The Retirement Thinker — With Wade Pfau

A proposal to create retirement accounts from Social Security steered Wade Pfau from a potential career as an economist to becoming one of the foremost thinkers in retirement income strategies.

To call Wade Pfau an expert when it comes to retirement income planning is an understatement. Pfau is co-founder of the Retirement Income Style Awareness Profile (the RISA) and  founder of Retirement Researcher, an educational resource for individuals and financial advisors on topics related to retirement income planning. 

“I mainly write programs to simulate how different retirement strategies perform,” says Pfau, who serves as a principal and the director of retirement research for McLean Asset Management and as a research fellow with the Alliance for Lifetime Income and Retirement Income Institute.  He is a professor of practice at the American College of Financial Services and has published more than 60 research articles in a wide variety of academic and practitioner journals. His research has been featured in the Economist, New York Times, Wall Street Journal, Time, Kiplinger’s, and Money magazine.

“Essentially, not much changes in retirement,” explains Pfau. “You still have your diversified investment portfolio, but rather than adding new savings, you start taking distributions.” What strategy you employ, though, to help ensure a successful retirement, he says, is what sets investors apart.

Paul Feldman: For those not familiar with you, can you tell us a little about your background and why you got interested in the business?

Wade Pfau: I’ve been in the retirement income space and financial planning side now since about 2010. I studied economics in college and went to graduate school for economics. I was thinking about becoming a U.S. government economist. I did an internship at the Social Security Administration. When I finished graduate school, I decided not to become a U.S. government economist, at least not right away. I thought it’d be neat to live in another country, and so I found a job as a professor in Japan where I was teaching at a public policy school — mainly with students who are from emerging market countries or developing countries and looking at their pension systems.

I spent 10 years in Japan, but when I was ready to return to the U.S. I realized that emerging-market pension systems was not a very marketable topic to U.S. audiences. So I started to pivot. I studied for the Chartered Financial Advisor designation on the investment side, but as a part of that, I came across some of the concepts of retirement income planning. 

The research I had done on Social Security for my dissertation was about President George W. Bush’s proposal to create personal retirement accounts from Social Security. I was evaluating that, and that ultimately led to this transition into retirement income planning. I mainly write programs to simulate how different retirement strategies perform. I came across the idea of the 4% rule and the concepts from the investment world. Essentially, not much changes in retirement. You still have your diversified investment portfolio, but rather than adding new savings, you start taking distributions.

Feldman: Are the risks different in retirement?

Pfau: There are different risks in retirement. Longevity risks, for example. People don’t know how long they’ll need to stretch their money out for the sequence of returns risk. When you’re taking distributions, market volatility effectively has a bigger impact on retirement. There’s a lot of disagreement about how to approach retirement.

There are two different schools of thought. Probability based is more of an investments-only school of thought. Safety first looked at the role for insurance. And so I started learning about risk pooling and insurance and how you can build strategies that also include insurance in the retirement income phase. And my research has pointed to that while there are different viable options, risk pooling through insurance is competitive with anything that an investment portfolio can do.

The math is really in favor of using risk pooling as part of a retirement strategy. I developed research in that area. I was at the American College of Financial Services full time for 10 years with their Ph.D. program and with the RICP (Retirement Income Certified Professional) designation. While I was doing research, I started writing books. 

My retirement planning guidebook has done well in becoming a resource that I try to make as comprehensive as possible about how to build retirement strategies, looking at all the different aspects — not just the investment side or not just the insurance side, but also Social Security, long-term care planning, health care and Medicare decisions, retirement housing, and tax planning, which is an active area of research for me right now.

I also look at tax-efficient retirement planning, estate planning, and the nonfinancial aspects of retirement as well. And I work with a registerd investment advisor firm based out of Virginia, McLean Asset Management, that has approximately a billion dollars in assets under management. 

I have a website, RetirementResearcher.com, which is more of an educational website for consumers and advisors on retirement topics. And I’ve worked on creating RISA, the Retirement Income Style Awareness assessment tool, which helps people provide a starting point for how they want to build a retirement strategy.

Feldman: Are you an active financial advisor?

Pfau: I am not a financial advisor myself. I work more behind the scenes helping to support the advisory team with research. When there’s a client who likes to get into the weeds, I do join those conversations sometimes, but not on a day-to-day basis.

Feldman: What types of conversations do you have when you’re pulled into a discussion with a client?

Pfau: It’s always interesting to have those conversations and to see their perspective, especially where they may not be fully immersed in the retirement research. They bring a different viewpoint or perspective to things, and that can lead to some interesting conversations. I remember one example.  Initially the idea was to help explain why risk pooling through insurance might contribute to their retirement strategy. I started explaining about how you could think of building a bond ladder to generate retirement income as a starting point, and then how you can add insurance on top of that. But ultimately what came out of that conversation was the client saying, “Oh, I like the bond ladder idea.” 

The idea of a retirement income bond ladder is the same as a regular bond ladder, except you spend the proceeds as they mature rather than reinvesting them, and rolling the ladder forward. So that was a pretty interesting highlight where going into a conversation using something as a baseline became what the individual was most interested in.

Feldman: How does the bond ladder do compared with risk pooling?

Pfau: The bond ladder is the foundation, and then we generally have two ways you could generate more spending power than with a bond ladder. One option is the diversified investment portfolio, where you rely on the stock market to generate higher returns to support more spending than bonds. And the other is risk pooling, where you pool that risk with an insurance company with fixed annuities, effectively having something like a bond ladder or a fixed income portfolio of their own. That provides an ability to subsidize payments to the long-lived through some of the premiums from the short-lived who end up not needing as much to fund their retirement.

And so that risk pooling supports a higher level of spending than bonds. You have the two different options: Are you more comfortable with the stock market to fund more spending than bonds, or risk pooling to fund more spending than bonds? The stocks and the annuities both provide at least the potential to spend more than do bonds alone.

Feldman: What is your take on the 4% rule? 

Pfau: When you talk to somebody in the real world, they’ll immediately say, “Well, the 4% rule is ridiculous. Nobody would behave that way.” The 4% rule does assume you always just increase your spending precisely for inflation. You never deviate. You’re never going to reduce your spending if it looks like your portfolio is losing value and so forth. It is very unrealistic in that regard. And so that’s always been an issue with the 4% rule: You can’t use it to define an actual retirement strategy. It’s meant just to be a benchmark to see what level of spending might be sustainable.

I used to have a lot of concerns that something like the 4% rule is not actually sustainable in a low interest rate world. But interest rates are now at the point where you can make the 4% rule work. For example, it assumes 30 years of spending, inflation adjusted. So we have TIPS — Treasury Inflation Protected Securities — in the U.S. so that you can build a 30-year TIPS ladder and get 30 years of inflation-adjusted spending. As long as the real interest rate on TIPS is about 1.3%, the 4% rule will work. And we’re now higher than that. The average TIPS yield is somewhere in the ballpark of 1.8% or higher. So the 4% rule can survive certainly as a benchmark in today’s interest rate environment.

Feldman: What are some things that are changing or on the table right now in regard to tax planning and estate planning? Estate planning could change significantly in the next couple of years.

Pfau: If Congress doesn’t take further action, we’ll have the higher tax schedule return in 2026 as it existed in 2017. And so we do have this period right now where there can be opportunities to generate taxes as part of a long-term planning strategy when we are in these lower tax brackets. But there’s so much for advisors to understand with tax planning. 

We have all these nonlinearities in the tax code for more mass affluent retirees who may have just under a million dollars — but even in excess of $2 million. If they’re in their 60s and they’re retired and they’re delaying Social Security, they can create a Roth conversion strategy that will set them up so that even when required minimum distributions start later, they may not face taxes on 85% of their Social Security benefits — and that can have a huge impact on longevity of their funds.

For clients who may be a bit wealthier than that, there’s also the Medicare surcharges, called IRMAA [income-related monthly adjustment amount]. In those cases, if you have $1 too much of income, depending which threshold you’re at, it has a huge shock or impact. And so when we think about the federal marginal tax rates, right now a lot of people in retirement may end up in the 12% or 22% bracket, which in a few years will become 15% and 25%.

But your actual effective marginal tax rate could be a lot higher, because if you’re in the phase where you have another dollar of income that forces more of your Social Security benefit to be taxed, that also may push some of your long-term capital gains from the 0% bracket to the 15% bracket. You may think that this year you’re in the 22% tax bracket, but you could end up being in a 55% federal income tax bracket. 

Feldman: How do you figure that out with your clients? 

Pfau: I’ve spent a lot of time writing programs to simulate different strategies to try to look at what you should be targeting when you start doing Roth conversions, generating additional taxable income this year, and then simulating that out through a full retirement. Some of the research in this area looks for mathematical solutions, but they have to make so many simplifications to do that. I take more of a simulation-based approach where I’ll say, “Instead of targeting this tax rate or that tax rate, let’s target them all. It takes a long time to run these programs, but then let’s see which one supported not just the retirement spending goals but then had the most legacy at the end as well.” And then whichever strategy just does best becomes the recommended course of action. And it does call for potentially paying more taxes in the short term to create stronger long-term benefits.

Now with the SECURE Act, an inherited IRA used to be able to get that lifetime stretch. Now there’s that 10-year window to take the distributions. So, if your adult children are inheriting an IRA, say in their 50s, they may, in their peak earnings years, face a much higher tax rate on those distributions than what you as a retiree would face. And therefore, if you think your children would be in the 25% tax bracket when they receive that IRA, you might want to take advantage of paying taxes now at 12% or 22% so that you got the taxes paid at a lower rate. When the Roth goes to the beneficiary, they still have to take the money out, but they don’t have to pay taxes on it. It’s all about looking for opportunities to pay taxes at the lowest possible rates.

Feldman: Where do most people go wrong with claiming Social Security? Too early or too late?

Pfau: I am a big advocate of the idea that, generally, at least the high earner in the couple should think about delaying as close to age 70 as possible. And I would say the big mistake is people who claim too early. 

Things are improving a lot. It used to be 10 years ago that about half of the population claimed at age 62. That number has fallen dramatically over the past 10 years. More people are waiting until their full retirement age or even past their full retirement age. So I think that’s a big improvement. But I do think, for most couples, it’s a mistake to have both individuals claim at 62. Sometimes people just want to get access to the funds, and they don’t have any choice.

But at the end of the day, I’ve done a lot of research along the lines that it is OK to spend other assets down as a part of delaying Social Security because the increased Social Security benefits that you’ll receive mean you’ll be able to take much less from your other assets in the future. And, so, in the long run, that’s going to leave you in a much better position.

 You’ve got more than a 50% chance of making it past age 80 these days. I don’t know if everyone realizes that, but that really speaks to why it often makes sense delaying Social Security and getting that higher inflation-adjusted lifetime income backed by the government.  

Feldman: People usually don’t spend what they had planned to spend. They usually will spend less. Have you found that to be the case?

Pfau: There have been plenty of studies. It’s the retirement consumption puzzle — this idea that even with extremely conservative assumptions, it seems like these retirement households could be spending more than they are, but they seem to hold on to their assets. Part of that may just be worrying about things like long-term care or just that they might live too long. They need to make sure they keep those assets in place. 

Feldman: How much should they spend in retirement? 

Pfau: Are they focused more on growth for their assets, or are they focused more on having predictable income? And of course, if you want more predictable income, you’re not able to have volatile assets backing that. Having a volatile investment portfolio implies you have the ability to have a volatile spending strategy as well. And so it does become an important factor for people to start thinking about how do I actually want to structure my retirement strategy? Those who want more predictable income might lean more toward an insurance-based starting point. Those who are more flexible with their spending and are more comfortable having volatile spending in retirement may feel more comfortable taking an investment-based approach that is much more focused on maximizing returns to the portfolio.

Feldman: So, at a higher level, how should advisors and their clients be thinking about retirement options?

Pfau: The idea of the retirement income style awareness is helping people see which strategy may resonate best with their personal preferences. What we’ve found in the research was two primary factors. The first is the one I mentioned earlier, the idea of probability based versus safety first: Are you comfortable relying on the stock market to fund your retirement spending, or would you prefer safety-first contractual protections to cover your bases?

The second main factor is this idea of optionality versus commitment. Optionality is do you want to maintain as much flexibility as possible for your assets? Or are you actually more comfortable committing to something that you know solves for your lifetime need.

We do find very strong predictive power, in that individuals who are more income protection oriented are much more likely to include an annuity as part of the retirement planning process. People who have that total return orientation — the probability based and optionality — they’re much less likely to ever resonate with a conversation around annuities. I think having people take the RISA assessment — that’s the major initiative I’ve been working on these past few years — really does provide a helpful starting point and will provide an idea of how they might want to approach their retirement. 

How people feel about these two factors translates into a very interesting way to think about the different retirement strategies out there. 

Paul Feldman started the website InsuranceNewsNet in 1999, followed by InsuranceNewsNet Magazine in 2008. Paul was a third-generation insurance agent before venturing into the media business. Paul won the 2012 Integrated Marketing Award (IMA) for Lead Gen Initiative for his Truth about Agent Recruiting video and was the runner-up for IMA's Marketer of the Year, a competition that includes consumer and B2B publishing companies. Find out more about Paul at www.paulfeldman.com.