Afford Anything - Retirement Planning in 2020, with Dr. Wade Pfau

Episode Date: August 19, 2020

#271: Dr. Wade Pfau, one of the foremost experts in the academic field of retirement planning, joins us to talk about how the events of 2020 might impact your retirement plans. If you’re wondering if you need to change your investing strategy, Wade’s recommendations may fascinate you. Watch out! These are NOT the recommendations you’re expecting from a typical financial independence retire early show. Prepare to be caught off-guard by what he says. For more information, visit the show notes at https://affordanything.com/episode271 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but not everything. Every choice that you make is a trade-off against something else, and that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention, anything in your life that's a scarce or limited resource. And that leads to two questions. Number one, what matters most to you? Not what does society say should matter most, like a big house or a fancy car, but what genuinely matters in your own life? That's the first question, and the second question is a little bit tougher. how do you make daily decisions that support that priority?

That's where we all get tripped up. This podcast exists to explore the answers to those two questions. My name is Paula Pan. I'm the host of the Afford Anything podcast, and today, Dr. Wade Fow joins us to talk about retirement planning in the year 2020. Dr. Fow is a professor of retirement income for the American College of Financial Services. He teaches in their new PhD program on financial services and retirement planning. And if you're thinking, I didn't know that there was a such thing as a professor of retirement income. Ditto, you're not alone.

We talked about that the last time that Dr. Fow came onto the podcast, which was in 2018. He mentioned at that time that retirement planning as an academic research field is actually fairly new. People have been studying financial planning and investment planning for a very long time. But there has been little research done specifically around retirement. planning. And within this growing field, Dr. Fowell has made a major name for himself. He has won two awards from the Journal of Financial Planning. He has also twice won the award for academic thought leadership from the Retirement Income Industry Association. He's won an award for Best Paper in the Retirement category from the Academy of Financial Services. He was named

by Investment News as Top 40 Under 40 in 2014. He is a co-editor of the Journal of Personal finance, and he speaks frequently at national conferences of organizations for financial professionals. He is a retire mentor for MarketWatch. He is the Director of Retirement Research for McLean Asset Management, and he is an expert panelist for the Wall Street Journal. He holds a doctorate in economics from Princeton University and is also a chartered financial analyst. Now, as I mentioned, this is Dr. Faust's second appearance on this show. Two and a half years ago, in March 2018, he was a guest on episode 119, in which he talked to... about figuring out how much you can spend in retirement. We wanted to bring Dr. Fow back on the show

to talk specifically about retirement planning in the context of the year 2020. And disclaimer, some of what his recommendations are are antithetical to the beliefs of the financial independence retire early fire community. You're going to hear him talk about annuities, and you're even going to hear him talk about, and I hate to say these next two words, Reverse Mortgages. If discussion about annuities and reverse mortgages came from anyone other than Dr. Fow, I probably wouldn't even bother sharing it. But Dr. Fowl is one of the foremost experts in the academic field of retirement planning. And so his knowledge and perspective is worth considering. So listen with an open ear and enjoy. Here he is, Dr. Wade Fowell. Hi, Wade. Hi, how are you? I'm excellent. How are you doing?

I'm doing great. I wanted to ask you about retirement planning in the context of the year 2020. This year, what we've seen in the markets, what we've seen in the economy is incredibly unexpected. Many people are wondering if they should change their strategy and if so how. To begin with, what is your overall impression of 2020? Do you also carry the same impression that many of us do that this is just, just, bewildering? Yeah, absolutely. I mean, it's kind of this perfect storm of factors in terms of market volatility, the potential for salary reductions or job losses. And then also really the most important factor that's not necessarily at the top of everyone's minds is just how low interest rates have fallen as well. It really raises the cost of retirement. Tell me more about that. How does dropping interest rates raise the cost of retirement? Well, it means you need more assets to fund a given expenditure your goal. Like if interest rates are 5% and you have a million dollars, you're getting $50,000 of interest a year from that million dollars. But if interest rates are 1%, you're getting $10,000 a year

of interest. And so if you wanted to spend $50,000, you're either now in a position where you need to spend down your principal or you would need $5 million to have the interest cover that same level of spending. Right. To what extent is that offset by the opportunity that low interest rates present in terms of assuming that you still are a mortgage holder, refinancing your mortgage or using this as an opportunity to buy rental properties at a low interest rate, to what extent can those be offset? Well, yeah, that can certainly be a factor that if you can refinance a mortgage that would lower potentially the mortgage payments each month, which helps to reduce some of the pressure on how much you actually need to spend in that whole universe of real estate investing.

I mean, that could be another option for some people. It's probably not on everybody's the forefront of what they've been thinking about, but it's certainly an option for some. But probably it wouldn't offset it sufficiently in order to make up for the fact that people are getting much worse returns in their savings accounts, in their bond. yields in all of those types of investments? Yeah, monthly mortgage payments wouldn't necessarily come down that much. And right now as well, with rental properties, the concern about vacancy rates or the ability of the tenants to pay their rents and so forth has got to be another consideration

where in the past people who may have viewed real estate as a relatively reliable source of income, they may have to question those assumptions somewhat as well. How do people deal with market volatility at a time like this? To begin with, do you have any ideas on why is the market so high, given that we also concurrently have such high unemployment? Yeah, I think that is a mystery for a lot of people that now essentially U.S. markets that have gotten back to so that they don't have losses for the year. And it really is hard to fathom that it seems like just the future earnings potential of corporations is still lower. And so I don't have a good explanation for how we've seen this sort of stock market recovery

in a way that's really disconnected from the overall economy. It's a conundrum. The fact that it is such a conundrum, anecdotally, I've noticed, is leading many people to start making guesses about what the market might do in the future. I've heard more people make attempts at market timing than I've heard in the past. Is this a time for market timing or should that be avoided? I think that should always be avoided because just like no one could really have expected markets to recover like this, we just don't know what the markets are going to do in the future.

And time and time again, just having a consistent buy-and-hold strategy has tended to be a better long-term performer. I mean, the only issue where you might think about repositioning assets, it wouldn't be, if you're close to retirement or if you're thinking about retirement, it wouldn't be a market timing argument, but more if suddenly now you can lock in your gains and take risk off the table and not have to worry about market volatility anymore, it might be an opportunity to make changes for that reason, but not because you have some idea about whether markets are going to go up or go down in the future because really nobody knows what's going to happen in that regard.

How should people, and you sort of alluded to this in the last answer, how should people be rethinking their asset allocation? Well, they always want to think about the asset allocation that's appropriate for their level of tolerance to deal with market volatility. That's always going to be the first step. If you're more aggressive, then you really feel comfortable with, then you probably shouldn't be that aggressive in the first place. But asset allocation, it also relates to someone's risk capacity, just how vulnerable are you to the market volatility? And for people who don't really

have their lifestyle disrupted due to market downturns, they can afford to be more aggressive if they want. They don't have to be, but that's an option that's available. And so just trying to balance your capacity for risk and your tolerance for risk to think about the best overall asset allocation. If a person has entered 2020 realizing that either their risk tolerance or their risk capacity is not what they previously thought it was. And they, as a result of what's happened in 2020, realized that their asset allocation is out of whack with where it should be, is now the best time to reallocate or should they wait until there's more market stability? Well, because of the issue with market timing, it's always a good idea to just make sure you're reallocating.

And to the extent that taxes don't present a problem for this, but reallocating to the appropriate asset allocation for you. Now that markets have recovered and people may have an opportunity to do that reallocation without necessarily locking in losses, that would further speak to the point that you might go ahead and do that today. but I want to be careful not to suggest a market timing reason for doing that. It's just now people have been afforded the opportunity to potentially reallocate because they're reminded that there may not be as comfortable with volatility as they thought they were. And now markets recovering now's a chance to make sure you're in the right position. If a person is planning on retiring within the next one to three years,

how should they cope with what now seems to be some pretty scary sequence of returns risk? Right. And that's a key difference in retirement, that if you experience a market downturn early on and you're forced to take distributions from those assets, you lock in these losses. So even if markets then recover, your portfolio doesn't get to recover. And so a big part of retirement planning is having a strategy to manage that sequence of returns risk. Now, there's actually four ways to do it. I'm happy to... Yeah, let's go through them. Yeah, sure. So option one, it's spent conservatively. It's the logic of things like the

4% rule of thumb for retirement income. And that may not necessarily be conservative enough in this low interest rate environment, but the idea is, what are you comfortable with? How low does your spending need to go so that you don't feel worried you might outlive your assets in terms of either because you live a long time or because markets perform poorly? And so that's the starting point. And then we have other options. Spending flexibly is another option. And that's something that people might be naturally doing right now

is they're stuck inside their homes and so forth anyway. That if you can just cut your spending so that you don't have to sell as many assets to fund spending after a market downturn, that can go a long way towards managing sequence of returns risk and helping to preserve your assets. So just having that flexibility to make adjustments to spending, The third approach is to reduce volatility, but it doesn't mean going into bonds necessarily,

because, and especially with this low interest rate environment, bonds cannot support much spending power. If you want 30 years of inflation-adjusted spending, which is what the 4% rule assumes, well, we have tips in the U.S. Treasury inflation-protected securities. But with where interest rates are today, you're only going to be looking at about a 3% withdrawal rate to fund 30 years of inflation-adjusted spending. So that's why the kind of the classic Spend Conservative 4% rule approach actually calls for 50 to 75% stocks in retirement. So when we talk about reducing volatility, again, it doesn't mean going into bonds necessarily,

but this is like bucketing strategies, people who use bonds for short-term expenses and stocks for long-term expenses. That's an example. This would be also where things like annuities would fit in where a simple income annuity, the insurance company is basically investing in a bond portfolio, but you get to spend more than bonds alone because you have this mortality credit, those individuals in the risk pool that don't live as long help to subsidize payments to those who live longer, which can raise the spending level for everyone from a pot of assets. And then the fourth approach, it's called buffer assets. It's just something outside the portfolio not correlates. with the portfolio that can be a temporary resource to spend from after market downturns

to avoid selling portfolio assets at a loss. And there's three buffer assets. The original one was cash, but I'm not a big fan of that because it's like, well, if I carve cash out of my portfolio, then I have a cash buffer, but I would now have to use a higher withdrawal rate from what's left in the portfolio to meet a spending goal. And I'm not in any better position that way. But this is where the discussion around reverse mortgages or whole life insurance, cash value, both provide these resources that are protected from declining in value that, again, just can help build a bridge, a temporary spending resource to help get people through market downturns. And so those are the three types of buffer assets, reverse mortgages, life insurance policies, and cash? It's interesting for me to hear you say that of those three, cash was the one that you commented that you're not a fan of, given that among many people, the popular impression of both whole life policies and reverse mortgages seems to be their high fees, high expenses. They typically are not viewed as financially sound.

Yeah, there's definitely a perception of that out there. And it's true that they can be expensive. So the issue then becomes, well, how can they actually contribute to the policy. plan. It's really because the sequence of returns risk, it works in such fascinating ways in terms of how small changes can have such big positive or negative impacts on the portfolio. And with buffer assets, the idea is if I can avoid spending when my portfolio's in trouble, that can have a huge impact on the sustainability of my portfolio. Instead of ending up at depleting my portfolio, I could still have the full principle still intact.

I mean, it's just a small adjustment to the spending can create so much more benefit to the portfolio so that if that benefit is greater than the cost of the buffer asset, you have a better net outcome. The buffer asset, your legacy at the end is what's left in your portfolio, plus the value of the buffer asset, which would be either the home value or the death benefit of the life insurance, but then minus the cost of the loan balance created when you're borrowing from that asset. So the reverse mortgage loan balance or the loan balance on the life insurance from borrowing

cash value. And if that combination is bigger, you have a better outcome. And when I do simulations on this, that's generally what I find, that the benefits to the portfolio exceed the costs of using those buffer assets. And so you have a better net outcome at the end, potentially. more spending and or more legacy for that retirement plan when you use that buffer asset. It's just a more efficient way to position assets. Are either of those options, either the reverse mortgage or the whole life policy,

are those options that a person should go into preventatively, like to take that on when they know that they are approaching retirement in case the market goes down in their early years in year one or year two of retirement, is that the approach that a person should take, or should they retire? And only if sequence of returns risk becomes an issue, should they then start considering those options? Let me just comment briefly on the life insurance, because the answer is a bit different. And then I think that question applies more strongly to the reverse mortgage. With the life insurance, it can take 10 or 15 years to really start building up cash value. So it's not going to be a strategy that you necessarily wait until retirement to start thinking about.

I've looked at cases of simulating 35 to 50-year-olds, and that range tends to work fine. As you get older, there's also issues about whether you'll be insurable to still be able to get the coverage. So it might not work as well with life insurance to wait until retirement. But for a reverse mortgage, yeah, that's the idea. I mean, you have to be at least 62 years old to open the government home equity conversion mortgage, reverse mortgage program. And then, yeah, it's actually the case that by opening it sooner rather than later before you might need it, it has a growing line of credit that grows at the same rate the loan

balance would have been growing. And by opening it sooner and letting that line of credit grow, you have. have the potential to have much more access to funds later on when you may need it. And so waiting until you need it to actually open it, it tends to perform worse than opening it sooner and having it as a growing resource retirement. What about taking out a he lock against your home rather than doing a reverse mortgage? Yeah, so that was a common idea in the past. But the the problem with helots is they can be frozen and canceled. And they also require a quicker repayment.

And so one of the early researchers about reverse mortgages, it was Harold Avinsky and Sean Pfeiffer and John Salter at Texas Tech University. Well, Avinsky and Salter work, the famous financial advisors, and they had helox for all their clients in the financial crisis, and the 2008-2009 version. And they were all frozen and canceled. And so just at the time that people might want to access those, they weren't available. And that's what initially led them to look at a reverse mortgage as an alternative to a traditional HELOC.

And that's the big benefit of the reverse mortgage compared to the HELOC. It can't be frozen or canceled. It's going to actually be growing over time. And it doesn't require that ongoing repayment. People can always make voluntary repayments. but otherwise you don't have to make the repayment until the loan becomes due, which is when you've either left the home due to death or decided to move somewhere else or not meeting the homeowner obligations like paying property taxes or doing basic home maintenance.

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Because I think the part that I'm failing to really grasp is why either of those could be an improvement over the option of using cash as a buffer. Sure, sure. And let me just, to make the math simple, use a more extreme case. Okay. Okay, so I mean, just suppose you've got a million dollars saved up for your retirement, following the 4% rule. So you want to spend $40,000. That's 4% of the million. Now to create the cash buffer, I've got to carve some of that portfolio out and sit it on the side in cash. Now I just, this is where the extreme part, just to make the math simpler. Like, suppose I carve out half of the portfolio and put it in cash. So now I've got $500,000 left. I've got $500,000. $500.000. thousand dollars in cash. Now to spend my $40,000 from my portfolio, it's $40,000 of $500,000. I'm now at an 8% withdrawal rate. And when you just look at, well, I'm using the cash buffer will help. But when you went from 4% to 8%, that's going to have a big impact too. And basically,

the cash buffer is not really anything real at that point. It's just, I'm now using an 8% withdrawal rate from my portfolio, but I can skip some of the distributions because I'll draw that from cash, but it doesn't really change my overall financial picture other than how it may change my asset allocation. And in that regard, if I'm moving from other types of bonds to cash, I'm looking at the drags on my returns. And I just might actually, lead to a worse overall outcome because of the cash drag, the lack of performance there. But ignoring that aspect, if I had the same asset allocation either way, nothing fundamentally changed. If I had the $500,000 of cash in my portfolio, I'm now using a 4% withdrawal rate

with no buffer asset. If I carve the cash out, I'm now using an 8% withdrawal rate with a buffer asset. But at that point, nothing's changed. It's the same situation either way. Two thoughts occur to me right away. I suppose one is the option of using the situation of the $100,000 portfolio with an intended 4% withdrawal rate, the $40,000 a year cost of living. Would it be more prudent to either during times of market decline, adopt one of the other options that you had discussed, lowering your cost of living during times of market decline such that you would only need to withdraw, say, 3% or 2% or 2.5% during a market contraction in order to be able to maintain that 4%. Would that be a better option? Or the other option that comes to mind is rather than retiring with only $100,000 portfolio and no cash buffer, delaying retirement by, let's say, a year or two so that you would retire with that $100,000 portfolio plus a $100,000 emergency fund?

Yeah, I mean, to the first question, you know, some sort of combination of these approaches in practice is probably what people will do. And so a little bit of a reduction to spending, a little bit of maybe pulling some cash from the buffer so that you don't necessarily take the full amount of spending from the buffer, but you do create some relief. I think that sort of blended approach of drawing from each of those tools or strategies, probably it is the best way to approach things for sure. And then with, the second part of that question about delaying retirement, that's always the best way to get a retirement plan on track is to delay retirement when feasible and when people have just the ability

to do that because delay in retirement lets you do several things, save more, work longer, then have a shorter subsequent retirement. I mean, given the same lifespan, you've now got one more year of work, one less year of retirement. And then also just delaying social security as part of that as well and getting that higher social security benefit. All that together for somebody who's potentially off track with their retirement plan, and we just have to be clear, especially with what's going on right now, that they have the potential to continue working. That is far and away the best way to get a retirement plan back on track when it's possible. Right. And that does then lead to the question of the issue that many people are facing right now is

that we have 41 million people unemployed, lack of jobs. And many of the options that people had originally planned on using in order to reduce their cost of living are also no longer on the table. So, for example, many people in this community had thought about using geo-arbitrage to reduce their cost of living if necessary, telling themselves, you know, if I have to drastically reduce my cost of living, I will go live in Cambodia or Guatemala for. for six months, where the cost of living, given the dollar exchange rate is significantly lower, I'll do that for the first six months of my retirement. That will allow me to live on less. And due to the pandemic, due to the virus, that's now no longer an option. That introduces some planning complexities. Yeah, and it's always been the case that people tend to retire sooner than they thought they would. If they might have said, I'm going to retire at 66 and then

might end up retiring at 61. And it is a combination of either a health-related reason or the need to provide long-term care to another family member or job loss. And it's too early to know right now what impact that job loss will be, but that's certainly going to lead many more people to retire sooner than anticipated. With the expenses being cut, I don't know, this may not apply across the board, but I'm certainly finding my household spending needs have declined at the present just because you can't really do anything anyway. But yeah, if I like that term you used, the geo-arbitrage, if you can move or spend more time in an area that has a lower cost of living, that can help reduce expenditures without reducing the standard of living. To do that internationally

right now, of course, you just have to wait until that sort of travel is again safe and impossible. If a person wanted to try to make the decision as to whether it's best for them in their situation to use a cash buffer versus a reverse mortgage or a life insurance policy, what tools could they use? Are there spreadsheets or calculators that they can use in order to compare the outcomes of those three options? No, there's really not. Each of them has been explored separately. Actually, at the American College, I've got a PhD student now writing a dissertation on this topic. Like if you, well, how do the different buffer assets perform? And then if you had the option to choose from multiple buffer assets, which would be the best approach to take.

And that's all still research and progress. So maybe we'll have a better answer for that at some point in the future. But at this stage, they haven't really been explored in that sort of joint way. And I think the simple way, if you did have, say, the life insurance, and the reverse mortgage, you could just look at the terms of what would be the interest rate with borrowing from each of those assets and choosing the one that had a lower interest rate at a particular time would probably be an easy way to make that decision. On the topic of interest rates, let's go back to a previous conversation that we had about

bonds. We talked earlier about how some people, due to the 2020 pandemic, have realized that either their risk tolerance or their risk capacity is not aligned with their current asset allocation. Certainly there are many people in Gen Z who this is their first major market crash, and they're realizing their risk tolerance is not what they thought it was. And similarly, there are many people who are close to retirement who realize that their allocation doesn't reflect their timeline to withdrawal. In those cases, you know, we've talked about asset allocation, but given the fact that bonds are performing, so poorly and are relatively unattractive right now in this low interest rate environment. What are other ways that people can offset equity exposure and create that balance? In terms of just basic investment strategies, I don't think there are a lot of other options,

at least within the investing world. I don't personally have as much background or knowledge about things like real estate and so forth, I suppose those could be options, but just striking that stock bond mix, it's really the best way to view that. Just about like people realizing, yeah, those who went through their first big market downturn, well, your behavior also might help you understand your risk tolerance, because people who really were not at the right asset allocation might have panicked and sold their stocks in March. And so they don't have those stocks anymore. If you actually weathered the downturn and you still, you didn't sell any stocks,

you stayed the course with your strategy, that suggests you do have more risk tolerance because you actually behaved in the way that showed you were willing to commit to the strategy you chose. Now, if you stuck to the strategy, but you still, it's stressful for you and you think it's not the right asset allocation, again, I don't say this is market timing, but you've got this unique opportunity right now where you might be able to adjust to. a lower stock allocation without having to lock in losses because markets have recovered. And so I think that would be an appropriate action to take. But the fact that you weathered the

downturn and didn't panic and didn't lower your stock allocation by selling stocks goes a long way towards suggesting you might have more risk tolerance than you thought you did. You mentioned earlier tips. There's also Jenny Mays. To what extent should those play a role in smoothing out the volatility in a portfolio? Well, tips are the inflation-adjusted bond. They give you a real rate of return that right now is negative due to the low interest rates, but then plus whatever inflation ends up being.

So they're better locked to people's spending goals that if inflation ends up being low, tips would have a lower return. But that's okay because your spending needs wouldn't grow as much either. And if inflation ends up being high, Tips give you a higher return. And that's great because you need the higher return because your spending needs are growing

for a faster inflation rate as well. So they're really, they're hedged to what your spending needs will be much better than other types of bonds. So for people thinking about retirement, tips is a really good starting point. You're not getting any sort of premium from them in terms of like credit risk and so forth as you'd get with corporate bonds and that sort of thing. so you could diversify more broadly, but tips and also iBonds, which have the limits each year about how much you can put in based on each social security number.

They give that same sort of inflation adjusted return for 30 years, and they don't have interest rate risk, where if interest rates go up, you don't have to accept a loss if you decide to sell them. There's a bit of a lockup period where I think you have to wait at least a year, and then for the first five years, there's a penalty. But beyond five years, there's no sort of penalty and there's no sort of potential interest rate risk in terms of capital loss. Should interest rates be higher in the future? If a person wanted to build a cash buffer or a cash equivalent buffer, would tips and I bonds be appropriate places to hold a portion of that money?

Certainly, eye bonds, if set up in advance because of this issue, I was just saying about the, at least for the first five years, you're going to get a hair. but if you still have five years, and plus there's limits on how much you can put in each year. But if you have five years to start building that up, for a couple, after five years, you could have, if each person's making their full contribution, $100,000 of I bonds. And it could even be higher if you follow the strategy of also being able to put in up to $5,000 from a tax refund. But otherwise, it's $10,000 per year per Social Security number. So yeah, if you've got enough runway there, you could then treat that as the cash buffer, so to speak.

And it would be giving you a return similar to inflation. I'm not sure exactly where the rates are if you buy the I bonds today. But I don't know that they can be negative. It's probably just right around zero, then plus whatever inflation ends up being. So, yeah, that's going to yield more than cash. And it could be a good resource for that sort of buffer approach towards thinking about retirement. We've talked quite a bit about sequence of returns risk and about strategies for people who are close to retirement. Let's flip that conversation and go the other way.

If a person is still right now 20 to 30 years away from retirement or more, should they be changing their strategy at all? Should they be rethinking things at all? Or should all of this be simply background noise? Well, in large part, it's background noise, but it's also worth kind of thinking about the lesson for the future, which is for people who retired, say, January 2020, these kinds of situations can happen, and it's best not to have yourself too overly exposed towards what we saw disrupting your retirement in a significant way. And so it's not relevant today for people who are 20 or 30 years. years from retirement, and if anything, it can be that buying opportunity to buy at a discount, at least back in March and April. But otherwise, it's not going to impact their retirement plans and being 20 or 30 years away. On the investing side, the labor market side is another issue. But just, again, the reminder that markets are volatile. So eventually when you do get closer to

retirement, if it's appropriate to take some of that risk off the table, always be thinking ahead. and just not to get greedy in terms of if markets are growing faster than you expected and you're meeting your goals sooner than you expected, you may be vulnerable to what goes up can come back down. And so just instead of getting more and more aggressive or whatever the case may be, just thinking about locking in some of those gains and building more protected type of income around that when you're getting close to retirement. If a person is currently unemployed or underemployed, but they do have some income coming in,

should they right now continue to be contributing to their retirement accounts, or should they be building up an emergency fund or further fortifying an emergency fund? Yeah, I mean, that's a great question. And also, it may speak to if they have other types of high interest debt that they could also be paying down. If there isn't an employer match on the contributions to your retirement plan, that's very valuable and that's free money you'd be giving up to devoted to other resources. So I'd probably think hard about at least putting enough into the retirement account to get any sort of employer match.

But then beyond that, it is important to have an emergency fund. And what we've been seeing just highlights all the more that you don't want to hold that off for too long, you do need to also be thinking about building up an emergency fund. And so it could be appropriate to shift some of your, what would have been contributions to a retirement plan into some other type of an emergency fund as well. Do you have any recommendations for the ideal size of emergency fund? No, I mean, it really does vary from person to person as a starting point if you could have either like three to six months of how much you spend or of your salary, that would be a great starting point.

But beyond that, I think it really just does depend on personal circumstances and what types of exposures you have about large unexpected expenses or reductions in income and so forth. Do individual stocks have any role in a retirement portfolio? I mean, they can. I personally just tend to go. for the broader market indices, but for people who like investing in individual stocks, there's no issue with that. You do just want to make sure you've got some diversification.

So your whole retirement isn't requiring one or two stocks to do well. But if you've got 20 or 30 different individual stocks, and they're not all in the same sector or industry, that should help to give you a level of diversification that is moving you in the right direction. towards like a total market portfolio. With regard to the aggregate total of your individual stocks as a percentage of your overall portfolio, is there any type of limit that you think is prudent? Well, if you're diversified enough, you could have all your stock holdings in individual

stocks. So then beyond that, I don't think there's any sort of rule. I mean, I personally don't own any individual stocks. I'm all in market indexed approaches. But for people who like that, it's just, I said 20 to 30, probably you want to lean closer to 30 to have enough diversification so that you're, it's this idea that there's market risk and the market portfolio gives you the exposure to the market risk. But with individual stocks, not only do they have exposure to what's happening in the market,

but they also have, it's called idiosyncratic risk. It's just a risk to the individual company, that an individual company can go out of business and its stock price can drop to zero. and so you need to diversify so that you have that diversification for the idiosyncratic risk. And as you hold more and more stocks, your risk levels are shifting towards like the overall market portfolio. And then that's what the like a total market index fund, you have a piece of every stock. And so your risk, you don't longer have that sort of individual company risk. You just have the market risk, which is going to be a lower overall level of risk.

than having a couple individual stocks. How should a person, if a person has the opportunity to have restricted stock units, you know, stocks from their own company, how should they think about the portion of their portfolio that they would want tied up in that, the amount of money that they would want tied up in that? I mean, that's an important question too. And the answer about diversification is you generally don't want to hold a whole lot of your own employer stock. Now, you might have incentives to get it, and so overall you might decide to have that. But it just, you don't have as much diversification because if something happens to your company,

you've got a lot of exposure to that already in terms of potential job loss. If it's a big company, potential impacts on the local real estate market, so potential impacts on your home value. And then as well, looking at losses in your investment portfolio. So you may like to diversify. away from your own company stock. You can either do that just by not holding it or you can't hold it, but then you could also look at some like financial derivative strategies

where you offset some of the risk that if there is a downturn for your company stock, you have financial derivatives that would help to offset that. It could be another approach to help for people who may feel they're too concentrated into one individual company stock. We'll come back to this episode in just a minute. But first, you voiced your support of at least some annuities. Can you talk a bit about if annuities should play a role in a person's retirement planning and if so how? How should a person approach this and make a decision about what is right for them? Yeah. So the basic punchline is when you shift from like investment management, wealth accumulation over to retirement distribution. the efficient frontier for your allocations shift from having a stock bond portfolio to a stock annuity portfolio. That just to the extent possible, bonds are the least efficient way to fund a retirement

spending goal over an unknown length of time. Annuities behave much like bonds, but also give you that additional mortality credit on top of it. So again, it's just mathematically speaking, instead of stocks and bonds, it's stocks and annuities. And then the way to approach that, there are many different types of annuities. The best one for any individual case could vary, but the starting point is the simple type of income annuity where you do annuitize the contract. You pay a single premium to get a guaranteed lifetime income. With that, you lose the liquidity and you lose the growth potential for those assets. So what we've seen develop since the 1990s are different types of

deferred annuities that don't annuitize the contracts, but that add some living benefit to them, that can effectively give you that guaranteed lifetime income, whether it's through a variable annuity or through a fixed index annuity. These are all options on the table that people can explore to just look at what option is going to give me the most downside, in the downside, the most protected lifetime income, and then for the annuities that may also offer the liquidity and upside exposure, if it has a lower downside guarantee, is that a trade-off you find acceptable in terms of upside exposure versus the downside guarantee? And then at that point, any of those different types of annuities could play a role in a retirement income plan. What about the fees and

expenses associated with annuities? Different types of annuities have different types of expense structures. The simple income annuity generally is going to be, well, it's a spread product, so you don't see any quoted fees. It looks like the fee is zero, but it's an internal fee that you don't see, and it's generally going to be low. The fixed index annuity is also a fixed annuity, so it works in that same manner as a spread product. And by what that, I mean, it's just like you could have a no-fee checking account, but the way the bank maintains its business is they're able to earn more on your funds than they pay you out in interest. same idea for any sort of fixed annuity as well, where the high fees tend to come into play,

that's generally a complaint about variable annuities, that they can have high fees between the fund expenses and the sub-accounts that you own, the mortality and expense charges, the potential for surrender charges in the early years of the contract. And then if you add that living benefit to have lifetime income protections, that's an optional benefit that would also include an additional charge. And that could, in some cases, raise your total charges up into the neighborhood of three or four percent a year. And so that's where we usually hear about this idea that annuities are expensive. But the way I would approach that, there's two basic considerations there. The first is, I don't think the fee drag matters as much as just how much assets do you need to

support your retirement goal. Like if I want to spend X number of dollars a year, how much would I need in an investment portfolio to feel comfortable I can meet that goal, and how much would it take an annuity to meet that goal? And you quickly get to the point where for people who are worried about outliving their money and are going to try to rely on the stock market as a way to fund their retirement, the quote-unquote safe withdrawal rate from their investments, because they're worried they might live a long time, they might get poor market returns, that's going to drop below the payout rate on the annuity, which then just means you can meet that spending goal with less assets. And then at that point, it doesn't really matter what the fee drag is.

The simple income annuity, we don't describe this way, but you could say in a way, it's like a hundred percent fee drag in year one because you lose the liquidity for those assets. Well, having a three and a half or a four percent fee drag, yeah, then you can accept the idea. You're probably going to spend down that asset. But the point of it is not necessarily to give you that asset, it's to meet that lifetime spending goal in the face of longevity, risk, and in the face of market volatility. And it could potentially meet that goal with a lower overall amount of assets. The other point there, too, is just asset allocation, that if people do worry about the stock market, but if having that income protection in place makes you feel more comfortable investing a little

bit more aggressively with your assets, then that additional exposure to the risk premium from the stock market could potentially offset some of the fee drags so that your overall, like, the cost to your legacy may not be as big as you're thinking. So that's how I would think about the fee issue. And again, there's many types of annuities, but it's the fee issue is usually talking specifically about a variable annuity. And that is a good point that the increased equity exposure that you are able to create, could create gains that offset some of the, some of those fees elsewhere. Right. Like if you would have been, say, 30% stocks without any annuity, but you get the variable annuity and you decide to go like 60, 40 inside the variable annuity, if markets do well

in your retirement, that additional exposure to the stock market, you might be better off overall, net of fees. If markets do poorly, you're going to deplete the variable annuity, and you'll probably deplete it a couple of years sooner because of the fee drag as well as the higher stock allocation. But the point is, it then provides that lifetime income after it's depleted versus an unprotected investment portfolio. It might last a couple of years longer since it didn't have that fee drag. But once that asset depletes, it's game over. You don't have any more spending power from that asset. And so then really across the range of potential outcomes, that's where you can not necessarily be made worse off, even with the fee drag, because the lifetime income and the

equity exposure offsets that fee drag. One of the themes that I am hearing from you, in terms of the conversation around annuities as well as our earlier conversation about reverse mortgages and whole life insurance policies, the bigger picture idea that seems to link these is to think or worry less about the fees and more about the amount of assets that you need in order to meet the spending requirements that you have for your retirement. Would you say that that's a fair characterization? Yeah, yeah, I think so. And it's really retirement involves new risks that we don't necessarily think as much about pre-retirement. It's this longevity risk, and that's just this idea. I don't know

how long my money needs to last, so I'm worried about spending it, because what if I live to 100? And then it's the sequence of returns risk that becomes a bigger issue when you're spending from your assets and retirements, where a market downturn can have a permanent impact on a retiree, even if the overall market recovered for the overall economy. So market volatility has a bigger impact as well. And that's really the starting point for this discussion about why these tools that generally don't have as positive a view in the conventional wisdom, whether it's annuities, life insurance, reverse mortgages, and so forth, why they actually can have a role to play for retirement planning, because they can provide a more effective way to manage those risks.

And by doing so, allows people to retire with less assets than they would otherwise feel they need if they're going to approach that just with an investment portfolio. And that's almost another way of saying that in order. to manage your retirement through an investment portfolio alone, the benefit is that you would save on fees, but the drawback is that you may need a higher balance of assets in order to be able to do that. Right. So like the 4% rule shows the logic. And I'm concerned the 4% rules too high to date because of the lower interest rate environment and people are living longer. But it shows the logic of the investment approach. It's based on the worst case 30-year period of market returns in the

U.S. since 1926. And it's assuming that a couple is going to have somebody live to age 95, so from 65 to 95. So it's saying, well, how conservative does my spending need to go so that I can endure this worst 30-year period of market returns in history and make sure the money lasts for 30 years? So I'm concerned it's not low enough, but it's the idea. It's you have to be extra conservative. And that means you have to use a lower withdrawal rate than could otherwise be possible. If you approach managing those risks differently, either by pooling those risks or through like the buffer asset concept and so forth, to just have a broader approach to how you think about managing retirement income risk.

Great. Well, thank you for spending this time with us. Is there anything else that you'd like to emphasize or any final points that you want to leave this community with? Yeah, I mean, just always, especially when I talk about like the early retirement community, I think the 4% rule is never meant to apply to the early retirement community because it was, it was thinking a 65 year old couple living in 95. It's based on 30 years. So if you're, say, 30 years old, the 4% rule is based on you living to 60 and you're probably going to live a whole lot

longer than that. So just make sure you are entering into retirement with flexibility about being able to make adjustments and don't ever just rely on something like the 4% rule. Take a broader, more complete approach to all that. What are some examples of that type of flexibility? Would that be part-time work? Would that be geo-arbitrage in non-pandemic conditions? Right. So being able to adjust expenses and geo-arbitrage could play a role in that. that, being able to pick up some part-time work as necessary so that you're not spending, that's another way to not spend from your assets if you could just cover it from employment income. So having some flexibility in that regard as well as on the spending side. I think those

are the two basic ideas. Great. Well, thank you so much. Where can people find you if they would like to learn more about you and your work? Sure. My website is Retirementresearcher.com. And if you visit it, there's a pop-up. You can just sign up. We send out an email every Saturday morning with links to various articles. And I do have a few books on Amazon. If you'd like to read more about any of this, the investment-based strategies or what I call a safety-first approach, which is about thinking, using annuities and life insurance alongside

investments and also just reverse mortgages. All these books are on Amazon if you do a search there. Thank you, Dr. Fow. What are some of the key takeaways? that we got from today's conversation. Here are four. Number one, always avoid timing the market. Now, on the surface, that sounds like a duh.

We've all heard, don't time the market. But in the moment, it can be very tempting to do so. When we see the market going up or going down, we want to buy on the dip, we want to sell to lock in our holdings. The market's high right now, but we're afraid it might go down again. It can be very tempting to start making guesses about what may happen in the future and adjust our actions accordingly. But that is the very definition of market timing.

And as many of our guests have recently echoed, and as Dr. Wade also corroborates, timing the market has no place in your retirement plan or your investment plan. I think that should always be avoided because just like no one could really have expected markets to recover like this, we just don't know what the markets are going to do in the future. And time and time again, just having a consistent buy-and-hold strategy has tended to be. be a better long-term performer. Hindsight is 2020. So while you may want to mentally kick yourself for missing out on that huge dip back in March or April, there was no way for any of us to know what would happen. There was no way back in March of 2020 for people to know what would happen in July

or August. And similarly, there's no way for us right now to have any clue about what's going to happen in December or in January of 2021. Like, you know, hindsight is 2020. I know there's the obvious pun in the way that that relates to this year. 2020 has certainly been a year full of hindsight. Like, I can't believe that Tiger King was the most normal part of this year. But the other joke that I often make is that hindsight is also 50-50, meaning any outcome can look obvious in hindsight when we can cherry-pick reasons why the thing that happened in the past, of course, would have happened.

But if something different had happened in the past, we could easily, with the benefit of hindsight, feel as though that was equally obvious. So hindsight is 50-50. If someone says, oh, yeah, I could have anticipated that. Well, yeah, you could have anticipated anything. And it is for those reasons that you shouldn't get carried away with listening to predictions or with making predictions yourself. Dr. Faust says that if you're thinking about retiring soon, you can reposition your assets to lock in gains and take some risk off the table and not worry about market volatility. But if you did this, you wouldn't be timing the market. You you would simply be reallocating your portfolio based on your own timeline to withdrawal.

In other words, you're making those choices not because of what you think the market may do, but because of what you think you yourself will do. If you think that you yourself will retire in the next year, then you adjust your allocation accordingly. But you do so based on your own lifestyle factors, not based on anticipation of broad macroeconomic events that are out. outside of your control. And so that is key takeaway number one. Don't time the market. Key takeaway number two. Your behavior can indicate whether or not to reallocate assets.

Now, this relates to the last thing I said, but it goes beyond simply your timeline to withdrawal. Dr. Fow notes that paying attention to your behavior, your emotional or psychological reaction to certain events, can give you clues on how to approach asset allocation. People who really were not at the right asset allocation might have panicked and sold their stocks in March. And so they don't have those stocks anymore. If you actually weathered the downturn and you still, you didn't sell any stocks, you stayed the course with your strategy. That suggests you do have more risk tolerance because you actually behaved in the way that showed you were willing to commit to the strategy you chose. Dr. Fow also mentioned that if you weathered the storm, but you felt stressed

to the entire time, now that the market's recovered, this could be a good time to think about reallocating to ensure that you're in the right position for the next downturn. And again, this is not because of market timing. It's because of what the downturn revealed about your own risk tolerance. So it's worth taking some time to reflect on how you felt during these last few months. Were you checking your accounts every day? Did you sell off a portion of your portfolio? or were you completely on autopilot without a care in the world? In the future, it could be worth keeping track of your feelings about your portfolio and about your investments and about your money in general. Keep a journal, keep a log, keep track, even if it's something as simple as bullet pointing,

one or two or three emotions per day that relate to your money. Keep track of how you feel so that you can then adjust your asset allocation based on actual data, not data about the markets, data about your behavior and your money. emotional state because ultimately for the average individual investor, your behavior will be, for better or for worse, one of the biggest determinants of your portfolio success. And so that is key takeaway number two. Key takeaway number three, have a strategy to manage sequence of returns risk. Now, as you may recall, sequence of returns risk is a reference to the risk that in the early years of your retirement, your returns will decline, forcing you to withdraw during a downturn at the beginning of a multi-decade retirement.

And drawing down from a beat-up portfolio at the start of your retirement has huge implications for the amount of compounding growth, compounding gains, that you might be able to achieve over the next 30 or 40 years of your retirement. And so, we need to have a strategy to manage this specific risk, the sequence of returns risk. Now, what do we mean by have a strategy? Dr. Fowt offers four options. Option one, it's spend conservatively. Ask yourself, what are you comfortable with? How low does your spending need to go for you to avoid worrying about whether or not you will outlive your assets?

How conservatively can you spend? That's option one. Option two. Spending flexibly is another option, and that's something that people might be naturally doing right now is they're stuck inside. their homes and so forth. Do you have a bare-bones worst-case spending plan for times like this, when you need to hunker down on your withdrawals? So that's the second option. Let's take a look at option number three. The third approach is to reduce volatility, but it doesn't mean going into bonds necessarily. As Dr. Fow says, bonds can't support much spending power. Tips and eye bonds may be

alternatives to consider, or you can use bonds for short-term expenses and stocks for long-term. term expenses, according to the bucket strategy. He says you could also consider a simple income annuity. And to learn more about annuities, check out episode 137. You can access that at afford anything.com slash episode 137, or we will also link to it in the show notes. So that's the third approach, reduce volatility. And finally, let's hear the fourth approach. The fourth approach, it's called buffer assets.

It's just something outside the portfolio not correlated with the portfolio that can be a temporary resource to spend from after market downturns to avoid selling portfolio assets at a loss. The fourth approach is to use buffer assets, and Dr. Fow names three types of buffer assets, cash, a reverse mortgage, and whole life insurance. Now, admittedly, this is one recommendation that many of you may understandably have a strong knee-jerk reaction to, as do I. I am not a fan of reverse mortgages. I am not a fan of whole life insurance. If I were to build any type of buffer asset, it would absolutely be cash. But Dr. Fowell mentions that his research has pointed to bonds being the least efficient way to fund a retirement spending goal. His research finds that annuities are more efficient, and he argues that the fees can be offset in different ways, such as becoming more aggressive in the stock market.

And that the fewer assets you need in your retirement plan, the better. fees in his world are not the end-all be-all of a strategy. They are simply one of many variables to consider. So I throw that out there because that is what is happening right now in the world of retirement income research. And Dr. Fow is a preeminent retirement researcher. So is this discussion about reverse mortgages completely disrupting my confirmation bias? Yeah, of course. But that's all the more reason to make myself hear it, particularly when it comes from such an esteemed source. And so to zoom out, those are four strategies that he talks about with regard to managing sequence of returns risk. Again, to go over the four strategies.

Option one is to spend conservatively. Option two is to spend flexibly. Option three is to reduce volatility, although that does not necessarily mean going into bonds. And option four is to create buffer assets. Those four options can all help you manage sequence of returns risk. And that is the third key takeaway. Finally, the fourth and final key takeaway is to be flexible to the greatest extent possible. Flexibility is one of the keys to making your retirement successful.

If you can be flexible on when you retire or where you retire or even how you retire, such as perhaps picking up some part-time work if you have the health and ability to be able to do so, this can help you in a major way. Again, flexibility on when, where, and how. how you retire. Can be a saving grace, as J.L. Collins says, flexibility is the only true security. So spend some time thinking about this. Does your retirement plan include some slack? Is there room for error? If not, you may want to think about what you'd be willing to temporarily cut back on in order to reduce your spending and therefore your withdrawal rate. Or you could think about

ways that you might generate income in retirement in a way that complements your interests or hobbies. So consider what you might gain from delaying retirement by a year or by two years. And I don't mean to get caught up in just one more year syndrome. But particularly if the market is down at a time in which you want to retire, run the scenario through a simulator. What would be the effect of adjusting either the when or the where or the how or some combination of those? Being able to adjust expenses and geo-arbitrage could play a role in that, being able to pick up some part time work as necessary so that you're not spending, that's another way to not spend from your assets if you could just cover it from employment income. So having some flexibility in that

regard as well as on the spending side. I think those are the two basic ideas. Remain flexible. That is the fourth and final key takeaway from this conversation with Dr. Wade Fow. If you enjoyed today's episode and you want to chat about it with other people in the Afford Anything community, head to Afford Anything.com. slash community. We have a thriving community there of people who talk about everything ranging from retirement planning to debt payoff to tips from working from home. And this is cool. So there is a group within our afford anything.com slash community that's starting a 30 day plank challenge. It's a health accountability group that we have. 30 day blank challenge. If you want to take part in that,

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