The 4% Rule Might Not Work, This Retirement Expert Says. Here’s His Strategy for a Downturn.

Today, Pfau is a professor of retirement income at the American College of Financial Services, a private college that trains financial professionals. His most recent book, “Retirement Planning Guidebook,” was published in September.

While many retirees are banking on a continuing rise in stocks to keep their portfolios growing, Pfau worries that markets will plunge and imperil this “overly optimistic” approach. He has embraced oft-criticized insurance products like variable annuities and whole-life insurance that will hold their value even if stocks crash, and he has done consulting work for insurers. He wrote another book, “Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement,” because these loans also can be used as “buffer assets” during market meltdowns.

Pfau, 44 years old, is already playing around with spreadsheets to analyze his own retirement plan. He recently built a model to determine when it is best to convert money from tax-deferred accounts to tax-free Roth accounts, partly because he wanted the answer for his own retirement accounts. We reached Pfau at his home north of Dallas. An edited version of our conversation follows: 

Barron’s: The 4% rule says a retiree can safely withdraw that percentage annually from a portfolio, adjusted for inflation. Why don’t you think it will work?  

Pfau: It’s not that I don’t think it will work. I think there is something like a 65% to 70% chance that the 4% rule works for today’s retirees rather than being a near certainty.

It’s a debate. Do you just stick with the historical data, or do you make the adjustment to say, ‘Wait a second. With low interest rates, you can’t have as high a bond return as we’ve had historically, and maybe you can’t predict as high a stock return as we’ve had historically either’?

What percent can people safely withdraw?

I think 3% would be a lot more realistic in terms of giving the same chance of success that we usually think about with the 4% rule.

Will people still have enough money to retire with a lower withdrawal rate?

One of the unrealistic assumptions of the 4% rule is that you don’t have any flexibility to adjust your spending over time. Someone could start retirement with a 4% withdrawal rate if they’re willing to cut back on spending somewhat if we do get into a bad market environment.

Anything else? 

People need to be smart about their Social Security claiming decisions. It’s OK to spend down investment assets in the short term so you can delay Social Security benefits until age 70, at least for the high earner of a married couple. The boost you get from Social Security benefits by waiting will really reduce the need to take distributions from investments after age 70. 

People also might look at ways to use home equity to support retirement spending, whether that’s downsizing the home or considering getting a line of credit through a reverse mortgage.

Isn’t tapping home equity to avoid selling stocks doubling down on a losing bet?

Using a buffer-based strategy such as home equity does buy into the idea that over long periods the stock market will perform at a reasonable level. If there’s no market recovery, it is going to be all the more harder to have any kind of sustainable retirement strategy.

Why are the first years of retirement most dangerous?

It’s the idea of sequence-of-return risk. I’ve estimated that if somebody is planning for a 30-year retirement, the market returns they experience in the first 10 years can explain 80% of the retirement outcome. If you get a market downturn early on, and markets recover later on, that doesn’t help all that much when you’re spending from that portfolio because you have less remaining to benefit from the subsequent market recovery. 

What’s the solution?

There are four ways to manage the sequence-of-return risk. One, spend conservatively. Two, spend flexibly. If you can reduce your spending after a market downturn, that can manage sequence-of-return risk because you don’t have to sell as many shares to meet the spending need. A third option is to be strategic about volatility in your portfolio, even using the idea of a rising equity glide path. The fourth option is using buffer assets like cash, a reverse mortgage or whole life policy with cash value.

What is a rising equity glide path?

Start with a lower stock allocation at the beginning of retirement, and then work your way up. Later in retirement, market volatility doesn’t have as much impact on the sustainability of your spending path, and you can adjust by having a higher stock allocation later on.   

Why do annuities make sense when interest rates and annuity payouts are low?

Well, because the fact that interest rates are low impacts every strategy. But the impact of low rates on annuities is less than the impact on a bond portfolio.

Most income annuities aren’t inflation-adjusted. 

An income annuity is not going to be the source of inflation protection in the retirement strategy. That is going to have to come from the investment side. But the annuity will allow a lower rate of withdrawal from your investment portfolio early on to mitigate sequence risk. Most retirees naturally spend less as they age, and they may not need inflation protection

Medical costs go up as you age.

Right, that’s the one offsetting factor. The medical expenses increase but everything else tends to decrease at a fast enough pace so that overall spending still goes down until very late in life when people may need to pay for more care in home or a nursing home or other type of long-term care needs.

Is long-term care insurance a good idea?

When I look at traditional long-term care insurance,  I struggle a bit because usually you use insurance for low-probability, high-cost events. And the problem with long-term care is that it’s a high probability, high-cost event. 

There are other hybrid approaches where you can combine long-term care insurance with life insurance or an annuity, and that’s where most of the new business is going, and that has some potential. 

How is your own money invested?

At my age level, I’m still primarily in equities. 

Do you own annuities?

I’m interested in variable annuities with living benefits, but I’m still too young. Usually, we don’t talk about getting annuities until you’re in your mid-to-late 50s. 

Variable annuities have a bad rep. You think it’s undeserved?

For a large part undeserved. They get a bad rep because they have a high fee drag, and I think about retirement not so much about the fee drag but about how much assets do you need to feel comfortable about retiring. Variable annuities mean you believe that markets will outperform but you also don’t want to stake your entire retirement on the market so you want some sort of backstop. 

You’ve been a proponent of products sold by insurers such as annuities, and you’ve done consulting work for insurers. How can we be sure your research isn’t conflicted?

Whenever I do some sort of research paper, I outline the methodology completely to give people a full understanding. Nothing is in a black box. The assumptions are all listed, and if people want to try it with different assumptions, they can do so.

If I’m concluding that annuities may be helpful, I try to give the benefit of the doubt in my assumptions to not using the annuities and still find a strong case can be made for the annuities.

Social Security is more generous than annuities. Shouldn’t people max it out before buying an annuity?

Yes. Insurance companies have to live in the real world so when interest rates are low that impacts annuities. Indeed if you are thinking about annuities, step one is at least the high earner in a couple should defer Social Security until 70. And then if you want more annuity protection beyond that, fine. It wouldn’t generally make sense to claim Social Security early and then buy a commercial annuity at the same time.

Does it ever feel odd to be focused on an event that won’t occur for you for a couple of decades?

For the most part, no. It only comes up at times when somebody is saying why is this young person telling me how to do retirement.

For me it’s not so much retirement, as tracking the ability to be financially independent. It’s still relevant for me to think about when I may be able to retire, even if I’m not necessarily ready. I have a personal interest in it.

A personal interest in what?

In playing around with spreadsheets and analyzing my own retirement plan. That’s what primarily drove me to do this tax planning research so that I could specifically build in Roth conversion strategies into my own planning.

Thank you, Wade. 

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