With an unprecedented number of Americans retiring, the question of how they will support themselves is at once an individual and collective imperative. Wade Pfau has just released what may be the most comprehensive book I’ve ever seen on the subject—and I’m not even halfway through it.
But I can already recommend Pfau’s Retirement Planning Guidebook both to financial advisors and any other individual confronting myriad retirement issues, problems that are going to present a generation with a set of challenges likely to surpass those previous cohorts endured. Pfau earned his Ph.D. at Princeton, where he wrote his thesis on Social Security under the supervision of former Federal Reserve Vice Chairman Alan Blinder. But Pfau’s book is accessible to reasonably educated individuals as well as advisors.
In the first chapter, he takes a deep dive into the four retirement income styles available to most Americans: 1) The total return approach favored by many RIAs, in which retirees essentially live off the capital appreciation and income generated by their portfolios; 2) a safety-first time segmentation using laddered bond portfolios; 3) a safety-first approach using annuities as an income floor; and 4) a hybrid risk wrap approach. The last style combines certain guaranteed income with what Pfau calls a “preference for technical liquidity and for back-loading retirement income” in the later years. This method resembles—and uses—a variable or indexed annuity.
According to the research Pfau has conducted, about one-third of retirees prefer the total return approach, while another third like the safety first annuities method. The bond ladder and hybrid approach each appeal to about 15% or 20% of people. Ultimately, a retiree’s preferred style involves a choice between flexibility and certainty. Pfau is in the process of creating a database with millions of Americans to continue research on these issues.
Many in this current generation of retirees enjoyed a four-decade bull market in equities, and that coincided with the advent of 401(k) plans. These developments have made them comfortable with the total-return approach. It’s worth recalling, however, that U.S. equities went sideways with two major drawdowns between 2000 and 2009. After the Great Recession in 2009, there was a spate of commentary arguing that defined contribution (DC) plans, including 401(k)s, were inadequate for many people’s retirement. In reality, these vehicles were designed to be supplemental retirement plans, not primary sources of retirement income.
A lot of people are feeling more flush than usual these days, as evidenced by the record "quit" rate. Something like 20 million people have quit their jobs since April. But fewer and fewer of them have traditional defined pensions—hence the increased interest in annuities, the next closest thing. Even if factors ranging from low interest rates to loss of control are deterring many individuals from purchasing them, annuities remain an excellent reference point for advisors and individuals seeking to create their pensions, or retirement paychecks.
Most financial advisors deal with clients who have substantial assets outside their DC plans, so they have more ways to generate retirement income than folks in the broader population. Given their superior asset levels, many clients can embrace a hybrid style, or multiple ones. For example, it’s quite common for many advisors to use a total return approach coupled with laddered bond portfolios.
Anecdotal evidence from advisors indicates that clients in the non-profit sector, such as academics, police officers and healthcare workers, many of whom have pensions, enjoy the guarantees of annuities, while people in the private sector, particularly entrepreneurs, prefer the flexibility of the total return approach. Ironically, each client segment might be able to benefit from a mix of styles, but people tend to gravitate toward what they are most comfortable with.
All four styles face a common challenge. That long bull market has helped both equities and bonds reach historic highs. This implies that the returns from stocks—and the bonds that underlie fixed annuities—will be significantly less than what people have come to expect.