Editor’s note: In a recent article, Wade D. Pfau, Ph.D., CFA, a professor of retirement income at The American College in Bryn Mawr, Pa., suggested that now is a tough time to retire. We decided to ask him some questions.
Q. In a recent article, you noted that now is a tough time to retire given today’s low interest rates and high stock valuations. Why is that?
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Saw this article and thought its important for you to read. The solutions to what appears to be low interest rates is to save money only to make investments in self, your own business or in income producing assets. I will cover this in detail on Cardone Zone.
Enjoy the article and look forward to your comments – GC
A. It’s simply because the higher the returns one can expect to earn from their investment portfolio, the more they can sustainably spend from their portfolio throughout retirement. But low interest rates and high stock market valuations both suggest that we should expect lower investment returns in the future, which means we have to spend less as well.
Q. Assuming someone must retire now, what sort of retirement income plan/withdrawal strategy might you suggest? Would the strategy/tactic be different depending on the “funding status” of the person? That is, would someone who has adequate funds to meet their desired standard of living choose a different tactic/strategy than someone who doesn’t have adequate funds?
A. Generally, the situation today calls for new retirees to hold somewhere in the neighborhood of 25-50% stocks (but this is a highly personalized decision and depends on multiple factors), and also holding some individual bonds to their maturity dates as well as considering a single-premium immediate annuity or deferred income annuity. But it is important to highlight that the proper strategy does relate to the funded status. Being fully funded for retirement means that you can safely lock-in your retirement spending goals without taking market risk. Just barely being funded leaves one quite vulnerable to switching from being able to meet their goals to not being able to meet their goals, and the stock allocation should probably be rather low. Having excess funds beyond what is needed to meet goals provides greater capacity to bear the risks of investing in stocks. As for underfunded individuals, the proper approach for what to do is the subject of much heated debate in the retirement income world. The choices are to eliminate stocks from the portfolio to best ensure that the situation won’t get even worse, or to use a higher stock allocation and to hope for the best.
Q. Can you describe the probability-based approach to retirement income planning vs. the safety-first approach and the pros and cons of each approach and address which approach might be best for what sort of person?
A. My description about what to do when underfunded highlights a key difference between these two main approaches for retirement income planning. The probability-based approach seeks to maximize the chances for meeting the retiree’s spending goals. Historically, this has suggested using a 50-75% stock allocation throughout retirement. But this approach really concerns advocates of the safety-first school, who view the possibility of running out of funds and not being able to at least meet basic spending needs as a catastrophic outcome. Safety-first advocates suggest leaving stocks out of the equation when funding at least one’s essential spending needs. Basically, the probability-based approach may give the best shot at meeting all of one’s goals while leaving one vulnerable to running out of wealth, while the safety-first approach does better at ensuring that at least the basics will always be covered while perhaps not ever being able to meet the overall spending goal. As for which is best, consider how you feel about the statement: your retirement plan has a 90% chance for success. If you are happy with this, then you are probability-based. But if you’re really worried about the converse (as there is a 10% chance for failure), then you are probably going to like the safety-first approach.
Q. What’s the worst-case scenario for those who use the probability-based approach? Is it that they might have to reduce their standard of living when market returns are unfavorable and/or if they underestimate their life expectancy?
A. Yes, both can happen. The worst-case scenario is that later in retirement the retiree ends up being forced to make substantial cuts to their spending for either of these reasons, which could make their final years quite worrisome and difficult. Most people will at least have their Social Security benefits, but if that isn’t enough, then…
Q. What’s the worst-case scenario for those who use the safety-first approach? Is that they might have to pay a lot to create their desired level of income?
A. The worst-case scenario is just that they ended up playing it too safe. The scrimped and saved and missed out on enjoying retirement as much as they could have, because they were too worried about negative events that ended up not happening. They paid the costs to lock in a level of spending and didn’t have room in the portfolio for more stocks. On average, stocks could have supported higher spending, but safety-first folks sacrifice that potential to ensure that their basics can be covered in any market environment.
Q. You note that creating a sustainable retirement income plan should be based on what the current market environment suggests is feasible? Why is that? Many advisers seem to justify their approach based on past performance. Are they wrong to do so?
A. The problem is that it’s hard to know what returns to expect from stocks and bonds in the future. The easy way to obtain an answer is to just look at what happened in the past. This is what many advisers do, and most of the time, this is a reasonable approach. But it doesn’t work when interest rates are far removed from their historical averages, and today interest rates are very low. Mathematically, low interest rates mean that bond returns will be low as well. If you believe that the premium stocks can potentially earn above bonds has not increased, this is suggests lower stock returns for reasons unrelated to the fact that stocks are also overvalued. So our history is going to suggest greater optimism for different retirement income approaches than is reasonable to expect in the current market environment.
Q. You suggest using dividend yield and price-earnings multiples as a way to gauge whether stock market valuations are high. Can you explain?
A. Research in this area has suggested that Nobel laureate Robert Shiller’s cyclically-adjusted price earnings ratio has done a decent job both at predicting future stock returns over the next 10-20-year horizon, as well as at predicting what the sustainable retirement withdrawal rate from their investment portfolio will be. That’s why I focus primarily on it as a good gauge of stock market valuations. It actually helps to predict long-term retirement planning outcomes.
Q. You suggest that sustainable withdrawal rates are related to returns by the underlying investment portfolio? Does that mean that retirees should plan on withdrawing less than 4% from their retirement portfolio for the immediate future? Also, could one increase withdrawal rates by changing the asset mix of their portfolio? What are the risks of doing so?
A. Choosing a withdrawal rate also depends on how much flexibility one has to adjust their spending. More flexibility means choosing a higher spending rate. But for someone without much flexibility, I certainly think 3% is closer to a sustainable withdrawal rate these days than 4%. About asset allocation, these numbers generally assume a fairly aggressive investment portfolio of 50-75% stocks. We could also calculate an exact withdrawal rate for someone building a 30-year ladder of maturing TIPS investments, but this would create the risk that all of the assets are gone if one lives beyond 30 years.A.
Q. How might retirees factor interest rates into their withdrawal rate strategy? What’s your thought about using TIPS along with stocks to provide income?
A. Holding TIPS to maturity, along with stocks, does fit into the idea of the safety-first strategy. TIPS could be used to cover essential spending needs, and stocks could cover the remainder of the spending goal. It’s a viable option. Naturally, lower interest rates will mean less income will be available from the TIPS. That’s been a prevailing theme for this discussion.
Q. Is now a bad or good time to buy bonds or income annuities?
Relatively speaking, I don’t think that now is better or worse just because interest rates are low. If these approaches fit into one’s strategy, they probably do so regardless of the level of interest rates. If one instead waits for interest rates to increase, that may or may not happen, and in the meantime retirees may be spending down their principal while they wait. They might not be better off even if rates do rise.
Q. Is there ever a good time to retire? If so, when? If not, why not?
A. Good question. In some sense, one might say no. In the early 1980s, you could say it was a great time to retire because interest rates were very high and market valuations were low, and sustainable spending rates ended up being in the neighborhood of 9% or 10%. But for new retirees at that time, it would have been hard to accumulate much wealth during the abysmal 1970s and early 1980s. A larger percentage of a smaller amount still isn’t necessarily leaving one better off. I wrote on article on ‘safe savings rates’ which accounts for this cyclicality for pre- and post-retirement. In reality, some of these varied outcomes balance out. Hopefully, today’s new retirees have been able to accumulate an above average amount of wealth to balance the poor conditions facing them today, but that may or may not be the case.