Power 20: Wade D. Pfau

Wade D. Pfau isn’t an adviser, but he has plenty to say on how financial planners ought to rethink their approach for preparing their clients for retirement.
An incoming teacher at The American College next spring, Mr. Pfau is a firm believer in two major schools of retirement income thought. One involves the study of the optimal withdrawal rate and the appropriate allocation based on historical returns. The other is the “safety first” philosophy, which concentrates more on shielding investors from market volatility and taking defensive measures to ensure that basic retirement needs are met, perhaps through bond ladders and inflation-adjusted annuities.
“There’s a lot of confusion from people who feel connected to both views, but these views are fundamentally different and come with different answers,” Mr. Pfau said.
Real-World Research
The 35-year-old associate professor and director of the Macroeconomic-Policy Program at the National Graduate Institue for Policy Studies in Japan noted that research concepts aren’t always roundly accepted by the planning community. “For some advisers, there’s a fundamental distrust of any academic results, especially when it’s leading academics talking about the ‘Safety First’ school of thought,” he said.
But there are real-world implications to both philosophies, and Mr. Pfau expects to expound on them further in the upcoming year with new research, aiming to encourage advisers to broaden their thinking when prepping clients for retirement.
“The ‘safest withdrawal’ approach assumes that stocks are less risky in the long run and that a 4% withdrawal rate is safe,” Mr. Pfau said. “’Safety first’ assumes that stock risk rises over time and that there is no such thing as a safe withdrawal rate.”
A relative newcomer to the world of retirement planning, Mr. Pfau made a splash in 2011 when he published a paper called “Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle.”
The paper promoted the concept of using a safe savings rate — the percentage of income people need to save in the accumulation phase to ensure sufficient wealth to cover expenses in retirement — as the basis of retirement planning, rather than focusing on a safe withdrawal rate.
The idea was revolutionary enough to win Mr. Pfau the Journal of Financial Planning’s 2011 Montgomery-Warschauer Award and put him on the map in the financial advisory world.
“[Mr. Pfau] is one of those few academics who really understands what planners are looking for and tries to distill the science into something everyone can use,” said Michael Finke, a professor at Texas Tech University. “He’s bringing the full force of science to the questions with the objective of helping planners make sound decisions.”
Through 2012, Mr. Pfau has continued weighing the question of achieving a safe level of income in retirement in papers such as “Spending Flexibility and Safe Withdrawal Rates,” which he co-wrote with Mr. Finke and Duncan Williams, a financial planner and Texas Tech Ph.D. candidate. The article studied the relationship between a client’s appetite for risk, optimal withdrawal rates and the use of guaranteed income.
In another paper this year, “An Efficient Frontier for Retirement Income,” Mr. Pfau examined a different approach for putting together a retirement income strategy, this time finding a way to support spending needs in retirement while maintaining a bundle of assets either to pass on or to act as a buffer.
According to the paper, the best way to tackle that issue for a hypothetical 65-year-old couple who want to fund an inflation-adjusted annual spending goal of 6% of their assets is with a combination of Social Security and a portfolio of stocks and fixed single-premium immediate annuities — no bonds and no variable annuities with living benefits.
The Next Frontier
Building on those findings will be a primary focus for 2013, and it could present a way to combine the two schools of thought on retirement income, Mr. Pfau said. The whole concept of building the “efficient frontier” for retirement income highlights the asset and product allocations that will help retirees strike a balance in the trade-off for meeting their spending goals and having enough in financial reserves.
“[The efficient frontier] allows for some possibility that you don’t meet all of your lifestyle goals, and it doesn’t call it failure — you might meet 98% of your goals,” Mr. Pfau said. “Being able to quantify how much you can achieve helps integrate these concepts.”
These ideas are along a similar continuum of research that explores having a withdrawal rate or a range of acceptable rates that can fluctuate during retirement, based on factors such as life expectancy, according to Michael Kitces, director of research at Pinnacle Advisory Group Inc.
That’s the next frontier of financial planning research.
“There’s an opportunity there: figuring out where we should draw the lines of when it is time to make the adjustment and what are the products we use to implement that,” Mr. Kitces said.
In addition to conducting research that builds taxes into his papers, as well as the pros and cons of delaying annuitization during retirement, the lesson Mr. Pfau intends to pass on in 2013 will be to encourage advisers to be open-minded about their approach to planning and the products and investments they use.
“The general starting point is to be agnostic about financial products; every person is going to have a different situation, and there is no one solution,” he said. “It’s not the case that systematic withdrawals or annuities are the superior strategy. Advisers use these income tools to build a portfolio that manages risk for the retiree. Keep an open mind.”
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