Wade Pfau: How to Pick the Best Retirement Income Strategy for Each Client

Q&A September 28, 2021 at 11:16 AM

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Annuities may not be appropriate income generators for every client. But how can folks make an informed decision unless they've separated annuity fact from annuity fiction?

"Annuities deserve an equal seat at the table with any other retirement income strategy," argues Wade Pfau, professor of retirement income and director of the Retirement Income Certified Professional program at The American College of Financial Services, in an interview with ThinkAdvisor. "The whole idea that annuities mean giving up something is not true."

Whether or not to buy an annuity depends largely on one's retirement income style, the concept of which Pfau explores in his new "Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success" (Retirement Researcher-Sept. 7).

It's an all-inclusive, 450-page-plus conversational reference book that answers all the critical questions and addresses many issues that most people have never even thought of.

In the interview, Pfau maintains that there are multiple retirement income styles and that clients' awareness of their preferred style will lead to a more satisfying retirement.

The total-return approach is not necessarily the right strategy for every client, he insists.

Pfau, in fact, is co-founder of a new firm, RISA — an acronym for Retirement Income Style Awareness — to help financial advisors create clients' and prospects' RISA profiles. The company is launching in late October.

Pfau's co-founder is Alex Murguia, managing principal of McLean Asset Management and the popular blog Retirement Researcher. Pfau is founder of the latter. McLean is Retirement Researcher's sister firm.

RISA identifies four retirement strategies: total return, risk wrap, time segmentation and protected income.

Next month, Pfau is conducting a webinar series to explain how RISA can help advisors and their clients.

In the interview, he maintains that FAs who represent themselves as serving clients beyond managing their investments should help them plan for retirement in ways that include explaining Social Security claiming strategies and Medicare pitfalls.

ThinkAdvisor recently interviewed the professor, who was on the phone from Dallas. He summed up the variations in preferred retirement income styles: "Different strokes for different folks."

Here are highlights of our interview:

THINKADVISOR: In your new book, you write about the importance of determining the client's retirement income style because "no one approach works best for everyone." How are you defining "style"?

WADE PFAU: Many advisors have one retirement income style in mind: total return. That is, they're comfortable relying on the stock market as a funding source for retirement; and they want to keep as much optionality as possible and make changes in the future.

But that style doesn't apply to everyone.

It's fine to have the total-return investment-only approach if the client is comfortable with it. But that's not going to appeal to everyone — different strokes for different folks.

What's another style, then?

A lot of people would feel more comfortable not having to rely on the stock market. They want to have some contractual protection to support their retirement spending and therefore would [feel better] committing to a protective strategy so they don't have to keep second-guessing themselves or making changes or monitoring the situation.

So that would suggest an annuity as one solution. But many advisors, for a variety of reasons, don't recommend annuities. Also, annuities have a reputation for high costs and requiring a lump sum to be paid up front, which are turnoffs to many people. Your thoughts?

Annuities deserve an equal seat at the table with any other strategy that meets the style of the client. Annuities are quite competitive with the risk premium for the stock market as a way to fund retirement expenses.

A lump-sum payment is usually [required] with a low-cost type of annuity. If it's a high-cost type, [often] a deferred annuity, it won't require [that].

The whole idea that annuities mean giving up something is not true.

Why is the total-return style the most popular?

It's possible that a lot of couples' financial planning discussions may be driven by the husband, which might lead to total-return strategies.

The wife might prefer more of an income-protection style, but she's not being listened to. We have empirical evidence of that.

Since women, on average, live longer than men, would they be inclined to want to buy an annuity if their style is focused on income protection?

That's a question we're now researching in our national study about retirement income style. I hope to have an answer by the end of this year.

Would this be a good area for female advisors or male advisors working with women in particular to discuss with their female clients?

Yes, indeed. If it's true that women have a [greater] preference for contractual income and committing to a [protective] strategy, absolutely.

Advisors should be aware of that and not pitch them a total-return investment strategy.

Research has shown that widows' top concern is having enough money to live on for the rest of their lives. Does that apply here?

We find that the retirement income style of people who have that longevity concern tends to be toward having some sort of protective income as a strategy and not relying just on the stock market.

In your book, you discuss Social Security as an investment, which could be "problematic," you say. You also state that Social Security can be "beneficial" as an investment. Please explain.

Thinking about Social Security as an investment leads people to want to claim early because they don't see the insurance value of Social Security's providing benefits if they live a very long time.

But Social Security is actually a very good investment when delaying benefits rather than taking them at 62 and throwing the money into the stock market — the usual [plan] when looking at [this claiming option].

With Social Security as an investment, you need to focus on the possibility of living a long time. If someone is living into their 80s, they may be looking at the implied return of an inflation-adjusted 3% to 5% by delaying Social Security.

And if somebody is living into their 90s, it can get up to [the level of] what we think of as average stock market returns.

But when delaying Social Security benefits past age 65, people can suffer a big shock, you write, if they don't know that Medicare enrollment isn't automatic in that scenario. Please elaborate.

One of the worst mistakes that can occur for retirees is that they didn't realize they had to take action to sign up for Medicare or that they thought they had some other insurance and that meant they didn't have to sign up.

There's only one situation where you can delay signing up for Medicare, and that's when someone is actively employed — or their spouse is — by a [company] that has 20 or more employees and has health insurance from that employer.

Otherwise, at age 65, Medicare becomes the primary payer. You may have some other insurance — like COBRA, veterans' benefits [etc.] — but by law, that becomes secondary insurance; and it may not pay enough if you don't have primary insurance.

So people can inadvertently get themselves into a situation where they don't have primary health insurance after age 65.

If they don't catch that during the initial enrollment period, they have to wait until a general enrollment period, which could delay coverage for up to 15 months; so you'd be without primary health insurance for that whole period.

Should advisors make clients aware of this big potential error?

Any advisor who's providing financial planning services beyond just simple investment management should at least be reminding their clients about this because it has huge financial implications.

It falls under the purview of any advisor who's portraying themselves as doing more for their clients than just managing investment strategies.

"Social Security is the best annuity money can buy," you write. How so?

If you claim at age 70, you're missing eight years of benefits than if you started at age 62. But by starting at 70, you're getting [about] 76% higher Social Security benefits for the rest of your life. The implied payout rates are much higher than any commercial annuity.

Annuities can be effective in filling a retirement income gap if the client doesn't have enough "reliable income to meet their core longevity expenses," you write. How does an advisor broach this topic with the client?

Start with a discussion of retirement income style awareness. Someone who has more confidence in the stock market as a source of growth will rely on that because they'll think of a diversified portfolio as producing [all their needed] coverage.

But someone who has a more "safety first" mindset would feel more comfortable having some sort of contractual protection to support spending and would want to fill that gap with either individual bonds or an annuity.

Often, people don't know how much they'll potentially spend in retirement or don't have a budget in mind. Does that come under the umbrella of filling a gap?

It's more of an asset allocation question: How much should I put in stocks? In bonds? In an annuity?

Then you'll allocate part of your retirement assets to annuities in the same sort of way as allocating stocks and bonds.

At what age is it best to buy an annuity?

It's pretty reasonable to start thinking about annuities as part of a financial plan in the five to 10 years leading up to retirement.

Then, if you're still pre-retirement, you can use a deferred annuity so that you build up additional deferral within the annuity before payment begins.

Or if you want to fill a gap, you can look at that question when you're at retirement age or any point after retiring.

The House Ways and Means Committee has approved legislation that would eliminate backdoor Roth conversions as of Jan. 1, 2022. This is part of the Democrats' reconciliation bill. What do you expect will happen?

It's hard to say exactly what the final tax package will look like, but the backdoor Roth contribution may go away. That's how it's looking right now.

My book will be [quickly] updated with any tax reform changes.

In our June 1 interview, you talked about the Social Security Tax Torpedo. Please briefly review that issue.

The Torpedo is one of several aspects of the tax code that puts you in a higher tax bracket without your realizing it.

This is more an issue for people who may have a couple of hundred thousand to a couple of million dollars and not for the super-high net worth. If you're wealthy enough, you're going to be paying taxes on 85% of your Social Security. There's no way to avoid it.

The Tax Torpedo will get worse after 2026, when we're scheduled to go back to the tax rates as they were in 2017 [before the sweeping GOP-led tax overhaul].

How deeply should advisors get involved in the details of clients' retirement planning?

That's up to the advisor on a case-by-case basis. Many issues border on things that advisors don't usually do. So they might look to outsource some of it, such as long-term care options.

An advisor can decide whether or not they want to count [such areas] as part of their practice. If not, they can try to provide some resources for clients.