for the discussion that doesn't actually exist because they’ll talk about annuities have high costs. Well, that's generally a reference to a variable annuity, but then they'll say annuities are not liquid and that's generally a reference to a simple income annuity. But you don't generally see high-cost non-liquid annuities. So, they're describing something that doesn't exist. The different types of annuities have different advantages and disadvantages. And it's important to consider the whole, all of it together.

Casey Weade: Well, you brought up something really interesting in your book in regards to variable annuities. So, I grew up in a world where variable annuities are bad, and I think some advisors grow up in worlds where fixed annuities are bad. I grew up in this world where variable annuities are bad and dad was more of a proponent of offering guaranteed income products and fixed annuities, indexed annuities, annuitization, things like that. And we would see a lot of variable annuities come in the door, we would audit those variable annuities. We still do this to this day. And I'm still in this position where I go, I just don't variable annuities. And it is a bias that I have but it's also because I've had a lot of experience that I've never seen a really good one. If I'm looking at it from an academic perspective, if you said in your book, many of the features of variable annuity can be accomplished with an income annuity combined with an aggressive investment portfolio. If we're thinking about efficiency, I like to think about the closest distance between point A and B. It's a straight line. So, if you want growth, use equities. If you want income, use annuities. If you want a death benefit, use life insurance. You find the most efficient tool to accomplish that end goal. And to me the variable annuity was always this vehicle it has, it's trying to accomplish everything. You've got this tool that gives you grow your allocated the market. So, you got the growth of the market, you've got a guaranteed income to the last rest your life. You got a death benefit to leave behind your heirs.

And so, it's accomplishing so many things that each one of those things comes with a fee. You end up with growth that's lackluster. You end up with income that's lower than you could get with, say, an indexed annuity or an income annuity. And you end up with a taxable death benefit. I'd rather allocate that fee to a life insurance policy. But in your book, you explained that those inefficiencies could be a benefit and the way that it may be the only way that a client would ever get an income guarantee. Even if it's an illusion, that's the only way that they would ever get or buy an income guarantee because they want that upside or they want that flexibility and maybe an income annuity doesn't give them. So, you have me kind of seeing even variable annuities in a different light.

Wade Pfau: Yeah. And so, kind of the punchline of all that is sort of generally the most efficient strategy is you have this life-only income annuity, and there's no cash refund. If you purchased it and get hit by the bus on the way out of the office, you'd lose the whole premium, but that's valuable because it you're offering the most risk to the risk pool and so you get the most returned back from the risk pool if you do end up living a long time. So, a life-only income annuity plus 100% stocks for everything else, which is also not going to make people comfortable because they look at even though you have the annuity, it's a different situation because you have this protected income. But when you look at your portfolio statement, it says 100% stocks. And so, the life-only income annuity and the 100% stock portfolio, neither of those are particularly attractive to individuals. So, a variable annuity might be less efficient than that but a good competitively priced variable annuity could still be a lot better than investments-only approach and that's where it might not be on the efficient frontier, but it's a lot closer to the efficient frontier than investments alone. And because…

Casey Weade: That was really insightful for me. And it's kind of overcoming some of the biases that I have so thank you for that. But when I look at income annuity, this kind of takes us into fixed indexed annuities, and for those of you that are unfamiliar, just go back and review what Wade said earlier. We've got income annuities that is handing that's what you think of most people think of as an annuity. You handle up some over to an insurance company, they guarantee income for the rest of your life. If you pass away, it's gone, but they're going to pay it forever. And then you have fixed annuities, pay a fixed rate of return for a fixed period, much like a CD. You have variable annuities that allocate your dollars into at-risk assets like mutual funds, then you can add income guarantees or death benefits to that. And then you have fixed indexed annuities that give you participation, market upside, none of the downsides with the ability to add things like income guarantees or death benefit writers.

So, now if I am looking for an income guarantee, quite often, I'm going to find them to get the best income guarantee even better than an income annuity with a fixed indexed annuity, rather than utilizing a variable annuity with an income writer or better than using an income annuity with an income writer. And so, I kind of wanted to go into that. Why is it that when I'm pricing these things today, I often find that fixed indexed annuities are paying a higher level of guaranteed income than an annuitization with the income annuity? Because with an income annuity, I'm giving up total control. I should get more income than if I put it in a fixed indexed annuity with an income writer. So, why is it that I'm seeing that in pricing?

Wade Pfau: Yeah. And that's a great question because, in theory, the income annuity should offer the highest payout, and then a fixed indexed annuity should be next because it's got longevity risk, but it doesn't take on the same kind of market risk with the way it's structured. And then a variable annuity should be at the bottom. But what we can observe sometimes is a fixed indexed annuity offers a higher payout rate than the income annuity. And that's a little bit of a puzzle but the basic explanation just seems to be the fixed indexed annuity is priced when it's priced competitively, it's accounting for the fact that not everyone's going to end up taking advantage of the benefit. Like with a simple income annuity, because it's an irreversible decision, you have no choice but to take full advantage of the benefit. You don't have any way to say, "No, I don't want to take the distribution.” You receive it automatically. With a fixed indexed annuity, people might not turn on the lifetime income or they might not take the full allowed amount out every year.

And so, that creates less risk for the insurance company because they're really only on the hook in the event that you outlive the contract value of your assets. And you should take full advantage to spend those assets as much as you can. But not everyone does that. And so, those who are not taking full advantage of it, create that opening for the insurance company to offer a little bit higher payout rate. And then those who do take full advantage of it can end up being better off than then if they used an income annuity. And so, it's people who can take advantage of those in that risk pool who are not taking full advantage of the opportunity they have, that seems to be the main explanation for why the fix…

Casey Weade: Yeah. That's counterintuitive. That's counterintuitive to what a lot of individuals think should be the case, right? If I give up total control, why do I get less income than I do, say with a fixed index? It's also counterintuitive to what a high surrender charts and in your book, you said it might be beneficial to actually seek out higher surrender charges in a fixed indexed annuity, as you got into that discussion. And if I'm going to, I think most people, they say, well, I'm going to put money with an insurance carrier. I want to say 5, 10, 12 whatever year fixed indexed annuity, I'm going to look for the lowest surrender charges. So, I want a 7% penalty in year one. I don't want a 25% penalty in year one, but you made an argument for actually seeking out a higher penalty potentially. Why would you make that argument?

Wade Pfau: Right. So, fixed index annuities they're meant to be a long-term investment or a long-term tool. And if you hold it on for the long term, you're never going to have to pay any surrender charge. It's only if you decide you want to get your money back earlier that you have to pay a surrender charge. Well, part of the reason a fixed index annuity has a surrender charge is when they have that, they can invest in longer-term assets and less liquid assets. And that's back to that earlier discussion. If you give them the potential to invest for higher yield through longer-term, less liquid types of assets, that can allow them to yield more than if they have to invest more in the short term because they're worried you might want your money back early. And so, by being willing to pay a higher surrender charge, you give that ability for them to invest for higher yield and that can then translate into getting better terms on the annuity. Then everything else being the same and annuity with a smaller surrender charge and get offers much yield as well.

Casey Weade: Well, I think these are thought-provoking things. I know I'm running out of time. So, I want to make sure I get to one of the things that I think will be really interesting to the listener and that was you can wrap up the book on life insurance. And when it came to life insurance, you said, hey, it's got four roles in a financial plan: legacy, behavioral hurdles, volatility buffers, fixed income alternatives. I mean, just let that sink in for a minute, right? Most people think, "Well, it's just for death benefits, just for legacy,” but then you've got behavioral hurdles, volatility buffers, fixed income alternatives. I don't think most people think of life insurance in those ways. So, first, I guess I want to talk about kind of the highlight here where you say life insurance. Buying life insurance can allow for a higher spending rate. And most of it, well, if I buy life insurance, I'm paying a premium then maybe I have a higher spending rate, but it's going to pay the life insurance premium. Yeah. What is it about life insurance that is potentially allowing for a higher spending rate?

Wade Pfau: Yeah. Well, it depends on how it's used. But you have to be clear about all this. So, I'm still a little bit young to be buying annuities. I am thinking ahead to that but I'm not too young to buy life insurance and I became so convinced by the research I was doing to get a big permanent life insurance policy because it can be used in different ways for retirement income. I think to say that it allows for a bigger spending rate, that's going to be linked more to the volatility buffer discussion, where I look at somebody, I think in the book, it was a 40-year old couple. They decide they need some life insurance and so they think about do they just get that pre-retirement for the normal to protect the family so buy term and invest the difference? Or do they think about permanent life insurance to plan ahead for retirement income, where they have to pay a higher premium on life insurance? So, they're going to have less than their investment portfolio but then that life insurance provides them an additional tool to plan as part of their retirement income.

And if you use it as a volatility buffer, which is when the market goes down, instead of spending from your investment portfolio that year, you take a loan from the cash value, and you try to give that portfolio chance to recover again. That can be really effective in helping them manage sequence of returns risk and this market volatility and retirement. And it really seems to work so that it can allow in the simulations I do for a higher level of spending using a higher withdrawal rate. And part of that is because you can use a higher withdrawal rate because not every year you're spending from the investment. Some years you're spending from this cash value outside of the investments. But then spending at a higher level, helping them manage that risk and so therefore still helping to support more legacy at the end of retirement as well, even after supporting that higher spending level in retirement. So, it's an example of a combination of life insurance and investments can be more efficient than just investments only.

Casey Weade: Well, it might actually be even more efficient than an annuity. You’re utilizing life insurance due to the tax benefits that can be achieved if properly structured, then that could be more efficient than using a tax-deferred annuity depending on the structure of the policy itself. And I refer to that in my book as a flexible withdrawal strategy. So, rather than using a flooring approach, we use a flexible approach. We actually take the income from the investment strategy, the investment portfolio, if the markets down then we will take the income from let's say a fixed annuity, indexed annuity, or maybe a cash value life insurance policy as well. There's our bond alternatives, sustain our income for a few years from that, and then we can go back to the investment portfolio once it's recovered. And I understand that very well from a fixed income alternative perspective of volatility buffer but then you mentioned behavioral hurdles as well.

And this is where I find that life insurance comes in handy quite often when we're sitting down with a couple that say, how many times have you heard it? Well, I was just recording a television show with a friend of ours. And as we were recording the show, he mentioned, well, we were out the other night and I wanted to spend some money on something, though. I've said, "Well, we got to make sure we have money left for the kids when we pass away.” He said, "Oh, they'll be okay.” But that's the kind of scenario we run into and often many times is people that really want to leave a legacy behind they have trouble spending. But we can utilize life insurance to satisfy those legacy goals and allow for higher spending and that is - is that what you would refer to as behavioral hurdle?

Wade Pfau: Oh, yeah, that could be one. I mean, something like the 4% rule assumes you're willing to spend your wealth down to zero at the end of retirement. So, if you specifically are trying to preserve your investments, to meet a legacy goal, you have to spend less from your investments. And so, in the book, I looked at four different types of scenarios. One was comparing, meeting your legacy goal with life insurance versus meeting your legacy goal by just spending less from your investments to make sure you left over enough to meet your spending goals. And the life insurance strategy. Again, it's allowed for meeting that legacy goal while still being able to spend more in retirement. So, that was another use. Yeah, it could be that. I think with the behavioral side I was also thinking more about, we talked about that life only income annuity, no liquidity, no upside, people tend to be nervous about those. But if you have life insurance, you can really view that as the ability to refund the annuity premium, so that when that individual passes away and their annuity payments stop, the death benefit from the life insurance replenishes that asset for the household and allows the remaining survivors to then decide what to do, but they're going to be okay in that case. So, that the behavioral ability to be comfortable having an annuity and retirement through the life insurance.

Casey Weade: Yeah. There's so much to be gleaned from all this. Our engineers are just eating this up right now. However, we may have lost a few people along the way. So, what's next for you, Wade? Do you have another book here in the middle of writing? What are you currently working on?

Wade Pfau: Yeah, not in the middle yet but my plan was always to have four books. And so, the last book partly will just be a summary of the other three books but then it's more of an overview of all different retirement income topics. And so, there will be new content on Social Security and Medicare planning, long-term care planning, just retirement living and lifestyle, tax efficiency for retirement, which are all areas that I didn't touch upon too much in the past books.

Casey Weade: Well, I can't wait to continue the discussion when those get released. In the meantime, I know everyone if they want to get connected with you, they want to find one of your books, they can go to RetirementResearcher.com. Check out all the amazing resources and writing that Wade has out there and as part of a gift to our listeners, for those of you that are listening in right now, if you would like to get a copy of Wade's book, that Safety-First Approach, Wade was so kind enough as to send us a small box of these over to our office and we are going to give them away until they're all gone. If you'd like to get your copy of this book, all you have to do is leave us an honest review on iTunes. And if you're listening on your iPhone, just scroll down to the bottom, leave a review right there at the bottom. If you want another way to do that, you can go over to RetireWithPurpose.com, click on the Podcast tab, check out the show notes and right there you also see a place that you can leave a review. Leave a review, send us an email at info@howardbailey.com with your iTunes username. We’ll match those things up and we will get you out a copy of Wade's book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. Wade, thank you so much for your help here and sharing all of your knowledge that you have. It's always a pleasure.

Wade Pfau: Well, thank you, Casey. Yeah. Likewise, thank you.

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