I read a lot of financial blogs, and I can't remember any other economists who blog as frequently as Wade Pfau. Maybe William Bernstein, although of course his doctorate is in a completely different field.
So it's nice to read small doses of economic research from someone who writes like a "regular guy", rough drafts and napkin sketches and all, rather than yet another ivory-tower academic who has his stone tablets hauled down the mountain every 3-4 years for everyone to scratch their heads over and try to decrypt into plain English. The only other popular-reading economist I can think of is Milevsky, and I don't even know if he blogs-- but at least he writes readable books. I'm trying to think of more economist's writing that I read regularly, and I'm drawing a blank.
Pfau seems to be spending his time in an area that I think holds a lot of promise-- figuring out how human behavior and variable spending affect portfolio survivability. I think it's very interesting to see him try to put realistic numbers on how much of a portfolio should be annuitized for bare-bones survival, and to try to translate "risk tolerance" into concepts that real-life retirees can sleep with at night.
He's co-author on an article in the March "Journal of Financial Planning" that speculates the 4% SWR may be too low. That's right, we may not be spending the money fast enough. Spending? Spending?!? We're so loss-averse and so risk-shy that we can't HANDLE the spending!
The Cliff Notes version of the article is summarized by Scott Burns here:
Life: How Much Will You Leave On the Table? - Registered Investment Advisor
The full article is here, with graphs:
Spending Flexibility and Safe Withdrawal Rates
I'm not trying to claim that Pfau has all the answers-- not yet anyway. But I feel like it's 1994 or 1998 and I'm reading about the SWR all over again for the first time. Keep an eye on this guy when you tweak your retirement spreadsheet.
So it's nice to read small doses of economic research from someone who writes like a "regular guy", rough drafts and napkin sketches and all, rather than yet another ivory-tower academic who has his stone tablets hauled down the mountain every 3-4 years for everyone to scratch their heads over and try to decrypt into plain English. The only other popular-reading economist I can think of is Milevsky, and I don't even know if he blogs-- but at least he writes readable books. I'm trying to think of more economist's writing that I read regularly, and I'm drawing a blank.
Pfau seems to be spending his time in an area that I think holds a lot of promise-- figuring out how human behavior and variable spending affect portfolio survivability. I think it's very interesting to see him try to put realistic numbers on how much of a portfolio should be annuitized for bare-bones survival, and to try to translate "risk tolerance" into concepts that real-life retirees can sleep with at night.
He's co-author on an article in the March "Journal of Financial Planning" that speculates the 4% SWR may be too low. That's right, we may not be spending the money fast enough. Spending? Spending?!? We're so loss-averse and so risk-shy that we can't HANDLE the spending!
The Cliff Notes version of the article is summarized by Scott Burns here:
Life: How Much Will You Leave On the Table? - Registered Investment Advisor
How would you like to double your retirement spending?
Well, Michael Finke is working on just that. He thinks we may be able to live better in retirement than most professionals have thought for nearly two decades. The Texas Tech University associate professor, along with two other researchers, Wade D. Pfau and Duncan Williams, has examined William Bengen’s well-known 4 percent safe spending rule and found that some retirees, perhaps many, can spend a lot higher on the hog. Simply raising the spending rate to 6 percent means you can spend 50 percent more.
“By emphasizing a portfolio’s ability to withstand a 30 or 40 year retirement,” the researchers write in the March issue of the Journal of Financial Planning, “we ignore the fact that at age 65 the probability of either spouse being alive at age 95 is only 18 percent.” As I pointed out in a recent column, it’s silly to have 95 percent confidence in your income when your chance of being alive is much smaller.
Excessive caution, he told me in a recent interview, means we buy long-term security at the expense of giving up many things we’d like to do today. We leave estates that are larger than planned and feel remorse for experiences we’ve missed.
The full article is here, with graphs:
Spending Flexibility and Safe Withdrawal Rates
What is missing from the shortfall literature is the consideration of what is lost when withdrawal rates are overly conservative. By emphasizing a portfolio’s ability to withstand a 30- or 40-year retirement, we ignore the fact that at age 65 the probability of either spouse being alive by age 95 is only 18 percent. If we strive for a 90 percent confidence level that the portfolio will provide a constant real income stream for at least 30 years, this means that we are planning for an eventuality that is only likely to occur 1.8 percent of the time. And even that figure assumes that clients are unable to make adjustments to their spending later in retirement. So by relying on standard historical or Monte Carlo simulations to determine a safe withdrawal rate, clients may be unduly sacrificing much of their desired lifestyle early in retirement.
The failure to include a client’s willingness to adjust is an important shortfall of the shortfall literature. A common thread in the analysis is that all failures are counted the same, without regard to when the failure occurred or what percentage of the client’s stated aggregate spending goal was funded. Such an all-or-nothing approach to retirement simulation is inconsistent with the way trade-offs are framed in retirement. In practice, advisers often help their clients prioritize spending goals with basic living expenses, insurance premiums, and debt payments receiving top priority. Other goals, such as travel and vehicle purchases, are scalable and may even be reasonably expected to disappear entirely late in life. Different spending goals have different priorities and importance (Curtis 2006). Some clients may reasonably prefer a higher travel budget in their 60s and 70s, even if it means a higher probability of having to cut back on their dining and vehicle budgets in their 80s. This would be considered failure in most shortfall risk analyses.
If a couple does not have a very strong desire to leave a liquid bequest (or has planned for the bequest through life insurance), the result of relying on standard simulations is that the vast majority will die with a lot of unspent money that they had intended to use to support their lifestyle. Ideally, we would like to include these unspent funds, and the happiness they could have provided if spent, in a calculation that also considers the serious implications of experiencing a shortfall. Fortunately, both can be modeled by using utility theory—the same concept that underlies modern portfolio theory.
[...]
For planners, the most significant insight is that a client’s willingness to take portfolio risk before retirement is equivalent to a willingness to accept shortfall risk after retirement. A risk-averse investor should choose a lower withdrawal rate in order to reduce the probability of having to reduce consumption later in retirement. This result is similar to the findings of the typical shortfall minimization strategy; however, the traditional approach fails to capture the preferences of a client who is willing to accept the risk of a diminished income in order to live better in retirement. The authors recognize that it may be difficult to consider a strategy that results in an increased shortfall risk; however, it may be helpful to encourage a client to choose among possible conservative strategies (say, between 4 percent and 6 percent) by articulating the shortfall risk/lifestyle return trade-off.
By increasing the size of the income floor in retirement, for example by investing a portion of assets in a guaranteed income product, an adviser is able to recommend both a higher asset decumulation rate and greater portfolio risk. In other words, a client will be better off with a riskier portfolio when the downside drop in spending is not as severe. The magnitude of guaranteed income may then be viewed as a client’s decumulation risk capacity. A larger pension or other source of annuitized income provides a cushion against the loss in quality of life if investment returns are unfavorable or the client outlives his or her assets. Advisers seeking a way to increase expected return in retiree portfolios may be best served by looking into the advantage of mixing a risky investment portfolio with products that protect a minimum level of income.
The economic framework used in this paper provides a scientific approach to a philosophical issue that has long been discussed in the planning community. Practitioners are often torn between a strict interpretation of the safe withdrawal guidance and a looser interpretation that allows retired clients to spend more on things that bring meaning to their lives while accepting greater risk. The implications of the analysis in this paper can give practitioners a framework from which they can engage clients in conversations about sensible trade-offs in retirement.
I'm not trying to claim that Pfau has all the answers-- not yet anyway. But I feel like it's 1994 or 1998 and I'm reading about the SWR all over again for the first time. Keep an eye on this guy when you tweak your retirement spreadsheet.