Exclusive Interview with Wade Pfau: Distribution Strategy Just as Important as Savings
Wade D. Pfau, Ph.D., CFA, is a Professor of Retirement Income in the Ph.D. program for Financial and Retirement Planning at The American College in Bryn Mawr, PA. He also serves as a Principal and Director for McLean Asset Management, helping to build retirement income solutions for clients, and Chief Planning Strategist of software provider inStream Solutions. He holds a doctorate in economics from Princeton University and publishes frequently in a wide variety of academic and practitioner research journals on topics related to retirement income. He hosts the Retirement Researcher website, and he recently authored his first book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement.
FN: Wade, what motivated you to get where you are today? Can you share a couple of life experiences that most influenced your career path?
Pfau: I went to graduate school with the plan of becoming a U.S. government economist. I instead took a detour and lived in Japan for ten years, working as an economics professor at a university in Tokyo. My interest in financial planning continued to build during this time, and I was fortunate to find my way into the field of retirement income planning. It is an extremely hot and relevant topic at this time as so many Americans approach retirement and must take personal responsibility for how to build a lifetime income with their defined-contribution retirement plans.
FN: As a contributor to Forbes writing on retirement issues, what have you found to be the most commonly asked question and why do you think there is so much interest in it?
Pfau: Readers are very interested to know how much they can spend in retirement. Spend too much and you risk running out, but spend too little and you risk not fully enjoying retirement. Once retired, individuals become more vulnerable to the experience of market returns. Uncertainty around longevity and the market create a lot of unease, and this becomes the key question for how to start building a retirement income plan.
FN: How has the DOL’s Conflict-of-Interest Rule changed the industry’s treatment of fiduciary? In what ways is this treatment of fiduciary irreversible even if the new administration rescinds the Rule?
Pfau: I think the whole debate has brought more attention to the fiduciary and suitability standards, leaving more Americans with an understanding about the differences. Companies that are making the transition to becoming a fiduciary may find it hard to turn back, even if the rules are rescinded.
FN: What represents the biggest challenge facing retirement plan fiduciaries?
Pfau: The biggest challenge will be to help the participants to develop sustainable retirement income plans. Thus far, the focus has been on accumulating assets. We also need appropriate defaults and distribution strategies for after retirement as well.
FN: What do you think is the hardest concept for retirement savers to understand and act on?
Pfau: I think it is hard for savers to translate between a lump-sum value of assets and a sustainable spending amount. Someone with $1 million may feel rich until they realize that this may only translate into $30,000 of annual spending should the individual seek to continue managing longevity and market risk on their own.
FN: You were among the first to observe the sequence of return risk for retirees and how this might put the 4% return assumption in danger. Can you explain how placing 2-3 years of expenses in cash leading up to retirement is one way to help retirees weather any sequence of return risk?
Pfau: Four ways to manage sequence of returns risk include spending conservatively, being flexible to reduce spending after market declines, reducing portfolio volatility, and drawing from an asset outside the financial portfolio. Sequence risk is triggered by having to sell assets at a loss to cover spending needs. Having a separate cash account with a few years of expenses can potentially help to manage sequence risk by reducing the need to take distributions from investments for a couple of years if there is a decline in the portfolio value. However, there are probably more efficient ways to manage sequence risk than to maintain a large pot of cash outside of the rest of the portfolio, leaving that rest of the portfolio smaller than it could be. The cash reserve idea relies on stock markets performing adequately if given sufficient time, but there is no guarantee that two to three years is a sufficient amount of time to avoid selling assets at a loss.
FN: A different way to reduce the sequence of return risk is to generate retirement income in novel ways. Your book on reverse mortgages is meant to address retirees’ income needs during retirement. Briefly explain the concept behind this.
Pfau: My book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement, provides an overview of the financial planning research about using a reverse mortgage as part of a retirement income plan. Reverse mortgages could be used to reduce portfolio distributions on an ongoing basis, such as by paying off an existing mortgage with a reverse mortgage, or developing an ongoing income stream from the reverse mortgage with the tenure payment option. A reverse mortgage line of credit can also be set up in advance and allowed to grow over time, and it can be tapped to cover some retirement spending when the investment markets are not performing well and portfolio depletion is a possibility. This second use is similar to the cash reserve idea, but the reverse mortgage line of credit exists completely separately from the rest of the investment portfolio and it grows over time.
FN: For individual retirees, what are the advantages of reverse mortgages?
Pfau: Reverse mortgages provide a way to create liquidity for an otherwise illiquid asset. For responsible retirees who will not be tempted to overspend because of this new liquidity, the reverse mortgage allows for more efficient use of home equity than to just leave it as a last resort asset to be used if all else fails.
FN: For individual retirees, what are the disadvantages of reverse mortgages?
Pfau: Retirees do need to shop around between lenders to find one with low upfront costs for setting up the reverse mortgage. It is now possible to set up reverse mortgages very cheaply, but some companies still quote high prices in the hope that customers will not shop around. There is still not an easy way to compare options rather than to work with several lenders to get quotes.
Also, being responsible is important. Do not fritter away home equity because it is available. Borrowers who will have too much temptation should probably avoid it.
FN: What might be some potential liabilities for a fiduciary who is considering recommending a client enter into a reverse mortgage?
Pfau: Many did due diligence about reverse mortgages years ago and may still carry negative views if they haven’t revisited the product as it exists today. This could create headaches when dealing with regulators or others who unfairly carry a negative impression. But home equity and Social Security are the two biggest assets on the balance sheets of most households. I’m not sure how a fiduciary can really get away with ignoring home equity when providing advice about the investment portfolio.
FN: Another way to address the sequence of return risk is to have sufficient assets at retirement. One way to accomplish this is to encourage parents to set up a Child IRA for their children. [Ed. Note: You can read more about it here: http://ChildIRA.com/ – just scroll down below the sliding picture and click the links to the relevant articles.] How does The Child IRA better prepare people for retirement? How does The Child IRA address a future retirement crisis like a collapse of Social Security? What do you think is the best way to get the message of The Child IRA to parents and grandparents?
Pfau: Compounding is very important to wealth accumulation. For assets invested at age 0 instead of age 20, with a 7% return they can quadruple by age 20. More time in the market, along with the associated tax deferral or tax free possibilities, definitely helps. Of course, the child needs earned income, which may not be practical for many families. Nonetheless, for those who can swing it, it’s an interesting idea.
FN: What further comments would you like to share with our readers?
Pfau: Retirement plans have focused on accumulating assets. Now it is time to turn attention to how to best distribute those assets to provide a sustainable income for life.
FN: Wade, thanks for taking the time to share your thoughts with our readers. The sense of a need for a distribution strategy is compelling and one worthy of addressing.