By Rebecca Fender, CFA
After Wade Pfau, CFA, received a hat tip from Nobel Prize laureate Bill Sharpe earlier at the 67th CFA Institute Annual Conference for his thorough research of the retirement problem, it was no surprise that Pfau drew a curious — and slightly intimidated — crowd the next day for a two-hour workshop to go through the details of “Best Practices in Retirement Planning.” Pfau reviewed dozens of scenarios and approaches to the problem, highlighting some of the more essential pieces of the debate.
The Quest for a Safe (and Simple) Withdrawal Rate
The often-cited 4% rule — which says that one should be able to safely withdraw 4% of one’s retirement date assets, inflation-adjusted, annually for 30 years — is an inefficient strategy, Pfau said. It assumes a rational investor who rebalances and no fee drag. The 4% rule also ignores sequence risk, and Pfau showed how just a one-year timing difference can create major differences in returns over 30-year time periods. Sequence risk also creates a debate about how to invest at the end of the accumulation phase, when the portfolio value is likely largest and you are most vulnerable to returns. Pfau suggests a conservative approach (to avoid the risk of losing too much) but notes that others advocate an aggressive approach (for fear of losing out on great gain). In the accumulation phase, we think of dollar-cost averaging, but this also applies in reverse as you spend down your retirement nest egg.
A Primer on Annuities
Pfau spoke at length about annuities, which he believes can be important tools in retirement planning. They match cash flows with the need for income and can effectively immunize a portfolio. Academics typically like this approach, Pfau says, and he agrees, while recognizing that low rates now make it a difficult time to retire.
On the other hand, annuities cannot be used for 100% of a portfolio because there will always be a need for liquidity because of unanticipated needs, so usually advisers limit usage to about 40% of a portfolio. Fees can be high, and from a behavioral perspective, clients don’t like to see their funds disappear from their account in exchange for the promise of future payments. The low adoption rates for annuities is known as “the annuity puzzle.”
There are also potential conflicts of interest with annuities. Financial advisers may not want to suggest annuities because the managed assets base will be lower, and therefore, their advisory fees will decline. Pfau says this is colloquially known as “annuicide” among advisers. However, fees for annuities can be high and benefit advisers, while greatly decreasing client returns. A fee-for-service arrangement may avoid both types of conflict, though annuities will not require ongoing advisory work for those who charge based on time.
Pfau discussed three types of annuities:
- Single premium immediate annuities (SPIAs) are structured so that a single lump sum payment is made at the start of the agreement. Investors don’t tend to like these, so only 4% of annuities are SPIAs, though Pfau thinks they are underused.
- Deferred income annuities (DIAs, also known as longevity insurance) have lower costs because guaranteed income begins later, not immediately, as with an SPIA. This strategy can be combined with a TIPS ladder in the short term before the annuity payouts begin, as described in the 2012 Financial Analysts Journal article “Making Retirement Income Last a Lifetime.”
- Deferred variable annuities with guaranteed lifetime withdrawal benefits are a popular package, whereby lifetime income is guaranteed (at relatively low levels compared with a SPIA) but an aggressive underlying portfolio that performs well can increase the payout. In addition, any remaining contract value of assets can be left to an estate. The downside is that fees for these products are very high.
Pfau’s research and thoughtful approach to this subject matter reinforce the complexity of the issue of retirement planning in a world of uncertain markets and uncertain lives. Fortunately, however, he and others, including Bill Sharpe, are working diligently on research and tools to provide more guidance to the retirees of the future.
- “Behavioral Finance and the Post-Retirement Crisis” (Allianz Global Investors)
- “William Bengen’s SAFEMAX” (Wade Pfau’s Retirement Researcher Blog)
- “Spending Flexibility and Safe Withdrawal Rates” (Journal of Financial Planning)
- “Spending Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates” (Financial Analysts Journal)
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