Wade Pfau has written an important book: How Much Can I Spend in Retirement?: A Guide to Investment-Based Retirement Income Strategies. It should be read by not just financial planners, but also all investment advisors who work with individual accounts.
The traditional way that investment advisors, as distinct from financial planners, have managed clients’ portfolios has been to try to build wealth, through getting good returns in some fashion, and sometimes, especially when the advisor has learned modern portfolio theory, keeping one eye on investment risk and the clients’ stomach for risk. Financial planners, as professional practitioners distinct from investment advisors, have trained their attention, instead, on funding their clients’ spending needs, of which the greatest is, normally, the costs of funding their lives through retirement.
Although there is a clear need to integrate wealth accumulation with the plans for drawing down that wealth, there has been a dearth of theory to guide practitioners in this integration. Worse, until recent years, there has been little work on how to create retirement income plans, apart from, for the last couple of decades, the formulation and acceptance of the familiar “4%” rule. It’s excusable that investment management has received most of the glory of the attention of trained economists, while retirement planning was neglected, because until the decline of defined-benefit plans and the rise of defined-contribution plans, retirement planning had comparatively little need for intellectual labor. Now, as many are aware, the retirement problem has increasingly attracted serious study, including that of such luminaries of financial economics as William Sharpe, Zvi Bodie and Robert Merton.
Pfau is one of the leaders in the economics of retirement planning, and he has built his still short career in this field. We are fortunate now to have his considered judgement on the totality of investment approaches to funding retirement. (In his preface to the book, he says that he will explore in later books the use of annuities and other insurance products for this purpose. And he has already published a book on reverse mortgages.i)
He addresses his book to the public, not to financial planners and investment advisors, but it is hardly likely that significant numbers of ordinary citizens will find, let alone read this book. I can’t picture my clients reading it. And that’s no great loss. It is important only that practitioners and sophisticated do-it-yourself investors read this book, and perhaps it is because Pfau thought that he was addressing the public that the book is mostly free from jargon and is written very clearly; there is therefore little excuse not to read it. (The ostensible readership may explain the otherwise superfluous brief introduction to fixed income analysis at the beginning of Chapter 7.)
Pfau systematically and at length analyzes virtually every approach that has been suggested for retirement income planning, using both reconstructions from historical data and projections based on Monte Carlo simulations. I have long been wary of Monte Carlo simulations, which have become the magic ingredient in financial planning software in much the same way that chlorophyll became the magic ingredient in chewing gum and oat bran in almost every processed baked food product. I was therefore very glad to see that Pfau, in an appendix to Chapter 3, lays out the processes and assumptions that he has incorporated in his simulations. These are reasonable and were chosen with good judgement. His are Monte Carlo simulations that I trust, knowing their limitations. (The description is only moderately technical; you won’t be able to reproduce his code exactly, but I am confident that his results are reproducible.)
Pfau classifies approaches to retirement income planning as either “probability-based” or “safety-first,” the latter being those that do not permit any risk of failure (barring an end-of-world economic future). The former, of course, are the ones that require analysis based on Monte Carlo simulation. His Exhibit 1.5 (p. 32) is a table of retirement income strategies, classified into these two approaches. The sheer number of them is astonishing, and although he describes the table as “just a sampling,” I was a little surprised that he did not include the “Discretionary Wealth Hypothesis” of Jarrod Wilcox, which the Research Foundation of the CFA Institute has brought to prominence in one of its monographs.ii But perhaps that is because Pfau considers it to be very similar to some of the others that he lists. Maybe this also reflects the professional separation of investment managers from financial planners.
Pfau begins his analysis with William Bengen’s 4% rule (that a safe spending rate from accumulated wealth is 4% of the amount at the start of retirement, and then the same inflation-adjusted dollar amount every year thereafter for 30 years, leaving, at worst, no money at the end of that time.) He finds that, for a process based on a high likelihood of success, it appears to be justifiable. But of course, there’s more to it than that.
And so the structure of the book, after an introduction to retirement planning, is:
- Sustainable spending rates assuming fixed investment returns and known longevity;
- The effects of investment volatility on sustainable spending rates, and in particular, the effects of sequence-of-returns risk (that is, the risk that arises if returns are negative in the early years of withdrawals from the accumulated investments);
- Managing sequence risk by constantly spending conservatively;
- The effects on retirement spending of varying the assumptions behind Bengen’s 4% rule;
- Managing sequence risk by varying spending over the retirement years;
- Managing sequence risk by using bonds to create any of several kinds of safety-first methodologies;
- Summing up the results of the foregoing studies, with Pfau’s recommendation for a sustainable spending strategy.
I began the book ready to pounce upon it if it did not integrate consideration of the wealth-accumulation phase with the drawdown phase, and I was very pleased to find that Pfau did just this, in Chapter 3, where he introduces sequence-of-returns risk and looks at it over both phases. He negotiates, also, another pitfall, when he considers the costs of investing, after basing his analyses on the returns to broad indices of asset class returns, like the S&P 500, which do not reflect the expense of management costs.
Pfau’s thoroughness (to a fault) and sense of fairness obligate him to devote considerable attention to strategies of which he is rightly skeptical. We therefore find him in Chapter 7 analyzing time-segmentation strategies (whereby a portion of the retirement period is covered by a safety-first approach, and is followed by a portion that is exposed to the risk of investment returns).
I have only minor quibbles with Pfau’s treatment of safety-first methods based on bond ladders, but these are for what he omits, not for any errors. He looks at bond ladders built on Treasury STRIPS, and also on TIPS, but leaves out stripped TIPS, which are available in the secondary market. Also, he assumes that ladders are built on annual payouts, whereas they can be practicably built for longer intervals, such as five years. But these are merely small variations on the themes that he analyses. Another quibble is that he slightly mischaracterizes Zvi Bodie’s safety-first methodology as being based on TIPS. In fact, Bodie recommends both I-Bonds, which Pfau also discusses, as well as TIPS, but Bodie points out that that TIPS are more tax-efficient in tax-advantaged retirement plans.iii
Pfau’s writing is lucid, but to describe his prose as “workmanlike” is to suggest that it is much livelier than it actually is. This is a book to be read in short sips and not gulped in one sitting. This is another reason it will not be read by the general public, even if we advisors recommend it. I did not read it with a view to picking out typos, but it appears to be cleanly edited. I could not help noticing, though, that in Exhibit 5.23 (p. 147), the headings for columns 2 through 6 are missing. The attentive reader of the accompanying text will be able to figure out what three of them represent, and the other two don’t much matter.
The penultimate chapter, in which Pfau sums up with a description of how to approach retirement planning, is the only disappointing one. It is an outline of the approach used by the advisory firm, McLean Asset Management, which he serves as director of retirement research, in creating plans for clients. While this approach appears to be thorough and reasonable, the chapter is not really a summary of all that has come before, or a recommendation of which approach, among the many approaches he has analyzed, one should use. This methodology seems to assume that clients have a certain degree of investment sophistication that allows them to make informed choices; many of us have clients, even highly intelligent and educated ones, who lack this sophistication. There are hints that McLean may, when a client has sufficient wealth to cover expenses in retirement, recommend a safety-first approach for the portion of total wealth that can do so, and otherwise recommend taking risks in the market, but it’s not entirely clear that that is the case.
This points to another issue, beyond what Pfau considers. As he is writing, he says, for the client, not the advisor, the choice between probabilistic approaches and safety-first approaches can fairly be left open. But those of us who advise clients face a moral decision: Do we recommend a probabilistic approach, if the client may not understand – and how can we really know if he does? – what the risks are? Or do we recommend a safety-first approach, if the client can even afford this in the first place, or have to fall short of his or her idea of retirement income? Although this is to a degree a matter of fiduciary responsibility, in that an advisor can charge more for the oversight of an investment portfolio than she can for a bond ladder, the ethical issue arises even in the absence of the advisor’s financial interest. There is no calculus to determine which overall approach advisors should recommend to any particular client; this is a choice with possibly grave consequences that we must make for someone else.
The matter of retirement spending from investment wealth is not, as Pfau is well aware, a concern for all citizens. It’s for the “mass affluent.” The so-called 1%, roughly speaking, have no need to worry. But there is a very large proportion of the population who are not even able to aspire to accumulating sufficient financial wealth to be able to add significantly to their Social Security benefits. For many of these, Merton is arguing that a much more flexible form of reverse mortgage than is available today could allow their greatest (non-financial) asset to be converted into income. Although this is clearly beyond the scope and purpose of Pfau’s book, we should remember that this book addresses concerns of a comparatively fortunate segment of the citizenry.
Pfau’s book has changed my thinking about advising clients, even for their wealth accumulation, and I expect to refer back to it frequently. It will not be the last word on investment approaches to retirement income planning, but it firmly establishes where current thought on the subject now stands, thanks in no small measure to Pfau’s own research efforts.
Adam Jared Apt, CFA, is a financial advisor and the owner of Peabody River Asset Management, based in Cambridge, MA.
i Wade D. Pfau, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (McLean, Virginia: Retirement Researcher Media, 2016).
ii Jarrod Wilcox, Jeffrey E. Horvitz, and Dan diBartolomeo, Investment Management for Taxable Private Investors (Charlottesville: Research Foundation of the CFA Institute, 2006).
iii Zvi Bodie and Michael J. Clowes, Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals (Upper Saddle River, New Jersey: Financial Time Prentice Hall, 2003).
Read more articles by Adam Jared Apt
