Wade Pfau: Pandemic Tears Up 4% Rule
The professor tells ThinkAdvisor why retirees shouldn't rely too much on investment portfolios and how they can fill the income gap.
By By Jane Wollman Rusoff | April 14, 2020 at 09:12 AM, published by ThinkAdvisor
In the good old days (before coronavirus), many people could rely on working longer to wrangle a wayward retirement plan back on track. Not anymore. The devastating loss of jobs set off by the COVID-19 pandemic is depriving many folks who planned to retire this year of that lever, as retirement expert Professor Wade Pfau tells ThinkAdvisor in an interview.
Another crushing change: The 4% rule of thumb for income withdrawal in retirement has shriveled to only 2.4% for investors taking “a moderate amount of risk,” according to Pfau’s latest calculations.
The multi-award-winning retirement authority is professor of retirement income and co-director of The New York Life Center for Retirement Income at The American College of Financial Services. Host of the blog Retirement Researcher, the chartered financial analyst holds a doctorate in economics from Princeton University.
In the interview, Pfau stresses that investors typically fall into the “trap” of depending on investment portfolios as the chief way to fund their retirement. Now, many of these folks who are at retirement find themselves needing a life raft.
Acquiring an annuity would have prevented such a dire scenario, he argues, and suggests two types to buy right now to help meet retirement income needs and avoid spending cuts.
For those planning to retire in 2020, he urges to not put off buying an annuity: Because of the steep decrease in interest rates, annuity payment rates have dropped and “could go down further,” he says.
In our conversation, he discusses retirement planning strategies at this chaotic juncture for both the “overfunded” and “underfunded” and two “buffer” assets that can help the latter.
ThinkAdvisor held a phone interview with Pfau, 42, on April 1. He revealed his own early-retirement timetable, which, he says, could now be delayed because of the severe market downturn.
Here are excerpts from our interview:
THINKADVISOR: Suppose an individual or couple were planning to retire this year. In view of the financial damage the pandemic has wrought, what should they be considering now?
WADE PFAU: They need to look at how much it will cost to fund their retirement goals and how much they have. For people who are still overfunded and have sufficient assets, this might be a good wake-up call to take some risk off the table, lock in goals and not expose themselves to [further] market volatility.
What about those who are underfunded?
They may need to look at alternative [techniques], especially if they can’t work for a longer time period. If they have much lower portfolio balances, they may have to scale back some of their expenses temporarily — cut spending now — which can help a lot to manage the risk of what’s happening [in the market]. This will give their portfolio more chance to recover. They won’t necessarily be looking at a permanently lower withdrawal rate.
When it comes to income planning, does the 4% rule of thumb in retirement still apply?
No. The probability that it would work is a lot lower now. It worked in the U.S. historically, but [previous years] never dealt with low interest rates and high stock market valuations at the same time.
What’s the so-called rule now?
I did some updates in mid-March; and for an investor taking a moderate amount of risk, I put out 2.4% as my equivalent of the 4% rule. That’s still about the same today.
It’s roughly half the amount of the traditional rule and means that a typical retiree would need to pull back spending significantly. Ordinarily, they’d have the option to delay retirement by working longer. What about now?
Working longer is the best way to get a retirement plan back on track, but the tragedy of the pandemic is that a lot of people may lose that lever, depending on which sector of the economy their job is in and other factors. However, those who do have the flexibility to continue working might look into it as a way to delay retirement.
You’ve said that during the first 10 years of retirement, market performance drives outcomes. But the market is in terrible shape. Is there a lesson to be learned here?
Yes. The pandemic and resulting market decline make it hard for people who are thinking of retiring this year. This speaks to [trying] not to fall into that trap: It’s a reminder that you can’t necessarily rely on a high rate of return from your investment portfolio as the key way to fund your retirement.
I assume you’re implying that many folks did just that?
Yes. [For example], during the long bull market, people put off getting an annuity: “Maybe I don’t really need an annuity because the stock market keeps going up. So I’ll be fine this way.”
What’s a good way to avoid that trap?
If you start thinking about [buying] an annuity before something like this happens, you won’t have to worry about this stuff when you’re close to retirement. An annuity can be an alternative to not having to make big cuts in spending.
Just where can an annuity fit in?
The simple income annuity can fit in for anyone who’s panicking about the stock market [and economy]. It would work so much better and support so much more spending than bonds can. Moving assets into an income annuity instead of bonds can be a way to meet your goals.
What other type of annuity might be suitable?
A variable annuity — for investors who are still comfortable in the market and don’t want to miss a rebound. It provides a way to lock in protection on the downside but still be able to invest. So if the stock market goes up, those assets [in the VA] go up as well.
You’re saying that now, in the middle of all the turbulence, would be a good time to buy a single income or variable annuity? Why not wait awhile?
If someone is at retirement, there’s not much sense in waiting. Because interest rates have been plummeting, annuity payout rates are also going down. It may take time before they go up again, and they could go down further. So people might want to try to take action.
What about buying a fixed indexed annuity? Will that help?
I worry about those because right now there’s a perfect storm. They do protect on the downside, but they’re not going to offer very much upside because of the low interest rates and high market volatility.
At this juncture, what percentage of assets should someone who’s at retirement put into an annuity?
They need to look at that from the perspective of: How much would it take for them to feel they have a comfortable amount to spend. If they say they want $40,000 of spending [annually] but don’t feel comfortable having stock market risk, then the allocation for the annuity can be how much it would take to achieve that.
Any other options for those who planned to retire this year?
There are two “buffer assets” you can spend from temporarily: reverse mortgages and cash value on whole life insurance policies.
Tell us about the insurance-policy option.
Someone with whole life insurance can borrow against its cash value to cover spending on a temporary basis so they don’t have to sell their portfolio of assets at a loss. It’s a loan that can help bridge the gap in spending so they’re not having to take that [money] from their portfolio.
On a personal note, how optimistic are you about funding your own retirement?
I’m 42, so I’m further away from retirement and have time to recover [from the market decline]. But I had been thinking about possibly retiring in the next five years because I have a goal of achieving financial independence. But now that’s going to get pushed out, depending on how things go. It might take five years longer than what I’d thought.
Sounds like you might be an advocate or member of the FIRE movement (Financial Independence, Retire Early). Are you?
Not in terms of planning to retire but just a little bit in wanting to be financially independent and have flexibility to do what I want to do. I’m not directly in the FIRE movement, but I’m somewhat sympathetic to it.
At this scary time, have you any other advice for financial advisors concerning retirement planning for their clients?
Approaching financial advising by managing an investment portfolio [only] is not going to be the best way to help clients achieve retirement success. Advisors have to go beyond that and be much more holistic. They need to look not just at investments but at how all the different household assets can fit together.