011: Rethinking Reverse Mortgages and Building Better Portfolios with Dr. Wade Pfau *
Dr. Wade Pfau, CFA, the Retirement Researcher, has made his career diving deep into the world of academic retirement research to find practical applications and strategies to help retirees and financial planners alike. He’s the Professor of Retirement Income at The American College and the Director of Retirement Research for McLean Asset Management and inStream Solutions.
In addition to the Retirement Researcher blog and publishing in many academic and practitioner journals, he is also a monthly columnist for Advisor Perspectives, a RetireMentor for Market Watch, a Wall Street Journal Expert Panelist, and a contributor to Forbes.
He is also the author of Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement and How Much Can I Spend in Retirement?: A Guide to Investment-Based Retirement Income Strategies. Though Dr. Pfau is an academic, his books aren’t unapproachable: they’re easy to read, engaging, and full of useful advice.
Today, Dr. Pfau joins the podcast to talk about the research that led to Reverse Mortgages, the key differences between investing before and after retirement, and how to build a more holistic portfolio designed to sustain your lifestyle, even in the face of a market downturn.
In this podcast interview, you’ll learn:
- How planning for retirement is like climbing a mountain – and why the descent is often the real challenge.
- The reason market volatility is riskiest in the first years of retirement.
- What makes investing before and after retirement so different – and why you may need a different kind of financial advisor after you retire.
- Why modern portfolio theory doesn’t take retirement or the individual into account – and what Dr. Pfau is doing about it.
- How to find an unbiased financial advisor who blends multiple schools of thought.
- Why Dr. Pfau developed inStream and what it offers financial planners.
- The basics of reverse mortgages – and the reasons a reverse mortgage can be an appealing buffer asset.
“We often think the goal of climbing a mountain is to get to the top. But that’s not the whole story. You have to make it back down the mountain as well.” – Dr. Wade Pfau
Investment Advisory Services may be offered through Howard Bailey Securities, LLC, a registered investment advisor. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements. The CLU® mark is the property of The American College, which reserves sole rights to its use, and is used by permission. Howard Bailey Financial is a registered trademark of Howard Bailey Financial. All rights reserved. Howard Bailey does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Not associated with or endorsed by the Social Security Administration or any other government agency.
Casey: Today's guest is Dr. Wade Pfau. Wade is a Professor of Retirement Income at the American College of Financial Services holding a Doctorate in Economics from Princeton University and is a chartered financial analyst. He is a co-editor of the Journal of Personal Finance, founder of the Retirement Researcher Blog, Forbes contributor, and expert panelist for the Wall Street Journal. He has authored two books titled How Much Can I Spend in Retirement? and Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement, both of which we will discuss today. We will have a wide-ranging discussion beginning with challenges facing retirees transitioning into retirement, why you shouldn't count on returns of 8% per year in retirement, and my favorite part as Dr. Pfau illustrates the different schools of thought when it comes to planning for retirement income, the investment versus insurance world, at odds for decades, but finally coming together to build more secure retirement strategies for today's retirees.
We will wrap up our conversation with discussions of reverse mortgages. I was very intrigued by Wade's research into these tools that have garnered such negative publicity over the last decade. You may be surprised by the applications, some of which I had never even thought of. We have molded our retirement income strategies after much of the research he has conducted over the years. So, I hope you're as thrilled as I am to engage in a discussion with the master of retirement income himself, Dr. Wade Pfau.
Casey: Welcome to Retire With Purpose Podcast. This is your host, Casey Weade, and joining me, Dr. Wade Pfau of the American College among many other things as I just reviewed with you and, doctor, welcome to the show.
Dr. Wade: Thanks. Yeah. Thanks for having me on the air.
Casey: Well, it's something I’ve looked forward to for a long time. Ever since I went through your Retirement Income Certified Professional, RICP, course at the American College, I have always looked forward to an opportunity to have a discussion regarding a lot of the topics that are at the top of my mind and really the way that we structured our planning for the families we work with day in and day out. Yeah. I'm going not try not to be too selfish here and make sure that we get the focus a lot on your new books and that is going to be a good topic of discussion here, as we spend a little bit of time talking about your book, How Much Can I Spend In Retirement? And then later in the show I really want to spend some time getting into Reverse Mortgages which have a bit of a bad name in the financial world and I want to dig into that and see what you have to say about it.
But first, I would really like to talk about retirement income planning and one of the analogies that you used in the book, you had a great chart that talked a little bit about mountain climbing and then so the dissent. So, you had this mountain climbing analogy for retirement. Can you expound on that a little bit?
Dr. Wade: Yeah. That’s a common way to think about retirement. It’s like when you're climbing a mountain, we often think the goal of mountain climbing is to get to the top and the reality is that’s not the whole story. You have to basically make it back down the mountain as well and for mountain climbing, getting down the mountain can be more dangerous than getting up the mountain. People are more tired and it’s easier to slip going downhill and so forth. And so, this analogy really works for retirement because with retirement, kind of the traditional mindset is we get to the top of the mountain, we meet some sort of wealth accumulation target, whatever that may be. If I save $1 million, I can retire, and something like that, but that's not the whole story. It’s not just meeting a wealth goal that you can now retire. You have to actually get down the mountain which means you have to sustain your lifestyle for no matter how long you live, not knowing how long you're going to live, not knowing what's going to be happening in the financial market and so forth. But you have to be able to sustain your lifestyle in the face of all that. And the risks of retirement are different than the pre-retirement risk. It can be more difficult to get down the mountain so to speak too to sustain a lifestyle in retirement than it is climbing the mountain saving for retirement.
Casey: So, would you say that it is easier to get to retirement through those accumulation years than it is to actually make that transition into retirement?
Dr. Wade: Yeah. That’s the idea that a technical concept is pre-retirement people have more risk capacity, which just means they really have more flexibility to manage risk than they do post-retirement. Pre-retirement, you’re working, you’re saving a percentage of your salary for retirement but you’re living off of your earnings and if something goes wrong in the market and so forth, you can adjust your plan, save a little more, work a little longer, just generally have more flexibility but postretirement now you're no longer working to the expense that it’s hard to go back to work. You don't have that flexibility anymore. You can’t use your earnings to get over a market downturn. You have to now sustain your lifestyle in the face of the market volatility and the nature of risk changes, that’s kind of on the market side there’s this idea of sequence of return to it, the idea that it's not just the average market return that’s going to impact your retirement, but the order that those returns come.
And if you get poor market returns in early retirement and you have to continue to take your distributions from your portfolio to fund your retirement, you may have to sell more shares or spend an increasing percentage of your declining balance and that can really dig a hole that becomes difficult to get out of. And so, that’s how market risk does changes in retirement. You’re more vulnerable to what happened in the early years of retirement. There’s less opportunities for the ups and downs in the market to average out and you become more susceptible to having permanent damage done by a market downturn in the early retirement years.
Casey: Sure. I often share with people that during those accumulation years, those ups and downs in the market present opportunity. We can’t dollar-cost averaging then when we start taking distributions, the opposite’s true. Now, we begin to participate in something called reverse dollar-cost averaging and actually violating the worst, the number one rule of investment, versus the buy low and sell high, and we can easily end up doing the rest, the opposite. But it's not just I think I know your focus is in common, how do we structure the most reliable income strategy for retirement that has been a large focus of your research but for a lot of people making this transition, now there's so much more to think about other than just do I have enough to make - will this last for the rest my life? Now, I have to take in consideration inflation. I have to think about taxes. I have to think about Medicare. I have to think about long-term care. All these health care expenses, liquidity, all these things can come ahead, and now we have to make some really important decisions. And I'm wondering from your perspective and interacting with all the other financial advisors that you’ve talked to over the years and you've trained over the years, do you think that there is a reason for some to seek a different type of advisor when they make that transition from accumulation to distribution?
Dr. Wade: Well, yes, certainly there’s different types of advisors out there and there’s a lot of advisors who are really just investment managers and they help you build hopefully diversified multi-asset class Investment portfolio. But the issue and this is our retirement income really has evolved that the distinct part of financial planning is because of the sequence of returns risk and because of the changing risk in retirement, the investing approach is pre-retirement for accumulating wealth. It really may not work best for postretirement, for managing and spending in retirement, and that’s where having an advisor who understands the differences in retirement and doesn't just apply the same investing approach postretirement as preretirement becomes important that the goals are different. You're not accumulating a nest egg. You’re managing distributions and trying to sustain that nest egg for the remainder of your life. It's really a different problem than traditional investment managers are used to solving. I mean, even going back in history that most of the investment theory based around Harry Markowitz’s Modern Portfolio Theory that he developed in the 1950s and he won a Nobel Prize for that in 1990, and after winning the Nobel Prize he was asked to write about how does Modern Portfolio Theory apply to households. He said he never really thought about it before. And after a thought about it for anything, he recognized it was never meant to apply to households and there’s this disconnect. It was for institutional investors. And the key idea is it was an asset-only model. It was just how do you choose an asset allocation to try to grow and accumulate wealth?
The household problem postretirement is not growing well. It’s meeting their expense goals, how do you sustain a standard of living? How do you meet your expenses? And that's not the problem that Modern Portfolio Theory was seeking to solve even though that's what all investment managers use. Modern Portfolio Theory, it’s a more simplified case. It’s just how do you manage wealth as though your need to spend from it. There’s no need. You don't have to take any distribution. You’re just managing wealth. But the post-retirement problem…
Casey: The primary goal being to accumulate wealth rather than manage the risks that come with distribution, in your book you mentioned that modern portfolios misapplied today and that basic model of stocks and bonds if we created a diversified portfolio then we should be able to create less risk than overall market and enough return. Saying that in your book, it made me think maybe this is the reason you set out to create retirement income certified professional designation. Was this one of your primary drivers for creating this school? I mean, the last thing we need is one more designation. What made you think that we needed another designation like this?
Dr. Wade: Well, yeah. I mean, just to be clear, I joined the American College after they'd already created the plan to fulfill the designation but, yeah, it absolutely does fill that hole with. Nothing in the general type of financial planning designations out there really dealt with postretirement that you have in like the CFP designation, which is really one of the main financial planning designations. There’s a whole unit on retirement planning but it's for the most part pre-retirement planning. It's about learning about different kind of qualified retirement plans, Roth IRAs, IRAs, 401(k)s, that sort of thing really didn't get into the issue of how do you manage that postretirement and there were still this major gap there and that’s where the RICP is. They came in and thought to help fill that gap of what’s really focused on what you do when you get to retirement and not just pre-retirement planning and saving for retirement and neglecting how things change when to transition from saving to taking those distributions.
Casey: Well, I found the course information be very valuable and being both the CFP practitioner as well as a RICP, I did find there's a tremendous amount of information in there that was not presented in the CFP program and I find that the certified financial planners are kind of seen as we’re kind of put on this pedestal as that is the person that I want managing my finances and that might be true but if we’re making this transition to retirement, they may need another level of education such as this, right?
Dr. Wade: Right. I think that’s really the idea that there is a lot more to retirement and that’s really just been in the last 10 years that this has come into focus and people always thought about retirement income.
Casey: Why is that?
Dr. Wade: Well, so there’s always a divide within the financial services world between the investment side and the insurance side and on the investment side, I guess, does people really hadn’t made that, had that awareness that we can talk more about how this all developed. Like, in 1994 Bill Bengen published what's known as the 4% rule that really guided the investing world and how to approach retirement spending. And that was really the first-time financial planning was introduced to this idea of sequence of returns that we talked about already. In 1994 before that article and that article I don't think was widely read until a few years after until the end of the 1990s. The idea of sequence of returns risk and how the amount you can spend in retirement might be less than what you would think based on the average market returns over that retirement period. So, no one had really conceptualized or explains that and that people are still using more simplified methods. They were saying things like, "Well, the stock market on average earns 7% after inflation so 7% should be a safe withdrawal rate with 100% stock portfolio. Every year my portfolio grows 7%. I can take 7% out, never even dip into my principal and unfortunately, that's not how things work and it really does take a long time for that concept to work its way into the investing world.
Casey: Well, one of the things you said in your book, you were quoted as saying, "Dismiss any retirement projection based on 8% to 12% returns.” So, that sounds like something you’re following right now. Why would someone dismiss someone that’s sharing with them historical returns of 8% to 12%? I mean, we know that the stock market has averaged somewhere in that range depending on the timeframe or especially over the long term. Why would we dismiss an 8% retirement return projection?
Dr. Wade: Well, yeah, there's a lot of issues that go into that and in the first, well, a lot of places, I mean, with 12% is the S&P 500 average 12% since 1926 but that's just a simple average. It’s not the growth rate of a dollar. The growth rate of a dollar would have been more like 10%, not after inflation, but before accounting for inflation. And so, if you're wanting to go with a number like that, then that assumes you’re going to be 100% stocks. That also assumes, it's really just – it works on average. So, if you're trying to build a financial plan and assumes it will work 50% of the time, but if you're comfortable with a plan that would only work 50% of the time, then maybe you can justify using that average but you'll also have to think about, well, with interest rates being lower, if stocks don’t suddenly outperform bonds by more than they have historically then the stock returns have to be lower as well. There's a lot of issues around will stocks be able to outperform bonds by as much as they have in the past?
And if you have those sorts of concerns, that’s another reason to think about lowering your assumptions about stock returns. But if you just simply wanted to start with saying something like stocks will earn 8% on average, I would be okay with that but you’re probably, again, you're not going to be 100% stock portfolio in retirement so that’s not going to be your portfolio’s average return. And if you want to have more than a 50% chance that your plan would work, you have to take an additional haircut off of that as well too to account for the higher probability of expense that you're looking for with the plan. A lot of issues in inflation so you got to account for if your spending needs to grow with inflation, you should be thinking about returns with inflation taken out which historically in 2% or 3%, the last two to account for that inflation aspect as well.
Casey: Now, in your opinion, do you believe that inflation has the same effect on retiree spending as it does for someone that might be in their accumulation years? Do they need to account for the same inflation rate? Will they feel inflation the same from 60 to 90 as someone will from 30 to 60?
Dr. Wade: So, yeah, that's an interesting question. Now, pre-retirement to the extent that you're working, often people’s salaries tend to keep pace with inflation so they do have more of that inflation protection in terms of just their earnings will keep pace. Postretirement, you have to make sure your asset can keep pace with inflation as that higher spending will grow and so that's where things like putting your money in a savings account or CDs, that sort of thing, those types of assets won't necessarily keep pace with inflation. Now, then there's the issue of is your spending going to grow with inflation or not and that can vary from person to person that the basic assumptions behind things like the 4% rule that you’re spending all these growths of inflation but there’s plenty of evidence that the average retiree spending does not go with inflation. It’s just simply there is this concept of you have the go-go years like 65 to 75, the slow-go years, 75 to 85, and then the no-go years after age 85 where you're just naturally spending less. You’re not going at to restaurants, you're not traveling as much, and in most every category except for healthcare expenses, your spending declines and then the healthcare is the big unknown where it just depends how much your health care cost grow with age and if you have health problems or not and that sort of thing about what happens with your overall spending levels.
Casey: Well, I think David Blanchett of Morningstar did some really interesting research around retiree spending patterns and how we may be overestimating the inflation rate and in turn overestimating the amount we need to have safe retirement or the amount of risk, but I think more importantly, that we need to take during retirement years because we have overestimated that inflation rate.
Dr. Wade: Yeah. I think kind of one of the baseline projections he does says if you're thinking about something like the 4% rule where your spending is always going with inflation, with a real, the average spending pattern he looked at, you could have retired with about 17% less in assets than you needed to have inflation-adjusted spending throughout retirement. He had the retirement spending smile where your spending declines until late in retirement where it comes back up due to healthcare expenses and it did allow you for being able to retire with less onsets than if you were following an assumption that your spending always work with inflation.
Casey: Yeah. And 17% is quite a dramatic amount for the average person.
Dr. Wade: Oh yeah. Absolutely, if retired two years earlier in that case.
Casey: When you talk about these two different schools of thought, the safety-first approach and then the probability approach to retirement income planning and so it seems like the whole financial planning world, the whole retirement planning world has kind of been separated for the most part into these two main camps and I would say it seems like the probability focus groups focused a lot more on your inflation rate and have ignored this research about retirement spending smile and how retirement spending changes over time and say, "Well, we’re just going to imply a 3% or a 4% inflation rate and this is why we need to take on this much risk.”
Dr. Wade: Yeah, I mean really both when it comes to the inflation question, all this study like the David Blanchette retirement spending smile, going back on that, it’s all based on the average person. So, of course, there’s a lot of differences in the population and there certainly are going to be some people who spending will keep pace with inflation. And so, I think when you look at the different approaches towards building retirement plans, it is a more conservative assumption to it than spending that grows with inflation. And, yeah, I think, generally speaking, the common approaches, that just inflate your expenses throughout retirement, 2% a year or 3% a year or something like that. And in an absence of a better way to approach the problem, it may be the best people have really to use. Probably the most sophisticated study in this area was one of the big things had their client data for people to have credit cards and banking accounts with them and they were really able to look carefully at expenditure patterns over time in classified retirees in a different category. They’re the globetrotters I think represented about 5% to 10% of retirees that travel was a much bigger expense for them but they were the ones who are really to be assuming they’re spending will grow with inflation.
But then there were others. There were like the homebodies who tend to stay at home more. Their biggest expense is just maintenance and upkeep of their home, that sort of thing, that they could really probably be pretty comfortable assuming their spending will not keep pace with inflation and it may be easier to - we may be able to fine tune better people’s spending patterns to some extent and I think increasingly we’ll get more research along those lines but, yeah, until then, people just have to kind of think about what does their budget look like, how might their budget change, and which of those expenses will grow with inflation which may sort of naturally tend to trend down or not have to keep pace with inflation to get a better assumption about that.
Casey: Well, we’ve kind of touched on this safety first versus probability approach a couple of times and I'm sure there's people listening going, “I thought everybody kind of had the same information, the same basic laws about retirement planning. What are these two different camps that you refer to? So, can you just explain a little bit about what you see as a safety-first approach and what you see as a probability approach? What's the difference?
Dr. Wade: Yeah. So, they’re really two very different approaches and to make it even simpler, the probability-based approach is much more investment-centric. It’s using an investment portfolio, the total return type of investing approach, the multiple asset classes that you can also have things like having different retirement buckets in there too but the really focusing retirement on an investment portfolio not seen much need for things like insurance at the – there’s one marketing I forgot. The “I hate annuities and so should you” that’s said.
Casey: I’ve heard that.
Dr. Wade: This belief that an investment portfolio can manage everything in retirement. And then on the other side, it’s more of an insurance approach. It’s using risk pooling, the power of income guarantees and insurance with annuities, life insurance, that sort of thing and using that as more of a building base for. If you have a certain amount of expenses per year say $80,000 or whatever the case may be, we’ll first look at things like Social Security which is a guaranteed lifetime income, if you have any other pension, that sort of thing. And then if there’s still a gap, rather than trying to manage your whole retirement through these distributions from an investment portfolio look at using income guarantees at an annuity of lifetime income protection to help manage the longevity risk of not knowing how long you're going to live and help manage that sequence of returns risk, where having to take distributions from a declining portfolio balance becomes increasingly risky in retirement so basing that more on insurance as the first building block. And then increasingly today and I hope this is where the RICP is helping as well is really you need both sides. You need insurance to need investment and you’re increasingly finding advisors and people thinking about retirement who are comfortable talking about both and integrating both into an overall plan to help better manage the longevity with the sequence of returns risk and the need for liquidity to help manage different spending shock over a long retirement.
Casey: Well, you mentioned the bad world of the investment world. You mentioned annuity and I’m sure there are some people that are cringing. They may have just put their nails in the steering wheels driving down the road when they heard that word and you're an academic. You're not in a sales position. You're not trying to sell a product or an investment tool. You’re just sitting there doing the research and you found these tools to have their place or have a use. Where do they have their use? I mean, one of the things that you mentioned in your book as you said, there is no single solution that can cover every risk, though some financial products have been touted as such. And initially, I would think that you might say annuities have been touted as that perfect silver bullet to solve all of your retirement needs but at the same time, you might also say that about an investment portfolio has been touted as the one silver bullet to solve all of your retirement problems at the same time. What can you say about annuities in general, good or bad?
Dr. Wade: Yeah. So, at a very basic level that an annuity offers payments for life and so when you look, well, building a retirement plan trying to meet your budget, trying to meet your spending goal over your lifetime, there’s really just three ways to think about that. You could use just bonds. If you’re worried about market risk and so forth, you could use bonds and have a very low volatility, low-risk type bond portfolio. That’s not going to allow you to spend very much and we can figure out exactly how much you can spend by looking at what interest rates are with TIP, treasury inflation-protected securities. If you want inflation-adjusted spending for a 30-year retirement, you’re looking at a number less than a 4% spending rate. So, if you want to spend more than bonds, this is where the two schools of thought come into play. You can go with a more aggressive investment portfolio and you may have to be looking at 50% to 75% stocks throughout your retirement. That's really been the investment answer to the retirement problem, getting the stock market to outperform the bond market and allow you to spend more or you can look at insurance and annuities as a way to also spend more than bonds.
Because with bonds, you’re going to run out of money at some point and with the annuity, you get an additional source of spending power that bonds don’t provide and that’s called risk pooling or mortality credit. Those who don't live as long, don't have to spend as much in retirement. But some of their premiums will help to subsidize the payments to those who do live longer and that can allow everyone to spend more than they would otherwise be comfortable spending with bonds because they know that if they do end up living a long time, they'll receive the subsidy from the risk pool and they’ll be able to support that higher spending model. They don't have to be worried about making sure their money lasts to 95 or 100 because if they live that long, they have the power of the lifetime income really helping to extend their retirement. And then those become the two ways to spend more than bonds, stocks or annuities with income guarantees and it just becomes a matter of how do you structure that altogether. You don't want to use all one or all the other but you might look at using some annuity to help fill in some of the gaps in the budget, especially for expenses that you really don’t want to take a lot of market risk to make sure you can't sustain that lifestyle for retirement.
Casey: Well, and you said in your book, understand which schools that they most identify with referring to the advisor and to what extent their own thinking might incorporate views from each school and ultimately, it sounds like you recognize that there are these two schools of thought. But my question would be why are there these two exclusive schools of thought where you turn on the radio and you've got one advisor saying annuities are the worst thing you could possibly do with your life savings. You’ve got another one that’s saying annuities are the best thing that you can do with your life savings. How did we get here? And how do we find that person that can blend those two schools of thought in an unbiased way?
Dr. Wade: Yeah. I mean, that's a question of how we got here. Part of it just feels with like how different types of advisors are compensated and some of the issues with if you’re an investment manager, anytime you recommend an annuity you're taking away assets that you can manage and therefore reducing the fees and charge. But then on the annuity side, they’re often sold as commissioned product, where the advisor you see the commission for selling the annuity and so you can say there's a bias there. Of course, they want to recommend the thing that will give them a commission but there’s really a bias on both sides of that. And then how we got here it’s probably just partly too how people were trained within the investment world there is the idea of stocks for the long run, the idea that if you hold on to stocks for a long enough period of time, they shall outperform bonds and that historically, of course, has always been true is when you're taking distributions from the portfolio, your time horizon gets effectively shortened and that for that sequence of returns with is able to amplify that investment volatility. And I think it’s just taking a long time for people to really incorporate that concept into their thinking about investments.
And then on the insurance side too, it’s just people may not be licensed to sell the other like if you can sell annuities, you may not be able to manage investments. I mean, legally you’re not allowed to so you don't really see the rules for investments but it is both. It’s having the income guarantee being able to more cheaply and efficiently meet your spending goal with a smaller asset base because that you are using with going there as well which then frees up more of the remaining assets that can be invested and can be invested more aggressively because you don't have to worry about where your next monthly bills are going to be paid from. You got that covered through the insurance side of the portfolio and bringing those two aspects together. It’s advisors that who are just licensed on one side that I think increasingly recognizing the value of both and you are finding more advisors today who are more comfortable looking at both the insurance and the investments to build a more holistic.
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Casey: Well, in your book on how much can I spend in retirement, you had brought up that the safety-first approach comes from a more academic foundation. What do you mean by that?
Dr. Wade: So, going back to the 1920s and then into the 1959 there were two articles published that really the foundations for the safety-first approach it’s basically the academic approach, but it's always been written about in such a mathematical way using calculus equations that no one really knew what they were talking about it. It’s like one of the articles that really gave us the safety-first approach that’s called something like the dynamic general equilibrium framework, and it’s just not easily – it doesn’t roll off the tongue. So, you had all this safety first discussion going on written mathematically and it didn't really penetrate into the public mindset until just more recently in the last 5 to 10 years where people like Prof. Zvi Bodie at Boston University, Laurence Kotlikoff also at Boston University, at York University, they’re all academics who have writing in a way that's more readable for the general public about the safety first approach, but that these ideas are now really starting to penetrate more into the public mindset than when it was just written up in academic articles using calculus. That’s what I meant about it’s an academic approach.
Casey: Okay. Is this part of the reason this whole discussion about probability versus safety first? We utilize your inStream program that you worked in developing and I'm curious what got you involved in developing another financial planning software? Did you see a gap that you found in other types of financial planning software? Because there's plenty of them out there, why should one use say inStream versus one of the other options?
Dr. Wade: Well, yeah, that’s again so much of the mindset was on accumulation. There wasn't really a lot on the retirement side so my involvement with inStream was really coming in on the retirement side to build in. Research that have been done post-late-1990s into the software. None of the other software had any of that, things like the distribution management rules of how do you adjust your pending in response to portfolio performance. There’s been a lot of research for financial planners in the Journal of Financial Planning and that sort of thing. Jonathan Guyton’s decision rules and the foreign ceiling rules, everything else that wasn't in any of the financial planning software. So, that was one of the first big areas where we tried to just, well, we should add, we should update the software so that it's more relevant that covers what's been analyzed and discussed since the late 1990s. And then even more recently in the last couple of years, we've done a lot more to also show annuities in the financial plan as well and to be able to compare a plan with and without the annuity and see how that impacts things like probability of success with magnitude of failure of what can go wrong if things do go wrong and at different metrics, how much legacy and spending power over time compared between the two different plans.
Casey: Well, and I think overall it seems like most software leans one way or another to try to push you into a certain type of investor product that that company wants you to be in ultimately and there are pros and cons to each. Whether we want to go probability only approach or safety-first approach or blend the two and utilizing some software that can really show you the hard numbers can be extremely helpful for families that we’re working with. And as I could probably sit here and talk about retirement income planning for another two hours but I know there's other things that we want to get to today, but I will leave us with this one quote which was, "The objective of investing in retirement is not to maximize risk-adjusted returns but to first ensure that basics will be covered in any market environment and then to invest the rest for additional upside.” Before we move on, I've got to hear you expound on that just a little.
Dr. Wade: Yeah. That's really kind of a statement about the safety-first approach that your goal in retirement is not just you’re either beating the benchmark or getting the most returns. Of course, there’s this idea that if you have more wealth, you should be able to spend more in retirement. There’s certainly a relationship between having more assets than being able to spend more, but it's not a perfect relationship and there's all kind of things going on. Just every day as interest rates are fluctuating, that means the cost of retirement is fluctuating or how much you can sustainably spend is fluctuating. And the goal of retirement is really just trying to make sure you can support your lifestyle and meeting your spending goals, meeting any legacy goals, and anything else that you have that your financial goal is being able to meet those, and that means thinking in a broader perspective than just trying to maximize your investment portfolio because there’s so much more going on when you're trying to fund expenses than when you're just trying to manage that asset-only type of pre-retirement mind selling. You’re just trying to manage an investment portfolio without considering the expenses that you want to use that portfolio to fund.
Casey: Well, I think that's a perfect transition into your other book, The Retirement Researchers Guide to Reverse Mortgages and I saw this on your website and I said, “Boy, I can't wait to read that book,” because you actually showed how reverse mortgages can help to improve the probability of success as utilized as retirement income strategy. And when I first I just spoke to another financial advisor saying, “I'm really excited to talk to Dr. Pfau about reverse mortgages,” and he said, "Oh, stay away from that,” and I had another one of the advisors in our office who he said, “I’d never recommend a reverse mortgage.” And I kind of came from that same school of thought because I think no matter what it is, if it’s annuities, if it’s a stock market, if it’s the bond market that's reverse mortgages, we all end up with these biases that we have in our head regarding, well, so-and-so said it was bad or read an article in Forbes that said it was bad. Kiplinger's, Wall Street Journal said it was bad.
My neighbor said it was the worst thing he ever could’ve ever done with his finances, and I thought, “Boy, wouldn't it be great to have an impartial or an unbiased bit of research that we could read and how we could actually utilize these things in our lives?” because I like to approach all the different options that are out there in an unbiased way. It’s sometimes very difficult to do so, but you are able to do it and I found it extremely eye-opening and I never would've said I would recommend reverse mortgage until I got done reading this book and now I can see where it could come in to play. What was your inspiration for picking this topic of all topics that are out there and writing all the research you put into it?
Dr. Wade: Yeah. So, I mean, yeah, I did kind of get a lot of tomatoes thrown at me talking about like annuities versus mortgages that sort of thing. But it all comes down to just the retirement problem is managing the sequence of returns with and the 4% rule investment approach is just telling you, well, you got to spend less and how low does the spending have to go to make sure you don't run out of money? But this is where having other tools can really help that plan. And so, I am with you on the reverse mortgages. I didn't really think much of them. Didn't really see the role they could play. I was invited to a meeting about reverse mortgages about three years back, sent me a stack of articles to read, and I said, “Wow. This is actually a really interesting tool to help manage that sequence of returns with. And that’s what first got me going in that area with Funding Longevity Taskforce that I became part of. It’s just a group of planners and researchers who look at reverse mortgages and then I just started writing about them. It was really originally meant to be a chapter in a broader book about retirement income but at some point, I realized the chapter is getting so long that it’s becoming a book of its own.
Casey: Yeah. We ended up 155 pages.
Dr. Wade: Yeah. Right.
Casey: I got to that. When I first opened up, I said, “Oh, this is going to take forever,” and I got into it and I read it in just a few days and leisurely. I really was able to get through it. I think most people would find that it's relatively easy to read where most research articles written by doctors are kind of difficult for the average person to read. People could pick this up and actually understand what's going on. So first, can you just share with us what the basics are of reverse mortgage. What is a reverse mortgage?
Dr. Wade: Well, so reverse mortgage is the ability to spend your home equity that you paid off your mortgage. You’ve got this home and maybe a significant asset and that's where a lot of American’s homes might be the biggest asset they have. And in the sort of traditional conventional wisdom is where you don't think about a reverse mortgage. You save it as a last resort. If my retirement fails, if I run out of any other option, if I depleted all my investment assets then I might consider a reverse mortgage and it really turns out with all the research that’s been done going back to basically since 2012 there's been a number of articles in the Journal of Financial Planning that were just looking at was there a better way to think about using a reverse mortgage? So, it’s a program and more than 90% of reverse mortgages are part of this home equity conversion mortgage program that the federal government first set up in 1989. The law might've been passed a little bit sooner and federally, it’s guaranteed to allow borrowers with the reverse mortgage to spend on their home equity and it builds a loan balance and that loan balance grows then the individual always keep the title to their home, but once they leave the home either there are certain eligibility requirements. You have to live in the home, you have to maintain it, be it property taxes. So, if the person passes away or if they otherwise move, then that's what makes the loan balance become due and the heirs can either sell the home to pay out the loan balance or if the loan balance defeated the value of the home, it’s called the nonrecourse loan where you can just essentially hand over the keys to the home and not have to bother with selling it.
But if the loan balance is smaller, you wouldn’t want to do that or if the family still wants to keep the home, they could look into a traditional mortgage to then refinance the reverse mortgage. There’s a number of different options there, but it delays having to pay back the loan balance until the end of retirement or until you've otherwise moved out of the home. And that can be a really powerful tool to manage the funds of returns with where you have, it’s a buffer asset. You have this asset outside the investment portfolio, the line of credit on your reverse mortgage that you can draw from as needed to help cover retirement expenses to help protect the portfolio, especially after a market downturn. Rather than selling portfolio assets at a loss, you might temporarily draw from the reverse mortgage line of credit and that can really help provide a way to preserve the portfolio. The line of credit growth throughout retirement is one of the more interesting aspects of the reverse mortgage that really caught the attention of researchers that you have this growing line of credit that we can talk more about why that is.
It’s a little bit more of a technical issue, but it's really the driving force that makes a reverse mortgage such an interesting and powerful tool to help manage a number of different risks in retirement depending. There’s a number of different ways they can be used. The research mostly was to help coordinate spending with an investment portfolio but it can be used to refinance the traditional mortgage and to take that fixed expense of mortgage payment out of their early retirement years, helping to reduce sequence risk because you’re lowering your spending need. It can just be a set up as a growing line of credit to help cover contingencies like helping healthcare bills, long-term care, in-home care expenses, that sort of thing and a lot of interesting other ways too like helping to delay Social Security benefits or as an alternative to an annuity, you can have something called the tenure payment which is a monthly payment necessarily for life but at least as long as you stay in the home and meet your homeowner obligation. So, a number of different ways that it can fit into a retirement plan and it’s a way to just bring liquidity to the home to allow you to use it in a more efficient way than just preserving the home at the last resort option if everything else goes wrong in retirement.
Casey: Well. I think that was one of the most eye-opening things for me inside the book was to find all these really cool ways that you could use for mortgages that just get the engine started. I think that's why a lot of people need to get going is to just get that retirement thought engine started so they can start thinking about things in more constructive ways. Rather than just criticizing and thinking negatively about these types of strategies, why don’t we just explore them and see if there might be a use for them sometime in our life for some reason that maybe we never thought about before, just keeping our mind open? But I know that’s very hard because you're driving down the road, you hear risk, reverse mortgage, and you go, “Oh, I think I’m going to listen to another podcast.” And so, I’m going to ask you how have reverse mortgages evolved over time? And it sounds like there's been some major changes that maybe have made them more attractive today than they used to be. Are fees lower? Are there things have changed that make you say, "Okay. Now, this is a more valuable tool than it used to be?”
Dr. Wade: Yes. So, it’s been administered by the federal government in every seems like every three or four years. They make major adjustments to the program, always working to help improve it. So, now there are things like non-borrowing spouse protection. That was an issue in the past that to be a borrower you had to be older than 62 so let’s say one spouse was under 62, they couldn’t be a borrower. And then if the older passed away or something like that, then the loan balance became due and that could be a problem if you still had a surviving spouse wanting to stay in the home. So, that was one of the changes in 2015 that now an eligible non-borrowing spouse is protected so that they can also stay in the home. And there’s just been a number of different improvements in that regard. There was a big change that went into effect in October of 2017 that increased the initial insurance cost so it has raised the cost somewhat compared to - that was though the cost had become really low before that and so prior to October 2017 you had even the $125 reverse mortgage where basically people had to pay for the required counseling session, but the lender would credit every other cost. That’s no longer possible to do because of the rising mortgage insurance premium to set up the reverse mortgage but…
Casey: Well, let’s talk about some of these problems with reverse mortgages. I know in your book you had about three pages just addressing one by one the bad reputation of reverse mortgages. So, let's talk to some of those things. I know I’ve heard in the past, well, if I get a reverse mortgage I’ll lose my home, I’ll lose my title of the home or no it's extremely expensive to set up. It’s going to cost a lot over time. I’m never going to leave a legacy behind my heirs. Talk to some of these that you might see and I think the biggest one for most is it's expensive for me to lose my home.
Dr. Wade: Yeah. So, the issue about losing the title of the home, that was just simply never true. That's always been an enduring miss of the home equity conversion mortgage program, but again that’s a federal government administered that more than 90% of reverse mortgages and it’s what I'm talking about. There are proprietary jumbo reverse mortgages but they’re a small part of the market. They never lose…
Casey: That’s over $600,000 home or mortgages.
Dr. Wade: Yeah. Right. Where if you have the federal program only covers up to the first $679,650 of the home’s value. So, if you have a much more expensive home or you have a mortgage that exceeds the borrowing capacity from that number, then you might look at one of those proprietary jumbo reverse mortgages but with a home equity conversion mortgage program, you never lose the title of the home. And then with cost, people can have a sticker shock. Now, a lot of that was going away prior to October 2017. It can be back. It can potentially cost up to $20,000 now to set up a reverse mortgage today.
Casey: And that's relative to the size the mortgage, correct?
Dr. Wade: And that would be, yeah, for a more expensive home getting closer to that 679, 650 number. So, that's where in like I had to redo my book after those little changes. There’s now a second edition that’s fully updated and I assume like the retail sticker like the retail pricing that you have to pay the full cost of setting up the reverse mortgage so that is part of the analysis and it still shows that the benefit can outweigh those costs but definitely there is that sticker shock that it can be expensive to set up and that's something that we’re again we’re seeing now this year primarily because the insurance premium. Today it’s 2% of the home value after that $679,650 and for that by itself, well, $500,000 home, 2% of that and you're looking at $10,000 there for the mortgage insurance and that’s the thing that can really drive us the cost of setting up the reverse mortgage.
Casey: So, would that be a good reason for someone to potentially look into doing a home equity line of credit versus doing a reverse mortgage or a HECM?
Dr. Wade: Well, the traditional home equity line of credit is another option but interestingly, that what really had triggered one of the early research teams for publishing about reverse mortgages. Well, first, you had Barry Sacks who’s rather, and then you had the group of professors and advisors at Texas Tech University including Harold Evensky, one of the leading kinds of thought leaders in the world of financial planning. With the financial crisis in 2008, they had set up traditional home equity lines of credit for their clients thinking that this could be a nice pool to dip into if there’s an issue and those were all frozen or canceled after the financial crisis and that led them to look for alternatives and so that’s one of the first big differences between the reverse mortgage and the traditional home equity line of credit.
Reverse mortgage can’t be frozen or canceled. It’s contractually protected to be there and that's part of what the mortgage insurance premium that you’re paying. It’s to make sure you have access to those funds. They’re not frozen or canceled as one big event. It can also it grows. It grows just like the loan balance would be growing, but if you don't have a loan balance, that you're keeping it mostly as a line of credit, you have this line of credit that's growing like the loan balance would have been growing and so you have this increasing value over time that you can tap into. And then just without traditional home equity line of credit, you still have the repayment provision, but you have to make those fixed repayments over time. The reverse mortgage gives you more of that flexibility to delay making any repayment. You can, of course, think voluntary repayments, but you're not required to make that repayment until you otherwise left the home or were not maintaining the home with property taxes and that sort of thing.
Casey: Well, I thought that was one of the more interesting parts of the discussion for me was that I can open up, just like I can open up a home equity line of credit when I first stepped into retirement so that you always have the ability to pull some funds out of the home equity. If I want, one of the really neat strategies you mentioned was using those dollars to do a Roth conversion. That was a big light bulb for me and how we can now use these dollars. If we don't have any other places we could go for cash or to pay the taxes on the Roth conversion, especially after new tax law that recently went through, I can tap the home equity in my house. That was a really neat discussion but I guess most people and even myself thought about a reverse mortgage as a place where we get an income stream, now, we basically get a mortgage payment back to us for the rest of our lives. We could get that tenure payment and we don't necessarily think of being able to open it up, not draw on it, and let it grow over time, and that was one of the things you covered in your books.
Dr. Wade: Yeah. That’s where most of the research has been really interested in that growing line of credit aspect. That's something that has been weakened a little bit in the October 2017 rule change that they slowed down the growth rate of the line of credit, but it still works. That’s not as powerful as it used to be, but it still works. But I would say what really – and in practice, most people were like 60% of people getting a reverse mortgage are using it to refinance their traditional mortgage and in a lot of cases, that's actually been strengthened by the new rules because the line of credit grows more slowly but that’s because any loan balance grows more slowly now. There’s a smaller ongoing mortgage insurance premium under the new rules. So, if you’re refinancing a traditional mortgage into a reverse mortgage, your loan balance will grow more slowly and so that's beneficial and that's one of the major changes we see now where when I had to redo the book, I changed my focus from that portfolio coordination with the growing line of credit being kind of the marquee way to use the reverse mortgage to refinancing a traditional mortgage as being the marquee because it's what’s used most commonly in practice and because it in a lot of cases may have even been strengthened by the new rules rather than hurt by the new rules.
Casey: So,, am I hearing you correctly, that you now see the best use of a reverse mortgage would be to pay off an existing mortgage?
Dr. Wade: Well, if you have an existing mortgage then, yeah, that that can be a very powerful way to help manage sequence of returns with. If you have paid off your mortgage and obviously you don’t need this as a use. So, the growing line of credit that we are talking about where you can just draw strategically over time. And it still works. It's not as powerful as it was pre-October 2017, but it still works and it can still help sustain a retirement for longer than otherwise.
Casey: Do you feel that I know you talked a little bit in your book about the use of a tenure, or the reverse mortgage with a lifetime payment being more powerful than utilizing an annuity, do you feel the same or some of these rules changed that?
Dr. Wade: No. That conclusion is still pretty much the same. With the tenure payment, you always have to have that caveat that it's not necessarily for a lifetime. If you live in a home until you die, then it was a lifetime payment but if you decide to move before the end of life, even to like a nursing home, then your tenure payment but not before a lifetime. But with that caveat aside, it does behave a lot like a lifetime income annuity. You receive this monthly income for as long and like with the caveat and but it works differently because you're not having to pay that annuity premium. You're not having to take the big premium out of your investment portfolio to fund that lifetime. It’s just every month as you receive your payment, that's when it’s added to your loan balance so it accumulates. The loan balance grows over time with each monthly payment and it accrues as you receive those payments. You're not having to pay it up front all at once. And it also has the protection that even if those monthly payments would exceed the line of credit, you’re still protected to receive those for life, for as long as you are eligible for the loan. So, it can be a very powerful alternative to getting a monthly income to help managing that sequence risk without having to actually annuitize part of the portfolio with an annuity.
Casey: Also, from a tax perspective, most of the families we work with have the majority, if not all, their life savings tied up in traditional IRAs or 401(k)s that have never been taxed and if they want to draw $40,000 a year, they may have to draw 5.5% a year to net $40,000. They might have to take $55,000 and net 40 out of their IRAs where they could take just the 40 out of their mortgage.
Dr. Wade: Right. Anything you take out at the reverse mortgage that’s proceeds from a loan and that's not taxable income. So, right, absolutely.
Casey: So many neat ways that we could use reverse mortgages. I think the key is to understand and one of the things you mentioned in your book is to really shop around for the best price because price does vary quite dramatically from one provider to the next or one banking institution to the next. And I hope that our listeners got a little bit out of that discussion when it comes to just opening our minds to the possibility of other tools that we might be able to use in our overall retirement planning strategies. It's not just about stocks. There’s a lot of other tools out there that you might want to think about utilizing or at least understanding, especially as life goes on. Life changes, the market evolves, and your own life evolves, why not try some of these different tools? So, thanks for that discussion. I just want to wrap up with a couple of generic questions. I know you started The Retirement Researcher and if you want to check out Dr. Pfau, you can go to RetirementResearcher.com. I'm on there on a regular basis doing my little retirement research and you can, of course, pick up either of Dr. Pfau’s books, The Retirement Researcher's Guide To Reverse Mortgages or How Much Can I Spend In Retirement? And I understand you're working on a third book, right?
Dr. Wade: I am. Yeah. The third book, so the book we’ve been talking about, the first chapter is an overview of retirement and that’s a lot of the safety-first discussion is there but the next book I'm working on will be about the safety-first school of thought, how much can I spend in retirement, but really, it’s focused on the probability-based school of thought. So, hopefully, by next spring, that third book will be out.
Casey: Great. Well, I’ll be keeping an eye out for that and I’ll be digging in as soon as it's released. Now, if I can ask you one question, I ask almost everyone that I have the opportunity to interview or meet for that matter that are thinking about retirement and you are thinking about retirement nearly every day. You’re a long ways from it but you’re thinking about retirement regularly and studying it more than probably 99.9% of people that are out there. So, my question to you is this. What does retirement mean to you?
Dr. Wade: Yeah. I'm interested in that. There’s a financial independence retire early community out there and that’s really how I've been thinking about it or as getting financial independence not necessarily eager to stop doing all the work because I enjoy a lot of what I do but being able to call the shots so to speak of, well, if I don't feel like going to someplace or doing something and not feeling any particular obligation to do it just pick and choose more what you work on as something that you can do once you have financial independence and then just being able to travel and to spend more time with the kids and that sort of thing. That’s for the most part, how I've been thinking about retirement at this point.
Casey: Well, that’s financial freedom and it’s most people are thinking about retirement as this day off in time at 62, 65 and when I get there, life will be great. However, I’ve talked to more and more people. I had a coach of mine that had this discussion initially with me several years ago that the sooner you reach that financial independence date, the more you're going to live your life the way that you really want to. You can really follow your dreams out as a previous guest of mine, Kary Oberbruner, discussed. It’s all about getting to that financial independence and then it's not about not doing anything. It's about using our God-given talents to the best of our ability and kind of breaking out of that jail that some call the daily grind.
Dr. Wade: Right. Being able to fulfill your time.
Casey: My last question for you is what is something you would like to see as absurd 25 years from now?
Dr. Wade: That's a good question. I spent 10 years living in Japan and it seemed like they had streamlined the tax systems and the healthcare systems so much more there and so there’s so much absurdities with the way our tax and healthcare systems are structured that it’d be nice to simplify a lot more and to not having to do this complicated 10-40 with all these different schedules and everything. It’d be nice to someday that was much more absurd that why did we ever waste so many resources having everyone have to do these complicated things when it could’ve just been automated and done at a much more simple basis.
Casey: Well, that’s going to eliminate a lot of the research that you’re spending your time on a daily basis, so hopefully that happens once you’ve reached that level of financial independence.
Dr. Wade: Right.
Casey: Well, Dr. Pfau, thank you so much for joining us here in Retire With Purpose. I've enjoyed our time and I hope that we get to spend more time in the future digging in this some specific strategies that we use for families day in and day out here at our daily financial. Thank you and we’ll catch you next time.
Dr. Wade: All right. Thank you.