371: Examining How Risk Tolerance and Aversion Factors Into Your Retirement Income Plan with Michael Finke, PhD
Today, I’m talking to Dr. Michael Finke, Professor of Wealth Management and the Frank M. Engle Distinguished Chair in Economic Security at the American College. He’s the Director of the Granum Center for Financial Security, and he’s been my professor a few times throughout my career.
I’ve always been a huge fan of his academic, unbiased approach, and you’ve undoubtedly seen Michael’s work featured here in our Weekend Reading for Retirees email series over the years. He’s published over 50 peer-reviewed articles and is widely quoted in many leading consumer publications.
In 2021, he co-authored a research paper titled, Guaranteed Income: A License to Spend with David Blanchett, a previous guest of the show, and also co-hosts the Wealth, Managed podcast with David as well. He’s been a tremendous resource to me and many others, and I’m thrilled to talk to him today.
In our conversation, Michael and I talk about how our eating and investing habits are so intertwined, how to find true happiness and your purpose in retirement, and how risk factors into your income planning, regardless of your risk tolerance.
In this podcast interview, you’ll learn:
- How Michael’s first career as a food consumption researcher influenced his economic perspective–and the correlation between healthy eating and investing.
- Why our society gets so distracted by outliers in economics and politics.
- How risk aversion influences everything we do in investing and retirement.
- Why annuities are being used more and more for wealth accumulation instead of lifetime income–and how this is changing the perception of annuities.
- Why so many people can’t stand to see the numbers in their bank accounts get smaller in retirement–even if they’re overfunded.
- "One of the things that I think advisors need to remember is that there is no guarantee in life, that when you make decisions, you make it based on evidence. And the bigger the sample, the more confident you can be in that suggestion." - @FinkeonFinance
- "There’s always unknowns. If anything is certain, it is that whatever you plan for retirement, it’s not going to end up playing out exactly the way that you expected." - @FinkeonFinance
- Michael Finke
- Michael Finke on Twitter
- Michael Finke on LinkedIn
- Wealth, Managed Podcast
- Guaranteed Income: A License to Spend
- Forget What You Know about Stock Returns by Michael Finke
- The American College
- Granum Center for Financial Security
- Ohio State University
- University of Missouri
- Outlive: The Science and Art of Longevity by Peter Attia, MD
- Warren Buffett
- Donald Trump
- University of Michigan
- Retirement Researcher
- David Blanchett
- EP 055: How to Navigate The Changing Retirement Landscape with David Blanchett
- Wade Pfau
- Robert French
- Alex Murguia
- Advisor Perspectives
- Meg Bartelt
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Casey Weade: Welcome to the Retire with Purpose podcast, where it is our mission to deliver you clarity and purpose and elevate meaning in your life through purpose-driven strategies and common-sense strategies. Today, we have a very special guest for you. This is your opportunity to join us for one of our full-length conversations with Dr. Michael Finke.
Who is Dr. Michael Finke? Well, he is a Professor of Wealth Management at The American College. He’s been my professor a couple of times throughout my career. He is also the Director for the Granum Center for Financial Security and the Frank M. Engle Distinguished Chair in Economic Security at the American College. He holds a doctorate in consumer economics from Ohio State University and a doctorate in finance from the University of Missouri.
He is a nationally renowned researcher. You’ve seen many of his articles show up on our Weekend Reading for Retirees email series. I’m a huge fan of Michael, much like many of the other researchers that we bring here on the show. He takes a very academic, unbiased approach, and these are the types of people that make a perfect fit for our fans and ultimately for your bottom line. He has published more than 50 peer-reviewed articles and is widely quoted in many of the nation’s leading consumer publications.
Casey Weade: With that, Michael, welcome to the podcast.
Michael Finke: Thank you, Casey. It’s great to be on the podcast.
Casey Weade: Well, I’m excited to have you here. It’s been a long time coming. I think we’ve had you on the calendar a couple of times over the last couple of years and we’ve finally been able to connect here. You’ve always been one of those men that’s been at the top of my list, just because not only have I followed your research and you’ve been a professor, but I love the approach that you take to personal finance, and especially retirement planning, which will definitely be a large focus for our conversation today.
We’re going to be talking food consumption, what that has to do with investing, and we’re talking about happiness and retirement. And we’re going to have a very strong focus on income planning. We’ll also bring some questions here into the conversation from our Weekend Reading subscribers. And I want to kick it off with food consumption.
So, you have a background, the first 10 years of your career, you spent as a food consumption researcher, I hear, and correct me if I’m wrong, but I want to know how does someone go from a– I don’t even know what a food consumption researcher is, did that for a decade though. So, what is a food consumption researcher? And how do you make this leap from food consumption researcher to Ph.D. in Finance, Ph.D. in Consumer Economics?
Michael Finke: Well, I mean, we can start out even earlier. I was going to Ohio State University. I decided to get an econ degree. I was busing tables at night. My econ advisor said, “Hey, there’s this department that has a scholarship and you can actually go and get your master’s, and it’s an agricultural economics where I think you’ll enjoy it.” So, I ended up doing my master’s in agricultural economics.
I had literally zero interest in agricultural production. That wasn’t interesting to me at all. But what interested me was why people made the decisions they did about the foods that they had. So, I ended up getting a Ph.D. in Applied Economics, and that was my interest. Actually, I did my dissertation on the use of food labels, who uses food labels and who doesn’t.
And one of the things I found in my research was that the kind of people who are more educated, who make more money, who have more wealth, they’re more likely to use food labels. And that really piqued my interest in understanding this relationship between wealth and healthy behaviors. And my theory was that investment in health is the same thing as investing in money, because what is an investment?
An investment is a sacrifice that you make today. So, when we invest for the future, we’re taking money that we could spend on fun stuff today and we’re instead putting it in a bank account and it grows over time. And hopefully, in the future sometime we actually spend it and use it to provide some enjoyment. When I decide to eat a grilled chicken sandwich instead of a hamburger for lunch, I’m doing the same thing. I’m sacrificing in the present so that I can live better in the future.
So, back in 2002, I decided I would take a Ph.D. class in investment theory because I always wanted to know more about what investment theory was all about. It seemed like it was very related to this. It must be related to this idea of food consumption theory because there was such a big overlap between wealth accumulation and eating healthy diets. And so, I took the class and I learned all about the theory of investing, which is very similar to the theory of healthy eating. Essentially, you’re sacrificing, you’re investing in something that could do really well in the future or could do not so well in the future. But because we’re naturally risk averse, we will have to be rewarded. We’re taking investment risk. And it’s the same thing when you invest in food consumption.
I’m reading this book called Outlive right now by Peter Attia, and he really makes this point that an investment in health is a volatile investment. It’s this what we call in economics as stochastic investment. In other words, you could sacrifice and eat and exercise and take care of yourself really well, then you could get cancer in 10 years. So, none of us know if it’s going to play out, but we all make decisions based on expectations on the averages.
So, that’s what motivates us to invest, is that on average we’re going to have more money if we invest in risky assets. And it may not always work out. That’s one of the points that I very often make when I do presentations is that we can’t rely on investment risk because in order for risk to be rewarded, it has to be real. So, it can’t bail us out of every single situation.
But there are so many overlaps between healthy behaviors and financial behaviors that is no wonder that we see such a high correlation. And in fact, over the last 30 years, what we’ve seen is this amazing difference in improvements in longevity among higher-income Americans and lower-income Americans. And I really attribute that to the fact that higher-income Americans make bigger investments in their health. So, they don’t smoke, they eat better, they exercise more frequently, and that is creating this big disparity.
Now, it also has implications for retirees because if people are making this investment in their health, they’re going to live better in retirement, they’re going to be more active for more years, they’re going to live longer, which means retirement is going to be longer for healthy Americans today than it’s ever been in the history of mankind. So, that also has important implications in terms of the cost of funding retirement and even some of the strategies that you use to fund retirement.
Casey Weade: Now, when I hear that, I think there are some that are going, yeah, but look at Warren Buffett, look at Donald Trump, he loves his McDonald’s, right? These aren’t guys that make good, healthy decisions. And look, they’re billionaires. And I think the same thing happens. Doesn’t the same thing happen in the world of investing where people see the outliers, they see the people that have concentrated portfolio risk or put everything in the Bitcoin at the right time and ended up extremely wealthy and extremely successful. It’s easy to make some of those mistakes by simply focusing on outliers.
Michael Finke: This is why I think statistics needs to be taught in schools so that everybody understands that you can have a certain set of behaviors that on average are going to lead to greater wealth or greater health or greater success or greater longevity. And there’s always going to be outliers, and it’s always the outliers that end up on TikTok because everybody is fascinated by the outliers. They want it to be them. But as an academic, you’re trained to ignore the outliers and only focus on the data.
So, one of the big advantages that I have is that I get to look, when I’m studying retirees, there is this Health and Retirement study that was created by the University of Michigan that starts in 1994. And it has 20,000 retirees in it. You can follow them all the way to the present day and you can see what choices they make that are predicted to have more positive outcomes. And by the way, it’s very difficult for me to admit that anything useful ever came out of the University of Michigan as an Ohio State grad, but it is to me, you have to. And this is one of the things that I think advisors need to remember is that there is no guarantee in life, that when you make decisions, you make it based on evidence. And the bigger the sample, the more confident you can be in that suggestion.
When you see these outliers, it’s very tempting to get distracted by them. But that’s not going to help you make a decision because you can do as many of the people who jump into the crypto market, you can see people making a lot of money. You can think, well, God, I wish that was me. I’m going to jump in, of course, at the wrong time. Investors are so reliable in terms of their willingness to jump in after something has gone up in value, buy things when they’re very expensive, subsequently underperform. But that’s just this human tendency to respond with emotion instead of responding with data. But that’s always going to get you in trouble in the long run, unless you get lucky. Some people will get lucky.
Casey Weade: Yeah, exactly. Now, I want to get into retirement in a moment, but I always get interested when I have someone on the podcast that is an academic that’s also close, of course, with other academics. We see this over at Retirement Researcher and you, as well as David Blanchett, have worked very closely together, as well as working closely on the Wealth, Managed podcast.
And I am always interested to see the differences in two very smart people in the way that they think about retirement or think about investing. And so, I wanted to ask you about your relationship with David. And where do you not see eye to eye? Where do you disagree on something? Where do you plan differently in your life? We had a conversation back in Episode 55 with David Blanchett. So, I encourage you go back, listen to that conversation. But that will probably provide you a little bit more insight on why I’m asking this question.
Michael Finke: I actually don’t think, and this is something that is a bit of a secret. For those of us who are trained as economists like Wade, I mean, Wade and David, they’re both trained as traditional economists, Wade especially, because he went to Princeton and got a Ph.D. in econ. We all think pretty much the same about most stuff. And that may come as a surprise to people on the outside that I can talk to any economist that does retirement research about annuities.
And I’m not going to get a difference of opinion about annuities. Everybody understands the basic mechanics of annuities, the advantage. We all use the same models to be able to estimate the benefit of pooling mortality risk. There’s not going to be that kind of disagreement that there is among practitioners because we all have the same basic set of assumptions. So, there is economic theory. We all agree that this theory reflects reality, and then we use the same kind of tools. So, you’re not going to see that.
Where you get these differences of opinion are areas where maybe there’s not quite enough data, and that’s where opinions start creeping in because you can say, well, this limited set of data seems to suggest that this is reality. Another researcher might have a different interpretation. And over time, what happens is that you form a consensus about what reality looks like.
So, I think if you sat down with Wade and David and I, you would have a very difficult time finding an area where we have any sort of a big difference of opinion. I tend to be more pessimistic when it comes to things like stock return expectations. And again, I attribute this to simply different interpretations of a limited data set. And if you look at the historical data, you’ll see that in the United States, there has been this what we call an equity risk premium, this bonus for investing in stocks. Historically, that may be about 6%.
But you see that that premium since the late 1980s has shrunk in the era of mutual funds and the defined contribution world where we’ve gone from one out of every seven investors investing in stocks to now one out of every two investors investing in stocks. And what that means is that according to economic theory, if there’s more demand for stocks, the expected return is going to go down. So, my interpretation of the data is that that equity risk premium right now may be very small if it exists at all over bonds, whereas someone like David might have a more optimistic interpretation of that premium that we might be able to get from investing in stocks. But the reality is that none of us know that it’s all about our interpretation of a limited data set.
Casey Weade: So, when I look at the three of you, so we have Pfau and Blanchett and, of course, yourself, Finke, and then when I look at Retirement Researcher, I’m sure you’re familiar with some of the research and work they’ve been doing around RISA, which is really cool stuff. And when we look at Bob French, Alex Murguia, and Dr. Pfau, now the three of them from a retirement income planning standpoint, maybe it’s their background, maybe it’s that they’re all classically trained economists, but maybe it’s also that they’re each choosing for themselves different retirement income approaches so they favor different ones from Pfau currently leaning towards risk wrap to Alex Murguia, I believe, his bucket approach, French’s total return.
And maybe the reason that they are leaning towards one approach or the other, maybe it’s not that they’re not all economists, maybe it is what you said a moment ago. Maybe it is the fact that there’s still limited research around retirement income strategies themselves. What are your thoughts?
Michael Finke: I think if you asked, again, where I think people like Alex, they’re scientists, but they’re specialists in a different area. So, Alex understands human behavior and psychology at a much deeper level than someone like me, because that’s not my area of expertise. I don’t know if there’s that much of a difference among all of us in reality. I think that their insight in particular on what would motivate someone to have a preference for being in one style or another, to have one style of retirement income planning, that is fascinating.
I think the data really does show that there are people who believe that they just want to manage their investments, pull money out of their investments. They feel that they don’t want to hand over money to an institution. They’re not as concerned with that risk of outliving their savings. They want to do it on their own. There’s another kind of person who values that security, and it may be related to things like confidence and financial literacy.
And because most workers these days, they’re not trained to manage their own money and figure out how to safely withdraw money from an investment portfolio. Most of them just want to delegate that and say, “All right, you tell me how much I can spend every year and you make sure that I don’t run out.” For them, the optimal solution is probably something that looks like the lower left-hand side of the quadrant in RISA, which is income. You focus on income planning and making sure that the money doesn’t run out.
There are definitely different preferences. But from the perspective of an economist, what we think is, all right, what is the approach that’s going to allow me to spend the most money every year given a certain set of assumptions? So, if I have this level of risk aversion, what does that mean when it comes to retirement income planning? And I’m just jumping right into retirement income planning because this is where I think it becomes most interesting is that our models show us that if you’re risk averse, really what that means is that you don’t want your spending to vary that much over time. So, that’s what risk aversion means, even when it comes to investing.
It’s a misunderstanding I think a lot of people have that are not in economics, they think that it’s annual volatility. But honestly, what risk aversion means is, am I willing to accept the possibility that in the future, I might have to spend less in order to get the potential that I could spend more? If I’m risk tolerant, then I am going to be more willing to accept variation in my spending. If I’m risk averse, then I’m going to be less willing to accept variation in my spending.
Now, one of the big problems with spending in retirement is that we don’t know how long we’re going to live, and if we end up living into our 90s, then we might have to cut back on our spending significantly. And if we’re risk averse, what we’ll do is we’ll spend less early on in retirement to avoid the possibility that we might have to cut back extremely when we’re in our 90s and that leads to underspending and that’s a suboptimal kind of strategy for retirement income. But I think it’s incredibly important to remember that when we talk about risk aversion in retirement, we’re talking about spending flexibility. And what I’m seeing now is a deeper understanding among people who are in this space. That’s really what it’s all about. It’s about lifestyle volatility.
Casey Weade: So, I’m wondering how this intertwines with your 2021 research paper that you did alongside of David, Guaranteed Income: A License to Spend. And what that found was it found that retirees who hold a higher percentage of wealth and guaranteed income, they spend more. Retirees will spend twice as much a year in retirement if they shift investments into a guaranteed income. And when I think about this, if someone is highly risk on, so they have a high-risk tolerance, meaning that they are willing to accept more volatility in their spending, will they still spend less even if they have a high-risk tolerance for that spending volatility than someone that has a guaranteed income approach?
Michael Finke: That is a great question. So, Wade and I wrote a paper back in 2012, where we really laid out what this means. So, if I’m more risk tolerant, what that means is I’m going to invest in assets that have a higher expected return so that I can spend more. And what I’m going to do is I’m actually going to spend more because I’m more risk tolerant. So, the first year of retirement, if I’m risk tolerant, I will spend more that year and I’m going to invest in risky assets because on average, I will be able to spend more every year in retirement.
Now, the downside is that if I get hammered early on in retirement because I’m investing in risky assets, I’m going to have to cut my spending down below what I would have been spending if I just started out in a conservative spending strategy because I’m risk averse. So, risk tolerance means I’m going to go all out, I’m going to try to get the most out of retirement, I’m going to spend a lot at the very beginning, I’m going to invest in stocks, but I have to be willing to cut back significantly if the market does not do as well.
And what I often see, again, a mistake of interpretation is that people think that someone who is risk tolerant will simply have a different asset allocation, but their spending won’t necessarily be different than someone who is risk averse. Now, someone who is risk tolerant and has a lifetime income benefit, in other words, they buy insurance to protect them against the worst possible outcome, which is that they get a bad sequence of investment returns and they live a long time. That’s the person who can actually spend the most optimally in retirement.
So, David and I have played around with the numbers a bit, and that type of a solution is interestingly more efficient than in some cases, buying, for example, a deferred income annuity that’s going to pay out even if the market does really well. So, you want to insure yourself if you’re going to take a lot of risks at the beginning of retirement, you open up the possibility that you’re really going to have to cut back later on. And the way to insure against that loss is to buy that lifetime income protection. That’s an insurance product. You’re going to have to pay a certain percentage every year for the insurance premium.
But in the face of a 2022, at the beginning of retirement, you can just continue to spend up to some sort of a threshold, that minimum withdrawal benefit. And then, you could deplete your money in 10 years and continue to spend that amount. Essentially, what you’ve done is you said, “All right, I want to take risk, I want to spend a lot of money. Didn’t work out, but at least I have this insurance that is going to pay out that’s going to allow me to continue to maintain a minimum threshold of spending.”
Casey Weade: What if someone had a slightly higher risk tolerance? And hear me out there, instead of buying a lifetime income, what if they just annuitize the first 10 years of retirement income needs? So, I’m going to allocate everything else equities, but I’m going to guarantee the next 10 years of income. Have you done any research around that?
Michael Finke: Well, I mean, so this comes down to, Casey, a lot of– because if you look at some of the historical data, what stocks have done in the United States is they recover over time. Whenever they fall in value, they tend to ultimately recover. And that means that holding stocks for a longer time horizon has helped investors. So, in other words, you can block out the first 10 years of spending, invest a high allocation in stocks for the more distant future. And historically, in the United States, that’s really paid out. But that’s not the way economic theory would predict that stocks would behave over 10 and 20-year time horizons. Economic theory says that there’s no free lunches, that simply holding stocks for a longer period of time is not going to guarantee you necessarily a higher return than if you’d invest in bonds.
And in fact, since the late 1980s, it’s been a pretty close horse race over 20-year time horizons. And there have been plenty of 10-year time horizons, especially if you started anywhere between early 1999 through the end of 2000, where over the course of 10 years, you ended up with less money if you invested in the S&P 500 than if you invested in bonds. That’s always a possibility. And one of my fears is that if you use the historical data to project the safety of that type of a strategy, then you’re going to have false confidence about its ability to bail you out so that you can actually maintain that lifestyle later on in retirement.
I love Monte Carlo analysis. I don’t criticize the methodology. I think the methodology is incredibly useful. But I do criticize the stuff that you type into the Monte Carlo analysis for the assumptions and that I think people are over-optimistic when they estimate historical stock returns because we just simply haven’t gotten those in the United States in recent years. I wrote an article a couple of years ago in Advisor Perspectives, and one of the points that I make is that since the late 1980s, a dollar invested in the S&P 500 with dividends has never grown to an amount greater than $7 over 20 years since the late 1980s.
Between 1934 and 1953, a dollar invested in the S&P 500 never grew to an amount less than $7. So, you have this whole 20-year period of data where stocks did something that they haven’t done since the late 1980s. If you toss that into a Monte Carlo, I think you’re going to get an over-optimistic estimate of the safety of an asset allocation that is higher in equities. Oftentimes, when you do a Monte Carlo and you use historical data, what you end up seeing is that you actually have less risk when you take more equity risk. So, equities basically because they have a higher expected return, they tend to bail you out no matter what the situation is.
But in today’s defined contribution, mutual fund, ETF world, I just don’t think that it’s possible for investors to get those same kind of returns that they got historically. So, they need to temper their expectations. That also affects their strategy when it comes to asset allocation.
Casey Weade: So, it sounds to me like what you’re saying is you would prefer personally and maybe backed by research, it sounds like, that you would prefer a guaranteed lifetime income over a bucketed strategy, and that is what you’re saying the research is backing, and correct me if I’m wrong, and if you’re saying setting aside a portion of those assets to create a guaranteed lifetime income is the most secure strategy, are you saying that that is kind of a paycheck to paycheck kind of scenario or guaranteeing just our basic income needs or non-discretionary expenses for the rest of your life, and then we’re supplementing that with paychecks from maybe traditional investments? I just want to gain some clarity around the strategy.
Michael Finke: Yeah. So, my philosophy has been that there’s a continuum of expenses in retirement that about 65% of expenses are non-discretionary and inflexible, and then about 35% of expenses are flexible. I don’t want to cover any of my inflexible expenses with stocks because if I invest in stocks, it means that if they don’t perform well, I have to cut back. So, I want to lock in at least that threshold of spending with Social Security and some kind of a guaranteed income strategy. I mean, my personal plan is that I want to create a base of income on top of Social Security that will cover all of my basic living expenses. And then I’m going to buy a QLAC and that’s going to provide a bump up in income later on that may provide a certain amount of inflation protection. It’s also tax efficient.
Also, by the time I’m 90 years old, I want to automate my income as much as possible. I don’t want to be managing a portfolio to create a lifestyle. I will probably continue to have a certain amount of investment risk in my portfolio that is going to contribute to my more flexible expenses. But at the same time, the question becomes how much am I going to be able to spend with a non-annuitized strategy that invests in risky assets where the only bump up I get is the equity risk premium, so the extra return I get for investing in stocks, versus how much could I spend every year if I either purely annuitize with something like a deferred income annuity or SPIA, or I got some kind of investment strategy that incorporated a lifetime income benefit. If that equity risk premium is not that high, it’s not going to counteract the loss of mortality credits from a strategy that incorporates some sort of an annuity element. So, this is where you have a balance.
And the other thing is that mortality credits are guaranteed, whereas the equity risk premium is not guaranteed. And a lot of advisors would say, “Well, I can spend more with the equity risk premium because I’m using these historical data where the equity risk premium is really high.” And I say, “I can spend more because I’m risk averse and I want to avoid the possibility that if I get unlucky, I’m going to have to cut back even those flexible expenses.”
Now, ideally, the perfect kind of annuity is one where for those flexible expenses, which is a variable income annuity, so kind of like the original variable annuity design, designed back in the early 1950s by a guy named William Greenough. And what he did was, and this is very similar to what a tontine is, everybody pulls their money together, they invest in a portfolio of assets, they decide how much income variability they’re willing to accept, and the asset allocation of the pool is going to determine the income variability. So, I could invest in a pool that is 60% stocks, 40% bonds. I get the mortality credit so that I can spend more, but everybody in the pool sees their income rise and fall over time based on the performance of the market. That is the ideal way to do it if your primary goal is lifestyle and not legacy.
Casey Weade: I mean, how do we get that type of vehicle today? How do we build that for ourselves?
Michael Finke: The only example of it right now is the TIAA variable annuity. But I think down the road what you’re going to see is increasing available of tontine-like structures that are really just an alternative for the traditional variable annuity with a lifetime income benefit. It’s a different type of structure.
Casey Weade: Previously, I’ve heard you mention the house money effect, where you’re taking some gains off the table in order to set aside some funds for guaranteed income benefits. You mentioned that you want to have some guaranteed income built into your strategy. So, is this how you are accomplishing that? Are you using this strategy? Maybe yes, maybe no. Please still explain the strategy.
Michael Finke: So, I mean, personally, I get a little deeper than that because there are also tax strategies that are involved with the use of annuities. The most obvious one being that in a non-qualified account, I can take the bond portion of my portfolio, wrap it in some kind of an annuity, either a very inexpensive variable annuity wrapper, or I can buy some sort of a product that is investing in the general account portfolio of an insurance company earning essentially corporate bond like returns over time, but all the other gains are deferred from taxation.
So, if you think about the concept of asset location, that’s all about locating assets within an account or a product that’s going to maximize the after-tax performance over time. So, if you’re locating assets in pre-retirement, then you’re putting your passive ETFs in a brokerage account fully taxable, you’re going to take your bonds and you’re going to put it into some kind of a wrapper, whether it be a traditional IRA or a Roth, or if you’re running out of space in those types of accounts in annuity.
So, I have a deferred income annuity that I am funding with the bond portion of my portfolio. It is growing at roughly 5% per year. It is free of taxation, so all of the compounded gains are on last year’s 5% gain. Instead of, if I had the money in CDs, I would be gaining 5%, but then I’d lose maybe 40% in tax so I would only be getting 3%. And then at retirement, my goal is to annuitize that portion of my savings to provide a base of income that supplement Social Security.
Casey Weade: Well, that’s fantastic. I like that. That was really helpful, very concise. And you’ve mentioned this word quite a few times, that a word of finance and annuities have surged in popularity just over the last few years. And it sounds like you see this trend continuing. How do you view the future of annuities? More importantly, how are financial advisors and investors going to shift the way they view annuities if they are?
Michael Finke: Well, I mean, let’s take a moment and talk about the annuity puzzle. So, economists call it an annuity puzzle because so many retirees just do not buy an annuity. And that really hasn’t changed all that much. You mentioned annuities are becoming more popular, but mainly, annuities are being used for accumulation. They’re not necessarily being used for lifetime income. So, we’re not seeing that revolution towards getting rid of that idiosyncratic risk of not knowing how long we’re going to live by buying pooled income with other retirees.
To me, the biggest change is going to happen if we start putting those types of annuities in retirement default. So, this is something that Dave and I have been working on for a while, which is trying to encourage more plan sponsors, more employers to include some base of annuity income within their target date fund so that when you get to retirement, say 30% of your savings is going to be used to fund, again, that base of income on top of Social Security. And what we know from default is and what we also know from annuity defaults looking at other countries is that once people get this, once people know that they’re going to get $15,000 every year that’s going to supplement Social Security, and 70%, they can just keep in the form of investments, they’re going to like that.
And every annuity that consumers own, whether it’s a pension or Social Security, do not ever try to take that away from them because they love their annuities. They don’t know they love their annuities because they’re not called annuities, but they are annuities. So, Social Security is an annuity. A pension is an annuity. They love this idea of knowing how much they can safely spend without running out of money. But we need to find a way to get consumers to feel more comfortable annuitizing a portion of their savings at retirement. I don’t think we’re there yet. And frankly, I don’t think the insurance industry historically, has done a good enough job of making a marketplace where consumers can feel comfortable just diving in and buying lifetime income. I think that there could be a lot of benefits.
The fact that in the rollover space, insurance companies are getting less than 1% of assets for a solution that is supposed to be the optimal way to generate retirement income, that’s really criminal. And it’s partially because of this negative perception of annuities, which is the result of historical consumer mis-selling of annuity products, oftentimes, people don’t know what they’re buying. There’s not the same level of information.
I don’t think insurance companies have collectively gotten together and standardized the way that information about these products is presented to consumers so consumers can choose the one that’s best for them. They can’t really figure out how much they’re paying. They don’t know what the prices are. That creates a market which is not ideal. And I think the insurance industry bears part of the blame for how small this market is right now. They could have been more deliberate. They could have recognized this opportunity to really provide value to consumers and instead really focus on the short term.
Casey Weade: Given that the insurance world isn’t there yet, the 401(k) industry isn’t there yet, and still, your choice is to work with a financial advisor to be provided these types of solutions, what can financial advisors do to better educate the consumer or the client and drive them towards a strategy that’s going to serve them best?
Michael Finke: I’ve been a big advocate of using a goal-based strategy, so there’s really two ways of generating retirement income. One is using an account-based strategy where you just focus on investing in stocks and bonds and TIPS. Your portfolio is the focus, and then you withdraw money every year from the portfolio. That’s the traditional 4% rule methodology.
A better methodology, I think, is to begin with a discussion about spending goals and then talk about things like what investment risk means and spending flexibility, and then you develop a process for funding the most spending for each of those goals with the least amount of your savings. And that really is what annuitization is all about. It’s being able to take less of your investment portfolio to fund the same amount of spending and do it without having to worry about potentially running out. If you frame it that way, I can take less of my portfolio to fund my basic expenses goal. Then, to me, it’s an obvious choice.
But if you start framing it in terms of an investment, if you use that account-based approach and say, “Well, you got $2 million, you can take $500,000, buy yourself a lifetime income,” then you start portraying it as an investment using the account-based strategy. And then you get these questions like, “Well, what is my rate of return on that investment?” Well, that’s not the point. Your rate of return is going to be whatever the insurance company assumes their general account is going to grow to the average longevity. So, your rate of return is never going to be higher than what you’d get from a portfolio of bonds to the average expected longevity. That’s not the point.
The point is that you can cover your spending goal with less of your savings through the use of an annuity. That’s why a goal-based approach is so much more effective at portraying the benefit of annuities. I still see that many advisors have this account-based approach, and it’s hard for a consumer to wrap their brain around why they would ever buy an annuity if you are using that account-based approach. It’s still focused on accumulation.
Casey Weade: I mean, just with what you said there, there’s some that are having a tough time with that, I’m sure. Well, if I would make more, if I allocated the bonds, then if I put it in annuity, then how could the annuity provide me more income?
Michael Finke: Right. So, that’s the birthday cake problem. So, the birthday cake problem, you haven’t heard that story?
Casey Weade: Go ahead. I know everybody hasn’t.
Michael Finke: So, imagine that your spouse calls you up and says it’s your son’s birthday. There’s a birthday cake on the counter. There’s going to be somewhere between 5 and 40 kids that are going to show up for the birthday party and they’re going to show up one at a time. And you have to decide how big of a slice of the cake to cut for each kid as they walk through the door. So, you have a birthday cake. On average, there’s going to be 20 kids coming through the door. And you have to figure out how big of a slice to cut for that first kid.
Well, you don’t want to run out of cake because if the 35th kid comes in, there’s no more cake, then they’re going to go home and tell their parents that they didn’t get any cake at the birthday party and you’re not going to get invited to any more barbecues. And so, you are risk averse. You cut a small piece of cake for that kid because you want to make sure that you don’t run out.
Now, what if instead, a bakery says, “I am willing to show up with a second birthday cake if more than 20 kids come through the door and you just need to pay a little bit more for the birthday cake,” so what that allows me to do is cut the first birthday cake into 20 pieces. Every kid gets a bigger piece of cake and I don’t have to worry about potentially running out because when the 21st kid comes through the door, the bakery shows up with a second birthday cake. I can continue to cut it into 20 slices. Each kid gets a bigger slice of the cake and I never have to worry about running out.
This is exactly what an insurance company does for you when you have a portfolio of safe investments like bonds and you’re trying to figure out how much of that portfolio to take out every year to fund spending when you know that you could live between 5 and 40 years. On average, you might live 20 years, but you’re not going to cut that slice of savings into those bigger pieces to your average expected longevity because you want to make sure the money lasts to the age of 95 or the age of 100. You don’t want to run out.
So, essentially, by transferring the idiosyncratic risk of not knowing how long I’m going to live to an insurance company, I can cut a bigger slice from my bond portfolio. I can spend as if I’m just going to live to my average longevity. So, man, I can spend as if I’m going to live to 88, but if I live beyond age 88, then the insurance company comes in and continues to pay my income no matter how long I live. So, I can spend more from my savings every year, and that might mean that right now, if you look at Treasury rates, I have to set aside close to $300,000 today to spend $15,000 per year up to the age of 100.
And if I’m a 65-year-old woman, I’ve got a 10% chance I’m going to live to the age of 100. So, I still have to accept a 10% failure rate. Or a woman can buy an annuity that pays her $15,000 per year and instead of having to set aside $300,000, she can set aside $220,000. It will fund that same $15,000 of spending. And she doesn’t have to accept a 10% chance of running out. So, which would you rather do? Take $220,000 of your savings by $15,000 a year or set aside $300,000 of your savings and spend $15,000 a year up to the age of 100 but still have to face a 10% risk of potentially running out. That’s the choice that you have to make.
Casey Weade: And not even factoring in the interest rate risk along the way. So, that’s great. I don’t know how I never heard the story, but it’s fantastic. That was really helpful. It was really helpful. I think many will find that really helpful and understanding how these vehicles work and why it may make sense for them. There was something that you were quoted saying, you were quoted saying, within the next 10 years, I want to see decumulation become just as important as accumulation. And people defaulted into a solution in retirement that allows them to spend more of the money they have saved. Is this what you’re talking about them defaulting into? And if so, how do you default into something like this? Is this really speaking to something along the lines of a 401(k) provided solution?
Michael Finke: Right. And basically, what you’re doing is your pensionizing maybe a third of their retirement savings so that they have the ability to spend at least that portion of their savings every year knowing that they’re not going to run out. Using the birthday cake example, they can spend more every year optimally because they know they’re not going to run out of that portion of their savings. I’m going to go in a slightly different direction, though, without question. It takes some advisors to task for not focusing enough on the reality that their clients save this money in order to live well.
But many advisors don’t take a decumulation mindset. They do things like they want to preserve the corpus of a retiree’s asset, pull money out of dividends and interest on their investment portfolio. When the reality is there’s only two places your money can go, it can either be spent by you or it can be passed on to others. To me, the most important question to ask at the beginning of the retirement income planning process is of your nest egg, how much do you want to pass on to someone else and how much do you want to spend?
And with the portion that you want to spend, let’s feel comfortable seeing the balance fall over time in order to meet your lifestyle goals because I think, in many cases, people are not comfortable with the idea of seeing their nest egg get smaller in retirement. Advisors haven’t primed them that this is necessary, especially in a low return environment, it’s necessary to be able to maintain the same lifestyle that they had before. And that’s a problem. That means that in many cases, the advisor wants to preserve as much of the capital as possible because their income is in many cases dependent on the amount of money that their clients have. Nobody has an incentive to encourage the client to actually spend the money down, but that’s why they sacrifice.
Going back to the beginning of our conversation, when you save money in a 401(k), that’s money that you could have spent on going out to dinner or you could have bought a nicer car. There’s all sorts of fun things you could have spent the money on, but instead you saved it for retirement. And then you get to retirement, you’ve got this nest egg and you actually don’t feel comfortable seeing it get smaller. This is what’s known as a reference point in behavioral finance. We cannot fixate on the value that we had when we were retired. And if it goes lower than that, we tend to freak out. We’re not comfortable with the idea of spending down our savings. That decumulation mindset is something that more advisors need to not just have themselves, but they need to get their clients to feel comfortable with the idea that spending down savings is the goal for the portion of their wealth where lifestyle is the primary objective.
Casey Weade: And back in March. I think this really just goes back to advisor education. Back in March, you had retweeted Meg Bartelt talking about the power of the RICP and what she learned in the Retirement Income Certified Professional program. You added to that tweet, the CFP designation is enough if you specialize in this area. Why is the CFP not the end-all, be-all? Because I think that’s what it’s been marketed at and I think that’s what people look for. They go, “If I find a CFP, then they should know how to plan for retirement income.” Why would they need a CFP and an RICP? Well, and you also rang the Wealth Management Certified Professional designation, of course. I think the alphabet soup gets a little confusing. We go, “Well, if I get a CPA, get a CPA. I get a CFP, I get a CFP. Why do I need these other things?”
Michael Finke: When we think about what retirement content is in the CFP, in my mind, it’s very much an accumulation mindset. It’s educating you on different types of retirement accounts and it’s understanding the tax rules, but it’s not necessarily about developing a process or sitting down with the client and creating a retirement income plan. And it doesn’t focus on the emotional aspects of that. And I think one of the benefits of programs like the WMCP and the RICP is that these are applied education programs.
So, what we do is we have interviews with experts, whether they’re expert practitioners or expert academics, had understanding. When you’re actually sitting down with the client, how do you execute this type of a strategy? And I think the RICP, there is so much that goes into retirement income planning, whether it’s understanding all the minutia of Medicare or Social Security or the products that are available to decumulate your savings or how to create different types of strategies for retirement income, That’s a unique set of knowledge. And I’m telling you that this is what so many consumers are looking for right now.
At the beginning of 2022, I did a survey of advisor services that would motivate people to actually hire a professional, and by far, the most popular response was understanding how much I can safely spend in retirement. And to me, that suggests that people are not looking for an account-based type of approach. People are looking for an approach that helps them achieve greater clarity and understanding about how much they can actually spend from their savings and that takes a whole different body of knowledge than the more accumulation-focused mindset.
Casey Weade: Michael, this has been awesome. I think we killed some retirement income stuff here, and if you’re ready for it, I’d like to go on some rapid-fire questions from our Weekend Reading subscribers. And I’m going to give you a toss up here right off the top, and then we’ll get a little bit more challenging, all right? But I know it’ll be super easy for you.
So, we have Debbie first, one of our Weekend Reading subscribers that asks a question about retirement income. So, Debbie’s question is, “I’m struggling with the idea of spending money with no income coming in and have postponed my retirement. My financial guy says I don’t need to worry. I have enough saved to get me to 95, but my mindset is not there.”
Michael Finke: Well, I think that Debbie is in the same position as a lot of retirees. My own mother is a great example of this. Like for her, she will spend every dollar of her pension every month, but when it comes to pulling money out of her IRA or spending money down in her checking account, she sees that as money that she has to feel a little bit guilty about spending. So, she very often doesn’t touch it. And a lot of Americans live that way.
In fact, when I look at this survey, the Health and Retirement survey, I see people like this. There’s one woman in particular that I’ve been following in the HRS who retired in her early 60s. She gets Social Security, pays her about $25,000 a year. She has $1.5 million of investments. And when I look at how much she’s spending every year, it’s exactly Social Security. She’s not touching the investments. And a lot of retirees are like this. They just don’t spend down their savings over time because they don’t feel like they’d feel comfortable spending it down.
And again, even if you have enough, even if you’re overfunded for retirement, this gives you the psychological ability, if you simply buy income with a portion of your savings, essentially buy a pension, then you give yourself license to be able to spend that money without worrying about running out. And to me, that is an enormous advantage for a retiree psychologically. I still think we haven’t gotten to the point where we feel comfortable with investments only spending the money down, seeing the value get smaller every year, and then worrying about it. Every year, when something goes on in the market that could potentially threaten the security of our investments, we worry about it. I don’t like the idea that we might have to cut back if our investments are falling in value.
Casey Weade: We’ve talked a lot about market risk when it comes to our income. However, there are a lot of unknowns. Cindy asked a question specifically about unknowns. And it’s one that we’ve received before. Cindy said, “I’m comfortable planning my retirement knowing all the things to plan for. My question is how do I prepare for all the unknowns?” She went on to say, “COVID came out of nowhere and changed the world. I’m uncertain now about how to prepare for retirement since.”
Michael Finke: It’s a great question and there’s always unknowns. I mean, if anything is certain, it is that whatever you plan for retirement, it’s not going to end up playing out exactly the way that you expected. So, there’s going to be health issues. There’s a couple, one spouse might die relatively early in retirement, it creates a whole new set of issues. You might have long-term care expenses. So, what you’re trying to do, and this is again, I’m putting my economist’s hat on, is identify those idiosyncratic risks that are insurable and then buy insurance to protect yourself against those unknown risks, but also create a plan that can withstand worst-case scenarios for things that are uninsurable and be prepared to expect the unexpected because it’s going to happen.
Casey Weade: Would one of those things be inflation? Looking at some of Blanchett’s research on inflation, where we find ourselves today, we go, “Okay, great. Let’s just create a guaranteed income for the rest of our life. But hey, what about inflation?”
Michael Finke: Yeah, it’s one of the reasons why, I know David and I are big fans of using a bridge strategy to try to maximize Social Security, wait until age 70 to delay claiming because then you can build a base of inflation-protected income. And there really aren’t that many great ways to protect against directly hedge against inflation risk over time. Now, if you want to get, I guess, a little bit depressed about the impact of inflation historically, if you had retired in the mid-1960s and you had a pension of $100,000 a year equivalent in the mid 1960s, by the time you got to the mid 1980s, 20 years later, $100,000 was actually buying you $27,000 worth of purchasing power.
And this inflation risk is especially acute when you experience inflation early on in retirement because it means that everything is more expensive for the entirety of your retirement experience. If inflation is very high later in retirement, it doesn’t really have as big of an impact because all those years during, say, the first 15 years of retirement, prices were pretty modest. So, you’re not decumulating your savings at as high of a rate. So, the biggest risk is high inflation early on in retirement. And delaying Social Security is really the best way to hedge against that kind of a risk.
Casey Weade: Now, what about outside of Social Security? What about certain assets we could invest in? They were getting this guaranteed income or delaying Social Security. Can we set aside a portion of our portfolio to be that inflation-protected portfolio that holds certain assets that maybe have performed the best on a diversified basis against inflation historically?
Michael Finke: Yeah, I know David has done some research in this area. Obviously, TIPS are the only direct hedge against inflation risk, Treasury Inflation-Protected Securities. But historically, equities and certain categories of equities have been a decent hedge against long-term inflation. But I think many of us who are economists are very careful to say that they are a true hedge. A hedge is something that, during periods of high inflation, is going to perform better. And it’s hard to identify assets that consistently will do that over time.
Now, equities provide that risk premium over time, historically, which means that they’ve done a better job of keeping up with inflation historically, but that’s not a guarantee. However, I think one of the reasons to invest for equities for long-run spending is that equities do tend to exhibit better return characteristics when held over long-term time horizons, and that can help counteract some of those impacts of inflation.
Casey Weade: What about the incorporation of real estate into that inflation-protected piece of our portfolio?
Michael Finke: It’s possible to the extent that real estate and different types of real estate investments correlate with inflation. Obviously, like commercial real estate, you can say that they will increase rents if inflation goes up. But again, you have to look at the data to see whether or not that is, in fact, the case. Investment corporate real estate right now seems to be suffering a bit during a period of high inflation. So, to the extent that it is a true hedge for that risk, it remains to be seen.
Casey Weade: Sure. Yeah. So, we have real estate, we have equities, we have TIPS, we have all these different tools that sometimes, I think, many forget. Gold hasn’t always been the best inflation hedge in what we’re seeing with real estate right now. It’s just a great reminder that, and to what you talked about earlier, you said, well, we’re always taking a historical approach based on sample size when we’re building a plan, especially around a Monte Carlo simulation. But what if the worst is different in the future than it has been in the past? What if it doesn’t come back? I’ve seen a lot of research. I don’t know if this necessarily came from you, but recently around the US being such an anomaly around the world when it comes to rebounding after a financial crisis.
Michael Finke: Yeah. So, David and I did that study for Advisor Perspectives. And in the United States, sometimes what advisors will do is they will use the Great Depression or the global financial crisis as a worst-case scenario example when they’re going backward and looking at what could have happened to a retirement portfolio. But in fact, those worst-case scenarios were actually not that bad in the United States, especially because we rebounded pretty quickly from those worst-case scenarios. That doesn’t always happen.
And what we see is that internationally, if you look country by country, there were plenty of countries that just simply did not rebound. So, that worst-case scenario from the United States is really an anomaly. And you can’t just look at the United States, again, because it’s a small sample size. And this is where scientists have disagreements in these areas where there is a small sample size. If we look at a larger sample size, we see that, boy, if you’re not investing internationally, there is a huge risk that a worst-case scenario could be significantly worse than the global average.
Casey Weade: It’s beyond that, too, right? I mean, the focus, and I wonder what the risk, how you have seen the risk shift for investors and retirees over the last 15 to 20 years as we’ve seen this shift into passive indexing or index funds. Hey, put everything in the S&P 500 Index ETF and everything will be okay. What are your thoughts on that?
Michael Finke: Yeah, there were some really interesting studies recently on the impact of demand on stock prices and expected returns. And the research has shown that when there is a consistent flow of money into any type of financial asset, including stocks, it’s easy to boost the price by a lot. And if you look at valuations of stocks right now, I’m a big believer that when you’re talking about expectations of future returns, you should look at the price of the investment asset right now as a way of predicting what returns are going to be over the next 10 or 20 years.
And valuations right now are still about double historical valuations for stocks in the United States, which means that this continued flow of money into a limited number of stocks in the United States means that our return expectations have to be more modest than they were historically. We can’t just look at historical returns to predict what’s going to happen in the future because that constant flow of money into equities has pushed the price up. And when things are more expensive, the expected return is lower.
Casey Weade: I think the whole thing in the whole conversation just further emphasizes and further entrenches myself and my belief that stocks aren’t the answer, life insurance isn’t the answer, annuities aren’t the answer, real estate isn’t the answer. We truly do have to take a diversified approach. And most don’t see a diversified approach outside of stocks and bonds, but we have to do that.
Michael Finke: Yeah, I think it’s almost a religion of the equity risk premium. And people believe that the equity risk premium is the answer to all of life’s problems, and that can get them in trouble because if your entire financial plan is built on the outperformance of stocks relative to other kinds of investments, you could be in for a tough surprise.
Casey Weade: Well, I know we have to bring things to a close and get you back to your conference. Maybe I’ll wrap up here with a couple of general questions. One being, if you look forward 25 years, 25 years from now, looking back today, what would you hope to be found as ridiculous as reflect on where we stand today, 25 years in the future?
Michael Finke: Oh, man. So, we just had a conference in D.C. last week, and one of the participants was a consumer, very average worker, had worked as a nurse in a nursing home facility. And she was so frustrated because she couldn’t get a financial advisor to talk to her because she didn’t have enough money. And she’s like, “Why can’t we just McDonaldize our retirement income plan?” And I thought to myself, I don’t know why that is. You should be able to just go online and very easily come up with efficient solutions for creating retirement income based on how you want to live in retirement.
And this piecemeal approach that we have right now, where it’s up to us to figure out what to do in a very complex marketplace, I hope we look back 20 years from today and say, “Man, I cannot believe that we had to wade through all of that complexity, given how easy it is to create something like this, something that can solve the retirement income problem right now.”
Casey Weade: Yeah, no, we’ve put a lot of thought and effort into architecting that for ourselves here at Howard Bailey. I mean, 100%, I love that. I think that’s the future. You should be able to hop online, you should be able to upload all of your information, and then you should be able to allocate your assets instantaneously. Insurance products, stocks, bonds should all be automated. And I believe that is where we’re headed over the next 25 years. ChatGPT is probably not quite there yet.
Michael Finke: Probably not. Yeah, remains to be seen. I’m certainly not the expert.
Casey Weade: Okay. Well, let me wrap with one final question. You’re on the Retire with Purpose podcast. So, what does retire with purpose mean to you, Michael?
Michael Finke: Being deliberate about what you want to do in retirement. Well, we could have a whole other podcast on this topic, which is the fact that oftentimes people think that retirement, they’re going to have a successful retirement if they just have enough money, but they haven’t really given any thought to what they’re going to do with that money when they retire. And I tell you, that to me is one of those missing areas of retirement planning that not enough workers actually think about, which is all right, now, you’re not worrying any anymore, what are you actually going to do? What’s going to make you happy?
Casey Weade: That’s great. Well, we missed that whole section here on happiness and retirement. So, maybe we’ll have to have you back on at some point in the future. But Michael, it’s been wonderful. I truly appreciate the opportunity to have the conversation and look forward to doing it again.
Michael Finke: Thank you. I really enjoyed it.