On this special episode of Morningstar's The Long View, we are featuring “The State of Retirement Income” panel live from the 2022 Morningstar Investment Conference. Morningstar’s Jeff Ptak sits down with three leaders in retirement research: Christine Benz, Morningstar’s director of personal finance and retirement planning, David Blanchett, managing director and head of retirement research for PGIM DC Solutions, and Karsten Jeske, the founder of Early Retirement Now.
Here are a few excerpts on portfolio construction, withdrawal rates, and sequence of returns from our panelists:
Ptak: David, wanted to turn to you for the next one, which is a tough one. Bonds have gotten whacked recently, and that probably has been a rude awakening for retirees who’ve come to depend on income streams and also the diversification benefits, I should say, that they confer from it. What, if anything, do you think that they should do in the face of the selloff in fixed income? Stay the course?
Blanchett: I think staying the course is key, I think that thinking about alternative investments or other ways to diversify portfolio. But I don’t think that bonds are dead. I think they play an important role in portfolio, and it’s kind of foolish this notion that the 60/40 is no longer a valid portfolio because it really has stood the test of time, not just in the US historically, but also across the international markets.
Ptak: And, Karsten, I take it that you concur as well when it comes to something like the traditional US 60/40 portfolio or even a global 60/40. You think that will stand the test of time? Or do you think people should be considering modifications to it?
Jeske: I’m tempted to do a little bit of what Cliff Asness said yesterday. You almost have no choice but to raise your risk a little bit, so maybe the new 60/40 has now become 70/30. That could be one option. The other option is, of course, now that bond yields are again at least 3%, if we have a slowdown, probably they have some room to go down. They could be a diversifier again. And so, it’s don’t run now, don’t sell at the bottom of the bond market because now it actually looks like bonds can have this diversification feature again.
Ptak: David, you alluded to some research that Christine and I and a colleague of ours, John Rekenthaler, had done on sustainable withdrawal rates. We did come up with less than 5%, in fact, less than 4%. It was 3.3%. But to your point, we were focused on that pot of money as if it was going to sustain the retiree throughout retirement. So that is a very useful distinction to draw. Christine, I wanted to turn to you for a minute and maybe widen out. You talk to retirees on a very regular basis. What are the biggest mistakes you see people make in setting their withdrawal rate and do you think they more often overspend or underspend?
Benz: Well, I think it depends on the cohort and it depends on the time period. But research from Vanguard and others have shown that in fact, underspending is, I think, a significant issue with many retirees, especially as we’ve had this steady march upward in terms of equity prices. We have many retirees who probably quite underspend relative to what they could spend, and that may be a choice. They may have a strong bequest motive that is motivating them to spend less, but I think that when we look at the data over the past decade, and I would guess that it’s true of many of the advisors’ clients, that tendency to underspend is a bigger deal and a bigger problem. I sometimes will meet an 80-plus-year-old retiree who will come up and proudly tell me that he spends 3% of his portfolio per year. So, he’s just taking out that fixed percentage of that portfolio and I’m thinking holy cow. I hope that your quality of life is good at that level, because to me that sounds way too small of a percentage, especially at that life stage.
Ptak: Maybe turning to the psychology of withdrawing. What do you think are some of the most useful tools retirees can use to manage through the psychology of withdrawing? I’m sure that one of the things that will come to mind, Christine, because you’ve done so much work on it, is bucketing. Maybe you can talk about why it is you think bucketing has the merit that it has?
Benz: I was initially introduced to bucketing, talking to Harold Evensky, probably 12 almost 15 years ago. And Harold was a financial planner, he’s largely retired now. He was a professor of financial planning. And he mentioned this bucket approach that he used with his clients, which was basically a cash bucket that he bolted onto the long-term portfolio that he was managing for them. And his comment to me was that it just gave his clients an extraordinary amount of peace of mind with the long-term plan. So, he would call them up in environments like right now and say “How are you feeling? Your portfolios dropped quite a bit. Are you still comfortable with this?” And they’d say “Yes, because we have our cash needs set aside in this bucket number one”—whatever you want to call it, the liquidity bucket. “And so, we know that we can still take that cruise that we had planned with our family for next year. We can still keep going out to dinner on Saturday night.” The things that really constitute quality of life for his clients. Those needs were all being met because they had that liquidity bucket set aside.
I always think with bucketing, advisors don’t have to use buckets at all, but I do think that it’s a helpful construct when talking about, well, here’s the asset allocation that I’m recommending. Here’s how we’re doing things to help the client understand whatever asset allocation that you’re recommending, and also just how the volatility in the market is not going to disrupt any near-term plans.
Ptak: David, maybe to build on an earlier comment that you made. It sounds like one of the tools that retirees could use to manage through the psychology of withdrawal is understanding the totality of their wealth, the sources of their cash flows and their durability. Other things come to mind that you think are particularly worthwhile tools that retirees should consider just to make sure that they can withdraw in an orderly way and with peace of mind?
Blanchett: I think that to me the reason it’s so fascinating, when you see people underspend because they’ve undersaved. So how is it that you are underspending when you’ve under saved it’s because it’s just so hard to take money from a portfolio when you have an uncertain life span. You don’t know how long you’re going to live. And so, when you read, you see the surveys that ask retirees: How do they think about their savings and their spending? They don’t want to deplete their capital, and so I think that creating behavioural mechanisms to help someone do that is incredibly valuable. Like buckets, for example, I’m a huge fan of them, because I think that they’re a very valuable behavioural way to help someone improve how they think about market risk. That being said, I don’t know that there’s huge academic benefits to them, you can create synthetically—the same thing with the portfolio, I think that’s the key. It’s the psychology of clients, and I’m sure you see a lot, helping them make better choices that even with an advisor they wouldn’t make on their own.
Jeske: Right. One is, have a plan. That gives you confidence. Then update your plan. So, for example, if you’re 80 years old and you’re still spending that 3%, well, have you updated your plan along the way? And obviously in defense of that 80-year-old, you can say well, the equity returns were probably so spectacularly above expectation, so your portfolio outgrew your spending. But regularly updating your plan and imagining three years into retirement, imagine you were to retire today again. With your current portfolio and your current spending, does it still work? Am I still confident?
And yes, I agree. So, the bucket strategy in some way is window dressing because if you rebalance the buckets, of course your money is fungible. You take it out of the cash bucket, but then your risky assets have to replenish the bucket. But it’s helpful, of course, in the sense of coming up with an asset allocation because we can’t be 100% equities, we have to have some safe assets, and there are different ways of gauging what is the right percentage of safe assets. One would be the bucket, where you have the bucket in the sense that, well, I want to make it through this length of a recession and this length of a weak economy like the 1970s, but you can’t be overly bond-heavy because you want to hedge against the supply-side shock in the 70s. But you want to have some bonds in there because you want to have the diversification benefits if we have a demand-shock recession.
So, you want to have some equity, some bonds, some cash. And I look at it from a historical simulation point of view. Some people do the Monte Carlo simulations, but you could arrive at the same results, roughly and very intuitively, through the bucket strategy. So, in that sense it helps, obviously.
Ptak: Christine, I wanted to ask you about flexible withdrawal approaches, which I think have come up several times during the course of the conversation. They can support higher withdrawals by, as you put it, putting spin on the ball. Can you talk about the pros and cons of these approaches and who they might be right for?
Benz: That was a big thrust of our paper. Everyone took that 3.3% number and ran with it. We did spend a lot of time looking at these variable strategies because we began with the argument that in a lot of ways these fixed real withdrawal systems are a little bit of a straw man because people don’t spend that way. David, your research has shown that, and then we also know that the variable strategies do tend to do a better job of helping a portfolio last throughout a 25- or 30-year time horizon. So, we tested a lot of different variable strategies, and we’re basically testing a couple of things. One is can this variable strategy help enlarge lifetime withdrawals?
If we’re using that 3.3% as a starting withdrawal rate. If we are able to be variable, can we lift that starting withdrawal and in turn lift lifetime withdrawals? And indeed, we found that the variable strategies do just that. They help the retirees’ cash flow calibrate up and down based on what’s going on with the portfolio. Jeff, I should credit you because you did all the work on this, but when we looked at the strategy that did the best job of the ones that we tested of enlarging lifetime income, the guardrails system did the best job of ratcheting up and down. And it’s a ratcheting system that is based off of the portfolio’s value, annually updating. And we found that it did the best job of delivering the highest lifetime cash flow.
The downside of a strategy like that is that for bequest-minded retirees it’ll tend to leave less left over at the end because the name of the game is that you’re spending less in down markets, but you can also spend more in up markets and that means that you’re going to consume your whole portfolio because you are annually revisiting this. That was the strategy that showed best of the four that we tested. Another really simple strategy that we looked at that showed reasonably well—it’s just a modest variation on the 4% guideline—the fixed real retirement spending, where we simply said in a down market, in the year after a down market, forgoing the inflation adjustment in that year after the portfolio incurs losses, is another way to help lift that starting withdrawal rate and lift lifetime withdrawals.
I would say the big negative of that is that if you’re in an environment like this one after a year like 2022, would an advisor want to turn around and tell their clients, “No inflation adjustment for you this year,” where you have a down market that’s running in tandem with inflation, I think that that is the downside to such a strategy.