Wednesday, December 3, 2014

Rising Glidepaths and Liability-Matching Portfolios

This week in the Wall Street Journal's Encore Report section, I have short pieces about reverse mortgages and budgeting in retirement.

Also, on Monday, William Bernstein published an article in the Wall Street Journal called, "How to Think About Risk in Retirement," in which he discusses rising equity glidepaths in retirement, and cites the rising equity glidepath article I wrote with Michael Kitces.

His column ends with:

Reverse glide path or two-bucket LMP/RP strategy? You say tuh-may-toe, I say tuh-mah-toe. Either approach will do a superb job of minimizing your risk of dying poor.
I like this quote, because for me it represents the distinction between probability-based and safety-first approaches to retirement income planning. In the research article, Michael and I discussed rising equity glidepaths in the context of being a probability-based approach.

But in presentations I've done, I generally discuss the strategy as more of a safety-first approach. That is how William Bernstein eloquently describes the strategy in his column. This is what he means by the term "liability-matching portfolio." Safer assets (individual bonds or income annuities) are matched to specific retirement spending needs, and then the remaining discretionary wealth can be invested more aggressively in a "risk portfolio."  That's the LMP/RP in the quote.

As you progress through retirement using a relatively conservative spending strategy, you are generally going to find, if stocks can enjoy some growth, that the percentage of remaining assets required to cover remaining spending needs is going to decline over time.

Actually, Michael and I wrote the "probability-based" article after first observing this sort of phenomenon in a "safety-first" article. (I should note that these opinions are mine, as Michael thinks the distinction between these two schools of thought is artificial and would probably not explain our research in the same way as I currently am).  

We had observed in an earlier article that if you put half of your assets into an income annuity at retirement, and the other half into stocks, and then you treat the present value of remaining annuity payments as a type of fixed income asset when measuring overall household wealth, your equity allocation will generally rise throughout retirement:

Source: Kitces and Pfau, "The True Impact of Immediate Annuities on Retirement Sustainability: A Total Wealth Perspective"

This is why I'm generally confident in the idea that rising glidepaths are justifiable. It can be explained either as (1) a risk management tool to get the same or slightly improved outcomes with a lower lifetime stock allocation using a probability-based approach, or as (2) the natural outcome of someone basing asset allocation on their funded status and devoting the necessarily percentage of their assets to safer assets covering their spending needs, and the rest of their discretionary wealth to more risky assets. Tuh-may-toe or tuh-mah-toe.


Thursday, November 20, 2014

MarketWatch Panel Discussion with Bob Powell, Dirk Cotton, and Joe Tomlinson

In October, Dirk Cotton, Joe Tomlinson, and I joined Bob Powell in New York City for a panel discussion about retirement income.

The end results are now available online.  The MarketWatch Team produced four columns about the discussion, and there are short video segments interspersed throughout:

Robert Powell: Loading up on Stocks -- After you Retire

Elizabeth O'Brien: Do You Need a 'Safety-First' Retirement Plan?

Robert Powell: Is Your Retirement 'Fully-Funded'?

Elizabeth O'Brien: The Retirement Risks You Can't Predict

See more at the MarketWatch Retirement Adviser website.

Wednesday, November 19, 2014

Should I Contribute to a Roth IRA or a Traditional IRA?

Especially with the growth of Roth 401(k) plans, many retirement savers will confront a decision at the margin about whether to contribute an additional dollar to a Roth account or a tax-deferred account.

At a basic level, the answer to this question relates to whether one is taxed at a higher marginal tax rate now compared to when one will be withdrawing these dollars in retirement. If one's marginal tax rate is higher now than in retirement, it is beneficial to contribute to the traditional IRA or 401(k), taking the tax break now, in order to pay lower taxes later in life. 

However, if the marginal tax rate will be higher in retirement, go ahead and contribute to the Roth account now in order to avoid higher taxes later in life.  

By this standard, many young people at the start of their career will have lower salaries and be in lower tax brackets relative to later in life and will benefit from contributing to a Roth. Mid-career individuals at peak earnings will be in higher marginal tax brackets and may see more advantage from a traditional tax-deferred approach.

"Roth IRAs: More Effective (and Popular) Than You Thought"

This isn't the full story, as a controversial study from T Rowe Price pointed out.  Their conclusion was that "most investors should use Roth IRAs over Traditional IRAs." They make this case even if marginal tax rates will be lower in retirement. The argument relates to their table on the first page of their study, which considers an individual who saves $1000 in a Roth IRA vs. saving $1000 in a traditional IRA and another $250 in a taxable account. That additional savings is the result of the $250 in reduced taxes created by making a contribution to the traditional IRA when someone is in the 25% tax bracket. Their point is that taxes will have to be paid over time from the taxable account, reducing the power from tax deferral, and that this gives a much greater edge to the Roth.

This point is valid, but I think they've really overstated the impact this point has on the final decision.  I haven't been able to exactly replicate their study, because they are not clear about some of their assumptions, and because I think they have a really odd way to generate retirement income that results in a rapidly growing spending path over retirement. To replicate their study the best I can with what I think are more reasonable retirement spending assumptions, I assume the following:

Roth IRA: Invest $1000 per year until age 65, which grows at 7%. Then for each year of a 30-year retirement, spend a fixed amount each year so that the account balance falls to $0 in year 30, assuming a 6% return. [with a fixed 6% return and withdrawals taken at the start of the year, the sustainable withdrawal rate for 30 years is 6.85%]

Traditional IRA: Invest $1000 per year until age 65, which grows at 7%. Then for each year of a 30-year retirement, spend a fixed amount each year so that the account balance falls to $0 in year 30, assuming a 6% return. The post-retirement tax rate is applied to these withdrawals, reducing the spendable income accordingly. (RMDs are not considered)

Taxable Account: Invest $250 per year until age 65, which grows at (1-.25)*7% = 5.25%. Then for each year of a 30-year retirement, spend a fixed amount each year so that the account balance falls to $0 in year 30, assuming a (1- retirement tax rate)*6% return. 

In all cases, I assume new contributions are added at the end of the year, and withdrawals are taken at the start of the year. 
With these assumptions, I created the following version of their table:

Now, as I note in the table, these are still extreme upper bounds about the relative benefits of the Roth IRA created by the tax issue for the taxable account. Why?  

First, the assumed returns are rather high. Based on the fact that someone is saving $1000 every year over a potentially long-career, we've got to assume these are compounded real returns, which essentially means that this person is investing in 100% stocks and getting the average historical return (which is about 6.5% since 1926). A more diversified portfolio with a lower stock allocation will lower these returns, and a lower return accordingly reduces the relative benefits of the Roth.

Second, the rather basic assumption about the taxes being applied to the taxable account is not appropriate. It assumes all portfolio growth is taxed each year at the marginal income tax rate.  This ignores the fact that capital gains taxes are deferred until when withdrawals are taken, and that long-term capital gains can be taxed at a lower rate. A more realistic assumption about how taxes will affect the taxable account would lower the taxes being paid each year, and therefore reduce the relative benefits of the Roth.

Third, and this is a matter I want to discuss more in a subsequent post, regards if one is making charitable contributions over time.  Donor-Advised Funds provide a way to contribute appreciated shares from your taxable account, which then basically let's you reset the cost basis of your account by contributing shares to charity rather than cash, but using that cash to replenish the shares just given away at a new higher cost basis. This reduces the disadvantages of having assets in taxable accounts.

Fourth, the study is completely ignoring the possibility of making Roth conversions at low marginal tax rates in years when income is low. This is a way to get the tax rate paid on those dollars to be much lower than otherwise, making it realistic to assume lower "post-retirement" tax rates to a degree that could make the traditional IRA look quite attractive.

Other Factors Which Favor Roth Accounts

  • Roth accounts do have extra flexibility in retirement, since withdrawals do not show up on tax forms. By using Roth distributions strategically, it could help to avoid paying taxes on Social Security income, capital gains, Medicare premiums, etc., in retirement.
  • Roth accounts are not impacted by RMDs. With tax-deferred accounts, RMDs will give you less control about when you have to pay taxes, and these RMDs could result in higher taxes on other income sources as they push up your AGI.
  • If the government raises tax rates in the future, this would benefit those who have already paid their taxes in advance with the Roth.

Other Factors Which Favor Tax-Deferred Accounts

  • The potential value from making Roth conversions cannot be overlooked. Suppose you retire at 62 and delay taking Social Security to 70. This provides 8 years to get extreme about moving lots of assets from a tax-deferred account to a Roth account at 10% or 15% marginal tax rates. 
  • Retirees who are not extremely wealthy will probably be in a lower tax bracket once they stop working. This favors the tax-deferred approach. 
  • Some folks distrust the government to the point that they seek to take any tax breaks when they can, as who knows what tax changes will happen in the future. Some of the benefits of Roths (such as not having RMDs or not being counted in the provisional income which determines whether Social Security benefits are taxed) could be eliminated one day. Of course, this sort of distrust could extend to an assumption that taxes will be higher in the future, which leans toward a Roth.


When I first read the T Rowe Price study, it got me really thinking about whether I may be making a mistake about how I'm managing my divisions between tax-deferred and Roth accounts. But in the end, I think I'm making the right decision. Tax diversification is important, and so it is good to have some funds in tax-deferred accounts and some in Roth accounts. I don't think there is a strong reason to shift completely over to the Roth account, to the extent it is even possible. Nonetheless, as my career progresses I will keep this issue in mind more, as there may be a point where a bigger allocation to Roths could make sense.

Monday, November 10, 2014

The Yin and Yang of Retirement Income Philosophies

I have a new paper available, written with Jeremy Cooper for Challenger in Australia. This paper, "The Yin and Yang of Retirement Income Philosophies," reviews what I've been called the probability-based and safety-first schools of thought for retirement income. That link provides the paper in an interaction web format, and for those preferring a PDF file, a link to the PDF version can be found in the lower left-hand corner of the screen. 

After providing an overview of each approach, we then develop a spectrum to categorize eight different strategies ranging from one extreme to the other. We provide further explanations about these eight strategies:

Retirement income is becoming a bigger deal all around the world. Australia has been very successful on the accumulation side with the mandatory contributions for their superannuation system. As contributors are now reaching retirement with a big pot of assets, the challenge becomes figuring out how to create a sustainable income for life. Challenger is one of the major financial service companies in Australia. And in a way that's different from the United States, Challenger is active in both investment management and insurance, which can allow them to more easily implement strategies on both sides of the spectrum. Since retirement income is still quite a new concept in Australia, this paper is meant to be educational, clarifying how retirement distribution does indeed require different thinking than pre-retirement wealth accumulation. 

Friday, October 31, 2014

Retirement Income from a Position of Strength

A couple quick announcements before today's post:

Yesterday's inStream webinar on "Understanding and Explaining Monte Carlo Simulations" ran into a couple of technical difficulties. The sound was cut off for a couple minutes near the start, and there was supposed to be a 250 person capacity, but people were being locked out after the first 100 arrived.  So we are going to have a repeat of the same webinar next Wednesday, November 5, from 2pm to 3pm eastern time.  This is the sign-up link.  This webinar will be recorded and posted on the inStream page if you are unable to attend. Though technically meant for financial advisors, anyone is welcome to join.

Next, a couple weeks back, Nobel laureate William Sharpe had a great interview with Bob Huebscher at Advisor Perspectives, mostly about issues related to retirement income.  The interview transcript is well worth reading.

And now, today's topic.  I received the following question at an old blog post:
I enjoy your blog. Thanks for all the great posts.

I enjoy Mr. Money Mustache's blog as well; I find it very interesting that you do. Given your academic training and professional experience in the field, I think it would be very illuminating if you commented on some of his advice (where you agree or not, and why). The intent is not to create some kind of MMM vs. Wade Pfau battle but to gain some interesting perspectives on retirement (particularly of the early variety) from two different angles.

There's no rivalry. I think I can guess why some readers might think there is a rivalry, and I'll comment on that. But then I'll explain why it's not an issue in this case.

I really enjoy Mr. Money Mustache's blog.  His blog introduced me to Republic Wireless and FreedomPop, and those two services alone are saving me a couple hundred dollars a month on cell and internet bills. As well, his recent post about credit card churning gave me the push toward finally doing that in a more organized and systematic fashion than I had been in the past. Though I'm not as frugal as he is, and I'm not so handy around the house such that I can't build my own showers and things, I do definitely identify with his anti-consumerism views. I do enjoy my job and so I'm not in as big of rush to gain financial independence as some of the extreme early retirees, but I am definitely working toward achieving financial independence at a relatively young age.

I guess the reason why readers might think there is a rivalry is a result of the concerns I have about the 4% rule for retirement income. Mr. Money Mustache wrote about the 4% rule, linking to a post I had made which describes the rule's origins. I had meant that as an introductory post to explain where the rule came from, and I followed it with a series of posts about real-world concerns over whether retiree's should be relying on the safety of this strategy. In particular, the 4% rule is calibrated to a 30-year retirement, and that is too short of a time horizon for early retirees.

That being said, Mr. Money Mustache is able to approach the matter of sustainable spending with a Position of Strength, to use his term. This also relates to what Nassim Nicholas Taleb calls Antifragility. Basically, Mr. Money Mustache has a lot of flexibility.  He could cut his spending in half and not experience a significant impact on his standard of living. In fact, he might feel good about that, because it will be a good chance to flex those frugality muscles. If we experience the type of market crash that could derail the traditional 4% rule, Mr. Money Mustache will tighten his belt, rebalance his portfolio, and come out stronger on the other side.  He has risk capacity. He can be more aggressive with his spending and investments, as at this point it's all about the upside for charitable spending, etc. He doesn't have to worry about the downside, because his standard of living is immune to the value of his financial portfolio.

And that's why there's no battle here. I'd be the last person to tell Mr. Money Mustache that 4% is too aggressive given his personal circumstances.

That doesn't mean I think the 4% rule is safe.  But in the end, it's all about flexibility, and Mr. Money Mustache has loads of flexibility.

Tuesday, October 21, 2014

Webinar: Understanding and Explaining Monte Carlo Results To Your Clients

Hello from Minneapolis.  I presented for 2 hours and 40 minutes today at the FPA Minnesota symposium.  I'm heading home now. I was really impressed by the turnout.  600 signed up for the conference, and it seemed like they were almost all there for the early morning session.  I'm used to crowds of 100-200 for these sorts of events, so kudos to the FPA Minnesota chapter!

I will be presenting another webinar open to anyone next Thursday, October 30. It starts at 4pm EDT.

This webinar will be for inStream solutions, and it will be a more informal type of webinar about how to interpret and use Monte Carlo simulations when working with clients.  I will have some slides, but they will be based on a Q&A type of approach, with some questions advisors may have about Monte Carlo, followed by my answers.  

For advisors reading this, Bob Veres also wrote a very nice article today for Advisor Perspectives, which discusses how larger planning firms are really getting excited about some of the features of inStream, and are using them in a slightly different way than we originally envisioned.  I still hope that the "best practices" feature described in the column will ultimately result in some great data to provide a better understanding about how real-world individuals make financial planning decisions over time.

Here are the webinar details for "Understanding and Explaining Monte Carlo Results To Your Clients":

You are invited to inStream's latest webinar.
Please join us for a discussion with Dr. Wade Pfau

- Learn how to better interpret probability levels of Monte Carlo simulations.  

- How to present the results easily

- How to explain the effect of different plan variables

- Convey what probability of success really means
Register now
The inStream team

Wednesday, October 15, 2014

Speaking Updates & Ph.D. Fellowship Opportunity at The American College

I started the day in New York City. This morning I joined Joe Tomlinson and Dirk Cotton for a MarketWatch panel discussion with Bob Powell.  Marketwatch will be producing some stories and videos about that event over the next couple months. As well, Joe, Dirk, and I enjoyed our own little Algonquin Round Table at the Algonquin Hotel last night. We had a good discussion about bond ladders for retirement, and came away with some research ideas for comparing bond funds and bond ladders in retirement. 

Academy of Financial Services

The Annual Meeting for the Academy of Financial Services will be held in Nashville tomorrow and Friday, October 16 & 17. For anyone in Nashville, it looks to be a good event with lots of folks from the retirement income research world. Michael Kitces, David Blanchett, and Joe Tomlinson will all be there, for instance.  I'm also filling in as a last minute replacement for Larry Kotlikoff to deliver the luncheon keynote address, and I'll be speaking on "Toward Best Practices in Retirement Income Planning." 

Speaking of research...

Ph.D. Fellowship at The American College

The Ph.D. Program in Financial and Retirement Planning is currently progressing along well, with three cohorts of students working their way through the program. This is a distance-based program with live webinar classes and a few one-week residencies. So students are located all over the United States. Thanks to a generous donation from two former executives at New York Life, there is a doctoral fellowship available for a student in the program. The idea for the fellowship is to spend about 20 hours per week conducting research in exchange for program tuition being covered, as well as a $30,000 per year stipend.  

We have been struggling to fill this position, on account that all of the current Ph.D. students also work as full-time financial planners and cannot devote an extra 20 hours per week beyond their already rigorous Ph.D. studies. This fellowship could be attractive to a young person just finishing their bachelors or masters degree in financial planning, and who is ultimately seeking an academic job. Though such an individual might prefer a full-time residency Ph.D. program. Nonetheless, if you fit this description, please do not hesitate to consider The American College along with other more traditional Ph.D. programs at Texas Tech, Georgia, Missouri, or Kansas State.

A third possibility, and the primary reason I bring this up on my blog, is that the fellowship could be filled by a recent retiree who has time and energy and a passion for research, and who might consider a twilight career at least as a part-time academic. I know some of my blog readers fit into this category, so let me know if you are interested to learn more.  Ideally, the doctoral fellow would be someone within commuting distance from Bryn Mawr, PA.  But I think we can be flexible about that, as now with tools like Skype or Google Hangout, it is easy interact online almost as easily as in person. The information below also suggests that the fellowship is for someone who can demonstrate financial need. But don't let that stop you from considering this opportunity, as I don't think a lack of financial need would prevent a highly qualified applicant from receiving the award. Please see the announcement below and let me know if you have any interest or questions. 

The Sy Sternberg and Fred Sievert Doctoral Fellowship
The Sternberg-Sievert Doctoral Fellowship was created to provide financial support to an individual who has both the desire and demonstrated potential to pursue a career in retirement planning research in an academic or industry setting. Funding for the Fellowship is provided by industry trailblazers Sy Sternberg and Fred Sievert who both dedicated years of service to New York Life as Chairman of the Board/CEO and President of the company, respectively.
The Sternberg-Sievert Fellowship includes tuition and fees for the PhD in Financial and Retirement Planning as well as an annual $30,000 stipend for living expenses. The Fellow must be able to work at least 20 hours per week on The American College campus while pursuing the doctorate online. Primary responsibilities of the Fellow include assisting faculty with research projects and providing support to The College’s Centers of Excellence which include the New York Life Center for Retirement Income. In addition, the Sternberg-Sievert Fellow may be required to represent the Fellowship program at donor events and when media opportunities arise.
Applicants must be newly admitted to the doctoral program and be able to demonstrate financial need.

A master’s degree in finance, economics, consumer science, actuarial science, or related discipline from a regionally accredited institution is required. Residence within commuting distance of The American College’s Bryn Mawr, Pennsylvania campus is highly preferred but not required.

A demonstrated ability to read and interpret scholarly material is required; the capacity to write for scholarly publications is highly desirable; a background in data collection, data analysis, and/or experience using statistical software packages such as SAS or R is highly preferred.

Applicants must have a professional appearance and be able to demonstrate fluency in both speaking and writing in the English language.
Tuition funding and stipend will be renewed annually for up to four years from starting the doctoral program and is contingent on annual satisfactory academic standing and job performance reviews as the Sy Sternberg and Fred Sievert Doctoral Fellow.
To Apply:
Indicate your interest in being considered for the Fellowship on the doctoral program application form and write a formal letter to the Doctoral Fellowship Committee that explains your interest in becoming the Sy Sternberg and Fred Sievert Doctoral Fellow. Your letter should include a discussion of the specific qualifications that you believe will maximize your effectiveness as the Sternberg-Sievert Doctoral Fellow. Add the letter to your application packet.