transcript

Speech-to-text transcription can look a little quirky. Please excuse any grammar or spelling errors.

Episode #635 - Retirement Insights: Annuities, RISA, and Real Estate Planning with Wade Pfau

Roger: Today we're going to have a wide ranging conversation with Wade Pfau from retirement researcher on annuities and RISA style assessments, reverse mortgages, tax optimization and so much more.

Roger: Hey there. Welcome to the show. My name is Roger Whitney. So glad to be here with you today. So we're going to chat with Wade Pfau. He recently came into the club for a private session with club members. So you're going to hear some, well, retirees a lot like you, asking questions and interacting with Wade on a whole host of topics. So I'm excited to get to that. Before we do, however, I want to invite you to join me on March 28, Saturday morning to bring the Noodle Live. On Saturday morning on March 28th we're going to go live on Zoom, have a cup of coffee and hang out and just debrief the month of topics that we've covered in the show. Have just a great interaction and Q and A on retirement planning in general. A good way to spend a Saturday morning with a little cup of coffee. So you can register for that and find out more at livewithroger.com and if you get the noodle every week we'll have a link in the noodle. With that, uh, said, let's get started with this retirement chat with Wade Pfau.

ROGER INTRODUCES WADE PFAU, AUTHOR OF THE RETIREMENT PLANNING GUIDEBOOK

Roger: Wade Pfau, author of the Retirement Planning Guidebook. I have the previous edition, I have the newest version yet, Wade. And this is going to be open discussion session about retirement topics. Wade is a prolific researcher and thinker on this topic and creator of the RISA which we have integrated into the masterclass. I'm having an active debate, Wade internally because we're refreshing our process in uh, our planning firm of using the RISA and have someone that is still attached to the old school risk tolerance questionnaire. So maybe we have some fun about, talk about that. So Wade, um, excited you're here. Uh, how you doing?

Wade Pfau: All right. I do have a bit of a cold right now, but I think I'll be able to power through if I start getting tired, you know why? Yeah. Overall good, good.

Roger: Wait, at 70% is still a very, a very bright light when it comes to retirement research. I'm going to start off with a few questions but I really want this to be an open roundtable with people to ask questions. Um, my first question is related to how is the transition to the private sector?

Wade Pfau: Yeah, it's been good. So I'm, I still have an affiliation with the American College, but. Right. I. No, uh, longer a full time Academic since now. Since January 2023 is when I really stepped down. So yeah. In place to that. Still doing speaking and writing the books, updating the books and things we're doing at retirement research and everything. It's been going good. It's one less thing to worry about not having to keep the RICP curriculum updated. Although I left right before AI made it a lot easier to write test questions and things, which was one of the things I hated most about the job. So my timing wasn't great then maybe

Roger: We'll get into AI a little bit too when it comes to getting answers. But have you had the chance since not having to be involved in the curriculum and more be in the private sector with the RISA of interacting with individual retirees and whether it's in their retirement plans or in the risk profiling,

Wade Pfau: Well, that's been about the same still that there's lots of opportunities. We've got that retirement researcher community and I do webinars and events with them. So. And monthly office hours and everything. So yeah, still getting a lot of good ideas and feedback. Overall, I'm probably not doing more, uh, than before in terms of conversations with retirees.

Roger: Okay.

Wade Pfau: Still, uh, a part of it.

Roger: Okay, well, let's start off with risk tolerance because the RISA is something that you've been on. You're relatively early in the journey. I know you and know Kevin was sharing how he was helping out a little bit when you guys were thinking through all that. Uh, now that it's a few years in, what are. What learnings do you have of people actually using that out in the wild?

Wade Pfau: No, it's been going strong and with. So with risk tolerance specifically, if you're. It doesn't replace a risk tolerance questionnaire. If you like the risk tolerance questionnaires, you can use that alongside the risa. It's not a replacement. What we just find is risk tolerance questionnaires. They're designed for modern portfolio theory, which is the like the accumulation phase when you're saving for retirement, trying to choose an asset allocation to get the highest risk adjusted return. So generally the more aggressive you invest, the better your shots at big growth opportunities. But if you're not comfortable with that volatility, the risk tolerance questionnaire aligns you with, well, how much bonds to have in your portfolio. And what we find is in retirement that's not. That relates to concerns people have about lifestyle, having the best possible lifestyle. They don't want to miss out on the opportunity to enjoy retirement. But it does not connect. So Whether you're risk tolerant or risk averse does not relate to. Are you worried about outliving your money or are you worried about having liquidity for unexpected spending needs, particularly related to health care and long term care? And so we find the risa, uh, works much better to identify people's concerns about retirement. Any retirement income style includes a role for the investment portfolio. If you like Riston's questionnaires, you can still use that to choose the stock allocation. It's just for me the last choice in a retirement plan is what the stock allocation should be. It's not really the first choice because it depends on everything else. The more reliable income you have, the more you're covered. If markets are volatile and you can behave more aggressively if you want, which you can invest more aggressively or spend more aggressively because you have a reliable income floor in place. And if you have reserve assets to deal with the unexpected, that gives you more risk capacity. And so if you have flexibility to adjust your spending, that gives you more risk capacity. So you really need to consider all these other aspects before you choose the stock allocation in my view. But that's doesn't replace the risk tolerance questionnaire though.

Roger: Yeah, there's, that's an interesting distinction. I think it's really important is before you think about upside capacity or investing for growth, to use layman terms, you want to build out how you're going to pay for your life in a way that you're that feel that fits who you are before you get to the risk investment allocation end of it. Right. It's building out that cash flow, whether that's a bucketing system or guaranteed payments or a combination of those things. That's job number one before you even start talking about allocation.

Wade Pfau: Right, right. And also your, your risk tolerance does not relate to your retirement income style. So whether you're probability based, comfortable relying on market growth or safety first, wanting contractual protections, you might think risk tolerance means you're probability based, but it's really not the case. It's just more this. If you're safety first, you might still really feel comfortable with the idea that markets are going to grow over time. You just don't want to have your whole retirement dependent on that outcome to be comfortable.

Roger: So it essentially helps identify the way you implement the strategy whether it's guaranteed income or market based approach. What learnings have you had in terms of people actually using it?

Wade Pfau: Good question. Nothing's really changed from the perspective of it does seem pretty clear that there's a distribution of retirement income Styles in the population. It's a third or a little more than a third is total return closer to upper 30% for income protection, and then a split between the time segmentation and risk wrap. And we haven't really seen any changes along those lines. The question always comes up, does someone's, uh, RISA score change over time? That's something we're monitoring, but we don't necessarily have any new insights other than our original research opportunities, where we were able to ask individuals in March 2020 and then in, uh, September 2020 to take the Risa. And March 2020 was a really scary time to be investing. So. So it was a natural experiment where if your retirement income style changed, it might have changed between March and September 2020, because things are much better by September. So we didn't see any changes, though systematic changes. We don't see changes for different age cohorts. So we think the style is really part of who you are as a person. And it's not going to change over time, but that's always going to be an ongoing thing that we need to look at and have any new insights beyond those general points.

Roger: I want to pivot a little bit to your book. Again, this is the older edition. We were having lunch at the Roundup and we were talking because you were working on the new edition and you were delaying. You were waiting, I think it was for healthcare, right? Is that what you had to wait, put everything on hold so you could finish that chapter because you didn't know whether they were going to extend the. The cliffs? What was it you were waiting on?

Wade Pfau: Right. Well, the last number I needed was the December CPI inflation number, which comes out sometime around January 12 or January 13. I think the morning of January 13. When I got that number, I updated the last couple things and published the book in the afternoon. But yeah, the health care. Whether the Affordable Care act subsidies were going to extend with the enhanced version or go back to the regular version, that was something I was holding out for too, because if I knew exactly the direction that was going, I could adjust the text accordingly. Now, we know the subsidies were not. The enhanced subsidies were not extended, but I still talk about both in the book just in case. This could still be something that changes in the future. So keeping the options open.

HOW TO USE THE RETIREMENT PLANNING GUIDEBOOK

Roger: I think this is an important book. I remember Kevin Lyles gifted this to everybody at the Roundup when it initially came out. I use it. I'll be honest, I have not read it straight through, but I use it as a reference guide when I'M looking at a particular topic and I would suggest anybody that is really into retirement planning and wanting to understand a lot of the technical part of it to get the book. But how would you suggest someone use it productively?

Wade Pfau: Well, a big change with the third edition. I took some of the feedback to heart and I it shorter. So the third edition is only 390 pages. Uh, the first edition I think was 470, something like that. And then the fifth edition got over. I'm sorry, the second edition got over 500 pages. So I trimmed a lot not to take out any important content, but to try to make it more reader friendly. Because when negative reviews came in it was always this is too much like a textbook, I can't read it. So I tried to improve it on that front, making it easier to read all the way through if you want to. But no, each chapter is on a clearly distinct topic and it would be perfectly fine to just move around and read chapters as those issues become relevant. And the Last chapter, chapter 13, putting it all together, you might even start there and read through it tries to summarize the whole book into a series of steps of what to pay attention to at different points and then start there. And if there's something you want to dive deeper into, go back to the relevant chapter for that.

AI IN RETIREMENT RESEARCH

Roger: Now let's go to AI for a second. Uh, do you use AI in your retirement research?

Wade Pfau: I've tried experimenting with it, but I've never really been able to get something, a result that I felt comfortable using. This is changing of course over time, but it still just seems like AI is just wanting to tell you what you want to hear. I remember just one example of this. Somebody had asked is it ever possible to be in the 20% like long term gains tax bracket without having to pay the 3.8% net investment income tax? So that really, there's no 20% bracket, it's really goes to 23.8%. And so I thought I'd ask ChatGPT about that. And they kept saying yes, it's possible. But their explanations were always, they didn't seem right. So it took like six or seven rounds of are you sure it's right when you're saying this or that? And then finally AI admitted, no, there's no way to pay 20% without paying the extra 3.8% as well.

Roger: So it's still a work in progress. And I see Virginia put in the chat is, uh. And it's true, Virginia, because I've been testing this of always using the latest model because it's growing so exponentially in terms of its capabilities. We recently had one and I think this is an important topic because a lot of us are using these just as our search and uh, prompt to get information. And it can be helpful, but it can be dangerous too. We had one using the most recent CLAUDE model where we were asking about a deduction and whether you had to standardize, uh, whether you had to would you still get it if you're using standard deduction, how would it go away? And if you don't prompt these things correctly, it will give you wrong answers unless you challenge it and know how to prompt it. And we were going to create some looms of examples because it's easy to get misled, uh, if you're not prompting it correctly because it's, you know, it's still a work in progress. So I was just curious your experience.

Wade Pfau: Yeah, it can be helpful and provide a lot of insights but you just have to be very careful that you verify especially anything that's becoming like a tax or legal type question, very technical, verify that it's giving you good information.

RRC MEMBER QUESTION: HOW DOES REAL ESTATE FIT INTO RETIREMENT PLANNING?

Roger: I'm going to go to a written question, then you uh, can raise your hand and I'll just tee up questions to have chats with Wade on all things retirement. Um, first one I want to tee up here, Wade is from Marilyn that she posted in the club is I would love some insights as to how and where real estate properties may play into retirement planning. For instance, when to time sales, exchanges, etc. Or income. How do you think about real estate when it comes to retirement?

Wade Pfau: Yeah, so it's an area that I don't do a lot of work in. So partly my answer has to be I'm just not really my area of specialty. But the way we think about that within financial planning, like if you're doing your funded ratio, you're trying to understand do you have sufficient assets to meet your retirement. You don't necessarily just plug in the value of your real estate properties as an asset available. Now, the way I think about it, more is put in the income streams. So if you're getting this rental income over time, include that as an income source and try to estimate how long it might last, what it might be, whether it adjusts for inflation or stays fixed. And then if you're thinking to sell the property at some point, treat that as an income source coming in at the time of the sale, then you have it is part of your plan and you got some flexibility around all that. There's all the tax questions around real estate. But you want to try to figure out how am I going to treat this income source, how much of it might be taxed and so forth.

Roger: So from a retirement planning process perspective, the asset itself is like a use asset. It's like your home. It's not productive for retirement unless it. The only part of it is, uh, productive is the throwing off of income. Right.

Wade Pfau: Right. And so therefore treat it as an income source.

Roger: Right. And then if you plan to sell it now, that's an inflow at some future date. So.

Wade Pfau: Right.

Roger: That's probably separate from all the tax strategy stuff.

Wade Pfau: Right.

Roger: Okay. Okay.

Wade Pfau: With the primary residence too, you might not count that as an asset as part of the assets available at the start of retirement because it provides a service that if you didn't own the home you'd have to pay rent some somewhere and so you could offset. I don't have to pay rent because I have this property. But if, therefore I don't want to include it as an asset for retirement spending. And with the one exception being if you're thinking about using a reverse mortgage to create liquidity as well, that then you might include it as an asset on your balance sheet.

REVERSE MORTGAGES AS A RETIREMENT TOOL — USAGE TRENDS, HOW THE HECM LINE OF CREDIT WORKS, UPFRONT COST HURDLES, AND WHY ADOPTION REMAINS LOW

Roger: And that's something you've written a lot about and talked a lot about of using your home as a source of income. How much is that actually done in your experience of using a reverse mortgage to turn on an income stream from your house?

Wade Pfau: It definitely has not taken off as a popular option. The number of reverse mortgages that are issued each year has been declining. Uh, ten years ago it was still 60,000 was about as low as it got per year. Now it's just been fluctuating around 30,000. And a big chunk of that is just refinancing existing ones too. Too. So it's only estimated about 1 to 2% of eligible homeowners use that as a retirement tool.

Roger: Do you think that.

Wade Pfau: I don't see anything on the horizon that's really going to change the momentum to make it more popular.

Roger: Do you think that's a missed opportunity nonetheless? I'm sorry, do you think that's a missed opportunity?

Wade Pfau: It can be a missed opportunity because of the whole way that it provides this resource that can help manage different risks in retirement. That the sequence of returns risk where instead of spending from my portfolio during market volatility periods, I, uh, could temporarily tap into the reverse mortgage to cover spending. And then the whole idea is you can't look at it in isolation the reverse mortgage, it looks expensive in isolation because that loan balance grows with compounding interest. But by being able to spend less from your portfolio, that can also create opportunities for your portfolio to have more growth over time. And when I do the simulations, really the odds are in favor of the portfolio grows by more than the loan balance on the reverse mortgage. And therefore you can pay the balance at some point and still have a net positive windfall.

Roger: Do you think some of the lack of adoption is the visceral feeling about our home and our homestead?

Wade Pfau: Yes, I think so. That people have been working their whole life to pay off a mortgage and a reverse mortgage is a mortgage and the last thing they want is another mortgage. Now, uh, it works differently because there's no fixed repayment obligation over time. So it has a different risk profile than traditional mortgages. But I think there's definitely this idea that I don't want to consider another mortgage. And also, a lot of the momentum changed around 2017. That's when the upfront cost to set up a reverse mortgage became higher. And I think that's a real hurdle people can't really envision. It's a 2% mortgage insurance premium on the home value. That's part of those setup. Costs that can now cause to just set up the reverse mortgage could be 20, $25,000. And I think that creates a huge sticker shock that's hard to overcome.

Kevin Lyles: It always struck me that the psychological profile don't match. In other words, someone who's willing to use a reverse mortgage as a buffer asset is they're going to that that person is going to have trouble then leaving the stock, the equities to grow during a downturn. In other words, if you take out a reverse mortgage, you're pretty risk tolerant to start with, so you're not really helping the person who needs the sequence of returns mitigation.

Wade Pfau: Right. Because it's really working partly as a way to help leverage your investments. Uh, you're not having to spend as much from your investments, so you're trying to benefit more from the market growth. And certainly if all your investments are in bonds, they're not going to grow faster than the loan balance on the reverse mortgage. And then you would not be looking at better outcomes for sure.

Roger: And the newer reverse mortgages can, can act a little bit heloch. Right. In the sense that you don't have to tap them.

Wade Pfau: Right, right. The home equity conversion mortgage program. Now, there are proprietary reverse mortgages for people who have more expensive homes that go well beyond the limit now is in the $1.2 million range. It changes every year, which is just the amount of the home value that the reverse mortgage applies to. So if you have a $5 million home, you might look at proprietary options instead. But yeah, definitely in the HECM market Now more than 99% are the adjustable rate HECMs and they have that growing line of credit. So it does work a lot like a heloc, but with the additional advantages that it can't be frozen or canceled and it will grow over time.

RRC MEMBER QUESTION: WHAT IS AN EFFECTIVE MARGINAL TAX RATE (EMR) AND HOW DOES IT AFFECT ROTH CONVERSION STRATEGY?

Roger: Yeah, that's not something that we've explored here in the club in depth as a tool that perhaps we can do something on. I see Brian has a question. He said, uh, I purchased the first edition of your book recently and purchased the third edition. Uh, since the tax section appears to be updated, I read the section on the EMR and am going to have to go through it again, likely more than once. What would be the practical application for a retiree of this without access to specialized software? And I, I think at first, Wade, if you could define EMR for us.

Wade Pfau: Mhm. Yeah. So the effective marginal tax rate, effective in this context means overall how much taxes will you pay on the next dollar? And that includes not just income tax, but also how that impacts if you're in the Social Security tax torpedo, another dollar of income might also cause another 50 or 85 cents of Social Security to be taxed. It's the preferential income stacking issue where your long term gains may be taxed at 0% because it's got a much higher limit. But as you generate more ordinary income, not only if, when you're in the 12% bracket, I take another dollar out of my IRA, it's taxed at 12% but then it's also pushing a dollar of my gains from 0 to 15%. And now I have a 27% effective marginal tax rate. It's also now with all these new tax deductions from last year, those phase out, especially that new age 65 plus bonus deduction that phases out as you have more income. So that raises the effective marginal tax rate. The state and local taxes have a really significant phase out at 30 cents per dollar. But that doesn't begin until you have $500,000 of adjusted gross income, the IRMAA, the Medicare surcharges when you exceed certain thresholds, two years later you have that Medicare um, premium surcharge. Is that uh, everything.

Roger: There's a lot there already in there.

Wade Pfau: Right, right. And those all then work together for impacting what is the effective marginal rate on generating more income. And then the whole tax planning conversation is how do I take advantage of paying taxes at lower rates? Which means potentially doing Roth conversions if I can. If I met all my expenses and I still have some capacity to pay taxes at a relatively low rate, I'll do Roth conversions. And just without the sophisticated software is just being mindful of the simplified version of all that is you fill up tax brackets, but that's too simplified. There's all these other hurdles that you run into. You don't just want to Simply fill the 12% bracket or fill the 22% bracket because, uh, there's all these other minefields that you might be paying multiple IRMAA surcharges, or you might be pushing all your capital gains to be taxed at 15% instead of 0%. And you want to be paying attention to all those issues. And that, that's the way I approach tax planning. So definitely that's been the chapter 10 on tax planning has been the chapter that's evolved the most over time. Uh, the, the third edition does talk about it in the context of effective marginal tax rates. Yeah.

NAVIGATING ACA SUBSIDY CLIFFS BEFORE MEDICARE

Roger: In an application too, you have the challenge of threading the needle of not having something unexpected happen that suddenly tips you over a trigger point or a cliff on something.

Wade Pfau: Oh, yeah, yeah. So if you're voluntarily taking money from your ira, uh, if you have, if you've been doing Roth conversions, you might now have a bigger flow fund of Roth assets that you could tap into. So and this is an important point, this is where most of the direct to consumer software is missing the boat. It's not just looking for Roth conversion opportunities if you have capacity to pay more taxes at a low rate. It's also you always have to deal with RMDs, but you don't necessarily just blindly cover all your spending from the Iraq. If that's voluntary, if it's above the RMD, if that's going to push you into paying really high tax rates on that. So it's about blending. I'll draw from my IRA up to a point where the tax rate gets too high. And then if I have the Roth assets, I'll cover the rest of my spending need by taking from the Roth, because that's not added to my adjusted gross income and I don't have to worry about the tax implications, which also

Roger: Which also goes against the “rule”, Roth is for growth. We don't touch her Roths, which is maybe a little shortsighted from a Tax planning perspective.

Wade Pfau: Right, right. Yeah. The Roth becomes a great legacy asset. But yeah, it's better, it's potentially better to spend from the Roth to cover part of your expenses. If you instead spent from the IRA and the tax bill you paid on that is much higher than what your, um, beneficiaries would be paying. It's better to spend from the Roth and then they can then get the IRA and pay a lower tax rate as an inherited IRA.

Roger: Let's go back to software for a second because this is first off, this is in the optimization pillar. This is, you should have a great life without doing any of this. Um, this is optimization from a software perspective. You said the consumer facing software. I don't even know of anything that I trust fully in the professional facing software. Do you have any that you love either?

Wade Pfau: The professional software, the, the one that I really learned these techniques from, that is closest in spirit to what I'm doing would be the Covisum software. But that's for financial advisors. And it's not really cost effective for an individual to get a license for their own planning. But, um, it's the software I'm most comfortable with in terms of being able to do these types of calculations.

Roger: And I imagine a lot of that is just having one that you're comfortable with and you know how to use, which is so you understand what it can do and what it can't do. Okay, so no recommendations there. I'm sorry, guys. K. Wade.

RRC Member: Wade it's great to, uh, see you, Roger. I have to admit I read Wade's book cover to cover before I met you, so.

Roger: Well, I'm glad that God makes people like you and Wade.

RRC Member: Wade. Ah, I'm a recovering academic also.

RRC MEMBER QUESTION: FIXED VS. INFLATION-ADJUSTED ANNUITIES

RRC Member: Um, so my question is more. Roger, is it okay to ask an annuity question?

Roger: You can ask whatever you want. I'm not against annuities.

RRC Member: Great. So, Wade, um, as a teacher, I have tiaa, ah, Traditional as an option for an annuity that my financial planners and I have looked at. And you know, it, it's something I'm considering as just a piece. Right. But the thing I, I, I just can't understand and get in my head is you go on in January and they give you what they think the payout would be if you're going to annuitize in three years, then you go on four months later. And that number's different, even though I have not changed any of my assumptions. So clearly that number is based on something in the market. Interest rates or Bond yields. And that's the piece I don't understand. I understand all the other pieces of how annuities work. But say you go on and you're doing, uh, I don't know, $100,000 annuity, and it says you'll get $10,000 a year, and then you go back and it says you'll get $8,000 a year. Can you just give me a simple. As t bill rates go up, this will go up, or as bond rates. That's the piece that I'm missing.

Wade Pfau: Yeah, you're right. And you can see that. So if it sounds like an income annuity scenario, if you go to places like immediateannuities.com as well, you'll see they update the rates every couple weeks. And it is very interest rate dependent. I've done estimates around that. And also it depends on age and so forth. But for people in their 60s, what I see is a 1% increase in interest rates. So that means going from 4% to 5% would cause the payout rate to increase by about 0.6%. If it was offering a, uh, 5.5% payout before, a 1% increase in interest rates would get you up to around 6.1%. That's going to be the main driver is just fluctuating interest rates. Also longevity. That as the actuaries are updating estimates about how long people will live, that will lead to. And then also as you age yourself, and so you're rerunning the numbers as you get older, the payout rate is also naturally just increasing. Holding interest rates the same, you'll see the payout rate go up over time. Ah. As you get older. Unless there's surprises where they think people are going to start living a lot longer, then it could go in the other direction too.

RRC Member: Yeah, that makes sense. And then the one other thing I couldn't understand is say a person is 65 and they want to start the annuity at 70. And so they go in and they look to say, what would it be at 70? You still have to keep updating that until you're 70 to find out what that number is like. If a person made a decision at 65 to annuitize at 70, they wouldn't know the exact payout until they turned 70. Is that correct? It's not guaranteed.

Wade Pfau: That would depend on the type of the annuity. So if it's an immediate annuity is just, uh, it gets confusing because that just means you're annuitizing the contract. Even if you're going to defer from 65 to 70, but you're locking in that annuitization today, then they should be able to tell you exactly what the payout will be at 70. But if it's a deferred annuity, meaning you're not annuitizing the contract, and then you're either, most people then don't ever annuitize. Deferred annuities. But if it has a living benefit so you can turn on income starting at 70, I think that would be the scenario where you would see it's going to adjust over time because you're not locking that in until, if you purchase that type of annuity, you lock in what the payout rate would be, but you still get to look at the account growth over time.

RRC Member: Okay, great. That's really helpful. It's just what I needed to know.

Wade Pfau: Okay, thank you. Sure, sure.

ANNUITY TIMING

Roger: When it comes to annuities, in this idea of buying secure income, Wade, is it best to go to what I would call an organic annuity, where it's an immediate annuity, it's a deferred annuity, but very straightforward. Or one of these indexed annuities that have a guaranteed income rider? What I found in my very limited experience in implementing this was it appeared that, like the indexed annuity that had a guaranteed, uh, uh, payment regardless of performance of contract was higher than the more organic one. And it was really difficult because I don't like to buy Twinkies. And so I really focused on, I don't care about any of the cool stuff. Just tell me what the guaranteed payment. Payment it as it is at this age, is there a risk in looking at that approach versus just the more organic annuities that we think about?

Wade Pfau: Well, um, yeah. Yeah. And so in theory, the organic annuity should have the highest payout. That's the. You're annuitizing the contract immediate annuity or income annuity. It's the most straightforward. You pay a premium, and they tell you what your monthly income will be for the rest of your life, whatever age you're deciding to start it. And then it could be joint life or single life. And it could have other provisions like a cash refund. If you pass away before receiving the full premium back, the remainder would go to your beneficiary, that sort of thing. But then, so in the fixed index annuity world, with the living benefits, in theory, they should have lower payout rates because they've given you more flexibility. You can still get your money back out of the contract. You can choose different how you're applying different indices to get the credited interest over time, you can decide whether or when exactly you want to turn on the income and so forth. So with that added flexibility, it should have a lower payout rate. But what we are seeing in practice is it's this behavioral thing where people who buy the immediate annuities, they can't make a mistake, they can't decide not to take out the income they've been promised. It's going to show up whether they have a reminder to turn it on or not. And with the fixed index annuities with living benefits, no one's knocking on your door and telling you, oh, you need to turn that income on. So people are holding those and they're not starting the guaranteed lifetime income. And then that just means you're spending your own money until the account depletes, and then the insurance company's on the hook to continue to pay you the rest of your life. So if you don't turn on the income, uh, the insurance company is not really at risk of having to pay you anything. And because people then buy those fixed index annuities with living benefits, because not everyone's using them in the most efficient manner, which is really just turn on that income as soon as possible. Or at least with the plan of when you want to turn it on. If you buy it at 65 with the plan to turn it on at 70, don't wait until 72, go ahead and turn it on at 70. Uh, because not everyone does that. Then through the competitive marketplace that allows those types of annuities to offer higher payout rates.

Roger: So they basically offer higher rates because they know that really nobody turns them on because of execution risk. Right. They just forget why they bought it and don't turn it on. So they. So it's attractive assuming that you're disciplined enough to do what you say you're going to do and remember it, you know, eight years later or whatever.

Wade Pfau: Yeah, yeah. It's one of those cases where you kind of can benefit off of other people not doing it right if you make sure you do it right yourself.

Roger: Yeah, we're always better drivers than everybody else. Wade, um, if you are, let's say that super disciplined person and execution risk is really nil, are there any additional risks to doing that from a guarantee standpoint, if you're not focused on the potential growth of anything?

Wade Pfau: Uh, there can be. Right. So if you're looking at the guaranteed levels, rather than assuming you're going to get this positive market index growth and so forth, but There can be issues related to the guarantees, and this is becoming much more of a legal question. But the most states have that state guarantee association for immediate annuities or the organic annuities, where up to a certain level of premium, the state's guaranteeing that if the company goes out of business, you'll continue to be paid. And it's not as clearly, and it may depend state by state too, but the protections on the living benefits may not be as strong as the protections on immediate or income annuities. That's also definitely a, uh, consideration. Although the whole risk of annuity contracts not paying what they promise can get overstated. It's a very rare event if you look at companies with strong credit ratings and so forth.

Roger: Yeah, in practice a lot of them will get absorbed by somebody else and they'll honor the contract.

Wade Pfau: Right. There's a huge reputational risk to the insurance industry. So before anyone's not getting their promised payments, there's a good chance that a consortium of insurers are going to step in and buy that book of business and continue those payments to avoid all the media coverage that would point to the risk.

RRC MEMBER QUESTION: SHOULD WE EXPLORE INTENTIONALLY BREAKING THE ACA CLIFF EVERY FEW YEARS?

RRC Member: Hey everybody. Good to see you. My question, it's kind of a two part question and I'll, uh, give a little background. I'm 57, my wife is 53. We have a decent brokerage account and we have the ability to keep our income below ACA cliffs. And so the question becomes is we have that ability, but it becomes a little bit like handcuffs, like ACA handcuffs in a way that is by keeping ourselves below that, we can't unlock money that we would therefore like to use. Fill up cash buckets, you know, spend more money, whatever we would like to do with it. And so then my question really part one is exploring a strategy of intentionally breaking the ACA cliff, like one out of every three years, right? Like keep it low, keep it low and then go the third year ish, um, utilize a 24% tax bracket and kind of go big based on parameters of the markets and some other things. So one is like a question of what do you think about a strategy like that? And then two, on the years that we are keeping it low, a uh, strategy around like keeping cashing out a LERP a little bit earlier, starting to take those payments a little bit early for tax deferred or tax exempt kind of monies. And then you guys already hit on it a little bit as taking Roth a little bit early because you can take out of a Roth and keep Those, those credits or keep the tax bill low and still gain income. So, so that's my questions.

Wade Pfau: Yeah, yeah, good question. And you. Right. You want to keep your adjusted gross income under the, or the, actually the Affordable Care act modified adjusted gross income, which is pretty close to adjusted gross income. But if you've claimed Social Security, it includes 100% of your Social Security benefits. And you really are looking this year especially to keep under 400% of your federal poverty line, which there's a set of numbers for the continental US and then Alaska and Hawaii have their own numbers. And then it also depends on the household size. But two people in the continental US now 84,600 is the threshold where if you have exactly $84,600 as your affordable Care act modified adjustable income premiums went up a lot this year. So it also depends on your premiums. But say your premiums are $30,000, at that income level, you might still be getting, I'm making up numbers, but say $22,000 of, of subsidies, $1 more, you lose out on $22,000 of subsidies. So that's the trade off of intentionally going over that limit. You're going to lose a big subsidy. So, so yeah, I think it makes sense to ask the question, should I consider maybe every few years doing that? I would. At least this year I'd hold off because this is now the first year where we're back that the subsidies that existed from 21 to 2020, 21 to 2025 didn't have this problem. They still had this long tail where you could continue to re. Receive subsidies. It would decline at 8 and a half cents per dollar of income. But you could, with a, uh, a big subsidy, you could have hundreds of thousands of dollars of income and still be getting some subsidies. And if that system returns in the future, then you, uh, you don't have to worry about this as much. And you wouldn't want to have to lose that subsidy this year when you, if it, if they return to the enhanced subsidies next year or the year after that. So I would think about playing it more, play it cool this year in terms of, try not to broach the threshold this year. But then if it's, there's no changes next year, there's no changes the year after that. And you're just looking at your situation and it's becoming harder and harder to not tap into any of the assets that would generate taxable income. And so you do decide, I'm going to broach that threshold one year, it Might be worth looking at. And then. Right. If you do broach the threshold, at that point, you can really go much more all in with it because there is no more problem. The good, the bad news is you lose all your subsidies $1 over the 400% threshold. But the good news is once you're over that threshold, you don't have to worry about losing subsidies anymore. So then you might go ahead and do a big Roth conversion that year, something along those lines. And then that will set you up in subsequent years to be able to tap into the Roth potentially if there's all the rules about making sure it's a qualified distribution. But, uh, going back to trying to stay under the threshold again. So to try to summarize that, yeah, I think there could be potential to looking at, uh, doing strategies along those lines. I would try to hold off this year being the year that you broach the threshold. But if it does seem like we're back to regular subsidies and that's not changing over the next few years, then it might be worth revisiting that you're going to take a year where you, you go ahead and broach the threshold and really broach the threshold by quite a bit. Thank you.

RRC Member: Thank you, and then the second part of that question is when you are trying to keep your retirement income the magi very low, to get underneath that cliff. Exploring, um, I'm with you, Roger that always the teachings is don't touch the Roth. Don't touch the Roth. Never touch the Roth. But in certain aspects, if you're trying to keep yourself under that cliff, and we actually are in Alaska, so, you know, those things are, they're worth like $35,000 to us, the subsidies. Then, you know, broaching the Roth to help keep yourself under that cliff seems like it might not be a bad strategy. I struggle with the math to how to put the equation together, but, but it seems just on a high level that it might make sense.

Wade Pfau: Right. It's, you gotta look at the cost. You're losing $22,000 of subsidies that might, or more that might be enough to make you decide it's okay to go ahead and cover some of that spending through the Roth. Hopefully you're not, you're able to like contributions and things. So you don't also have the 10% penalty. But even with a 10% penalty, you still have to assess it might be worth it to avoid losing all those remaining subsidies.

RRC Member: Yeah. From our strategy, I would definitely not in for a few years until we're over the 59 and a half so you don't hit the penalty, but after that. And I guess it kind of goes further of is, you know, trying to put math equations together for some of this stuff to be anywhere close to definitive. Is that just kind of a fool's game?

Wade Pfau: Yeah. Yes. In terms of trying to do the lifetime optimization, when I look at these kind of lifetime problems, I do the simulate. I don't try to write math equations to solve it. I just run the numbers and I check what happens if I use this target for effective marginal tax rates, 10% or 11% or 12% or 13%, and then see which gives me the best outcome. And that's how I decide. Because it really is hard to otherwise try to sort through and figure that out. Yeah, In a different way.

Roger: And I think it's one of those. You want to think through it in an organized way to get to a judgment call. Right. Because it's not going to be exact. One framework that might be helpful is, you know, comes from aviation, is the OODA loop. Like when we build a decision pod, it's generally off of an OODA loop, which is an, uh, acronym, which is first observed. Right. And core. You did a good job of what are the things that are going to interact here? Just get all the data of the things that are going to interact here. What my assets are, what values I are by tax category, what are the things that might be affected by my decisions. And then the second O is orient. Now that you have all the facts, because you already have a plan of record and you're thinking of this new path and you understand a lot of the, uh, interactions. Interactions, you can say, okay, let's orient this. What's my intent here? Right, because we. Solving for ACA subsidies is optimizing, which is optional, but there's optimizing to pick up a penny and there's optimizing to pick up a dollar. It's a lot of money, $22,000, uh, even if it doesn't impact your life from a trajectory standpoint. But once you orient, you can get a sense for what am I trying to solve for and play with these different scenarios. So you can get to a point where you can decide and your decision won't be perfect, but you'll at least get to a place where I thought through this logically and, uh, at whatever level of detail is your jam. One option in there from the observed standpoint that I didn't hear mentioned was, and I'm going to answer a question related to this, another option is to borrow rather than tap an IRA or Roth assets. If you're struggling to come up with money and still stay under the cliff because there is the option of borrowing via a HELOC or, you know, some other vehicle to bridge the gap until you are, you feel more comfortable realizing income in a different year. That's an option.

Wade Pfau: Uh-huh. Any way to cover spending without having to add to your adjusted gross income is what you're looking for in this situation.

Roger: Yeah. Yeah.

FIXED INDEX ANNUITIES WITH LIVING BENEFITS VS. INCOME ANNUITIES

Roger: Hey, Bob.

Bob: Hello. Uh, thanks for taking the time, Wade, to meet with us. Circling back to annuities for one question. In regards to immediate annuities, what is the latest research on, uh, buying an annuity that is a fixed cost or a fixed benefit, uh, going forward or buying that 2%, 3%, 4%. Ah, kicker every year.

Wade Pfau: Yeah, great, great question. So the way I approach it, I generally come to the conclusion you don't need the inflation protection through the annuity, so you don't necessarily need to add a cola. Um, that is the downside annuities, there are no CPI adjusted income annuities, so you, you don't get the inflation protection. That's often looked at as a downside of annuities. But the issue is no one's putting all their money into the annuity. A very simple example, just to use very simple numbers, supposed to meet your spending needs, it takes 4% of your assets. If you put half your money and we're just making simple numbers half into an annuity that pays at 5%, then to meet your expenses, you only need to use 3% from the rest of your investments. That will get you to the overall 4% spending goal. Now, the annuity doesn't increase for inflation, but by not trying to build in cost of living adjustments or inflation protection in makes a premium less for a given amount of income. And when I look at this with like research and simulations, one way to manage sequence risk is you just use a lower distribution rate. And so what I tend to find is by just going with the fixed annuity without inflation adjustments, that lets me use an even lower distribution rate from the non annuity investments. That gives them a stronger foundation and grow over time so that they can provide the inflation adjustments that I need for my spending. And then you can always revisit as well, you can ladder in later on. Well, one thing is just over time, we often assume spending will grow with inflation. But the reality is there's the go, go, slow, go, no go years. So even though the annuity is not keeping up with inflation, you might find it's still providing enough reliable income that you're good, you don't need anymore. If you do find you'd really like to have more reliable income, then you could revisit and layer in an additional, uh, annuity purchase at a later date. But you have the flexibility to make that decision. And so it's also, you're giving yourself more options by not building the inflation adjustment into, or the cost of living adjustment into the annuity itself. So I tend to lean more to. Don't bother with the colas. Just get the fixed annuity for the lowest premium possible for a given amount of income and then manage the, uh, inflation from the investment side of the equation.

Bob: Thank you.

Roger: One question related to annuities and buying guaranteed income. You're basically buying a pension, right? Trading money for a pension is how early should someone be if they want to do this? They made that decision. How early should someone be layering in a pension that, uh, whether it's annuitized or not, that's going to start on a certain date? I mean, is Wade buying these things and layering them out for his future wage? Should a 50 year old Wade do it or a 60 year old Wade do it? When should this actual implementation start?

Wade Pfau: Uh-huh. You can start at younger ages. The simplified answer to this is when people get to their mid-70s. That's when mortality starts picking up so that you start to see a big growth in the payout rates. Then it's interpreted as, if I wait, I'll get more mortality credits or more longevity credits from the annuity, I'll get a higher payout rate. But the reality is at younger ages, the younger you start, the more longevity credits you're getting. It's just most people are living still at those ages, so the annuity payout rates are not going to be as high. But if you're thinking of it as a bond replacement in your portfolio, you can potentially start at younger ages 40, 45, 50. Just moving some of your bond allocation over to the immediate annuity. Now, there can be value in waiting, and also if that you should think of the annuity as more of a bond. And so if buying it too early with your risk tolerance makes you not aggressive enough with your investing, that would be a reason to hold off. But if you have the capacity to move some of your bonds to annuities, and this is something you want to do, it can be done at younger ages. It's just there can also be value in waiting to just keep your options open with decisions about, uh, I might ultimately end up not wanting to buy the annuity or whatever the case may be. So there's no particular need to purchase at younger ages. But I think that you can justify, if that's something you want to do, it's perfectly justifiable as well.

Roger: And that's assuming that you're willing to give up optionality with that money.

Wade Pfau: Mhm. Yeah. You would lose, especially with the immediate annuities. That's the irreversible commitment. So you would lose optionality and then that the premium would. When you're making your own balance sheet of your assets, you could layer in. This is the present value of my lifetime annuity payments, but it's no longer on your. In your investment account statements or your net worth statements. Really?

Roger: Yeah.

Wade Pfau: Losing that money too.

Roger: Yeah. All right, Mark Trotman has a question then. I have one last question to wrap this up. Uh, hey, Mark.

Mark Trotman: Yeah, this is just a quick follow up and thanks, Wade, for that explanation. So my question is, given that, um, kind of timeline you just laid out buying an annuity early versus buying it much later, is there kind of an optimal window if it's not like a must have, but it's a nice to have, like what age would be. You don't actually need it, but it's nice to add it as guaranteed lifetime income. Would it be better to hold off until some age where that optimal kind of timing is?

Wade Pfau: Yeah, for that kind of question. That's where it's probably going to start pointing more towards like around age 75, because that's when you can start locking in that income at a much lower cost subsequently from that point. Uh, so that's probably how I would think about approaching it. Uh, something else. I was going to say that I've lost track.

Roger: Oh no, he's getting tired from his cold.

Wade Pfau: Yeah, well, it's. There's something, well, that Moshe Malewski talks about the, the idea of the implied longevity yield. It's just, what would you have to earn on your investments to justify waiting another five years to buy the annuity? And by the time you're getting to your mid-70s and beyond, it becomes, uh, M. Because the payout rates are starting to accelerate at that point, it becomes a lot. You'd have to earn a much higher rate of return on your investments to keep up with justifying delaying the annuity purchase. So that also points to once you get to your mid-70s, it's looking pretty good in terms of. It might Be hard to beat what the annuity is offering through continuing to invest and covering those expenses through the portfolio for the next five years and then buy an annuity five years later. It becomes hard to beat the annuity. The older you get it becomes the harder it becomes to beat the annuity. And uh, you really start seeing that effect becoming stronger in your mid-70s.

INTERPRETING RETIREMENT PLANNING SOFTWARE

Roger: All right, my last question Wade, because I know you need a nap and I hope you get better soon is, and this is something I'm exploring and I'm going to do an episode on coming up is there's a lot of consumer facing software for retirement planning. Golden was one of the bigger ones. Everybody in the club uses a uh, version of MoneyGuide Elite to do retirement planning within the masterclass or more Monte Carlo based. And then there's a household balance sheet as an alternative which we we've taught as well when using software and for projections to help make pretty high stakes decisions. Claiming Social Security or can I retire? How much can I spend? Do you have any wisdom of being careful and understanding what the results are really telling you beyond the words they're using like confidence and success and things like that? What are some cautions that we should look out for in how we interpret results from software?

Wade Pfau: Mhm. Well one thing that's probably good news, um, for the most part with the software you put in a spending goal and it assumes you never really deviate from that. And so if it's telling you a probability of success, and if it says 90% success rate, that doesn't mean there's a 10% chance you're going to run out of money. The reality is at some point, if it looks like you're on one of those failure trajectories, you'll probably cut your spending a little bit. And that can be a very powerful way to manage uh, the sequence of the investment risk in retirement. So it points to not necessarily needing, if you have the flexibility to cut spending, it means you don't necessarily have to target an overly high probability of success because it's really just the probability that you're going to have to cut your spending a little bit at some point.

Roger: And so that's assuming that you're putting in some discretionary spending over above your rice and beans budget. In our vernacular, Our base, great life plus wants if you have those hardwired in there, that's where there's more optionality than initially that may appear.

Wade Pfau: Right? Right. Yeah. If nothing is flexible, then that forces you to use a higher probability of success. Because you can't take that risk of having to make cuts anywhere.

Roger: So this is a question that often comes up in probability in Monte Carlo scenarios. They factor in. There are iterations that have bear markets at the beginning.

Wade Pfau: Uh-huh.

Roger Whitney: Uh, and that's captured in those thousand trials or however many trials when you're stress testing whatever the result is, you're going to stress test what happens if we have a long term care event, how does that impact the feasibility? Or if someone dies early, is it relevant to stress test what happens if we have a bad market the year we retire? Or is that sort of double counting? Because it's already factored into some of those trials, Right?

Wade Pfau: Well, it would be factored into some of the trials, but it's like you're just forcing year one. There's going to be a downturn. It's not year one. There's a whole mix of possibilities and that's going to lower the success rate. It might be interesting to just see, does having a bad market year guaranteed in year one cause my success rate to drop from 90% to 80% or does it drop to 60%? Just having some sense of how vulnerable is my plan to a big market downturn early on could be helpful information of how sensitive the plan is.

Roger: Yeah, you don't necessarily need to assume year one's definitely going to be bad. Thank you so much for hanging out. I'm sorry you're a little sick. Uh, you brought it. Even at 60, 70%, whatever percentage you're at, uh, I appreciate the work that you do in forwarding disciplined thinking on this retirement.

Wade Pfau: Thank you.

Roger: Problem that we're all trying to solve so we can still have a great life and not just worry about running out of money. Can't wait to see you maybe at the next roundup. Thanks so much, Wade. I hope you get better.

Wade Pfau: Oh, thank you. Yeah, thanks, everyone. It's been a pleasure.

SMART SPRINT

Roger: On your marks, get set. All right, we're off to set a baby step you can take in the next seven days to not just rock retirement, but rock life. Well, in this case, it's about rocking retirement. And I'm going to suggest if you are doing your own retirement planning or you really want to be empowered to work with your retirement planner that you buy. The Retirement Planning Guidebook, third edition. It is a one. If you're a super geek, you're going to read this cover to cover. If you are not a super geek, this is the most approachable version of this book and it's a wonderful reference guide. Divided by topics. So it's a great handbook to have. So that's your sprint. If you're interested in taking your knowledge of retirement planning and topics to the next level, get Wade's book. It's a good one.

CLOSING THOUGHTS

Roger: This is the time of year we try to do this every couple years to freshen things up a bit. Um, I'm, um, experimenting with different segue music at the beginning and I'm going to experiment with the Noodle Live, which I'm really excited to hang out. See how many people show up with a cup of coffee and we're just going to talk retirement and talk about the shows. Maybe I was unclear or something. Maybe you can correct my speech. So that'll be fun and so you'll hear, you'll see some things. I'm going to experiment in segments so we can keep this relevant to you because we've listened to you hopefully in the survey to make this more practical to help you rock retirement. So we'll see how it goes. Have a great day.

The opinions voiced in this podcast are for general information only and not intended to provide specific advice or recommendations for any individual. All performance references are historical and do not guarantee future results. All indices are unmanaged and cannot be invested in directly. Make sure you consult your legal, tax or financial advisor before making any decisions. This podcast may include testimonials and or endorsements.