Author Wade Pfau discusses his book on planning for a worry-free retirement.

People are living longer. This makes retirement expensive and planning for it agonizingly complex. To make matters worse, stock markets are volatile. That adds to the risk that asset portfolios may decline in value just when retirees need money the most. Retirees may also face sudden financial shocks because of illness or other unexpected expenses. How can these risks be managed over a period of 25 to 30 years?

Preparing for a safe and secure retirement requires an integrated approach, notes Wade Pfau, author of Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. In a conversation with Knowledge at Wharton, Pfau discusses strategies retirees can use to minimize anxiety in their golden years.

Knowledge at Wharton: What are the biggest worries people have about retirement?

Wade Pfau: When you’re trying to meet a spending goal over your retirement and covering your annual budget, [most people have] three main worries. The first is longevity risk. It’s this idea of, “I don’t know how long I’m going to live.” Some people will live a long time, and that makes retirement expensive. The longer you live, the more your retirement costs. You have to plan for that.

The second risk is related to market volatility. When you’re living on distributions from your assets, market volatility gets amplified and has a bigger impact. Whenever there’s a downturn, you have to sell more shares to meet your spending goal. That leaves less behind if there is a subsequent market recovery.

The third source of worry involves so-called spending shocks. Those are the potentially large expenses that may or may not happen. If they do happen — a big health care bill, long-term care events, helping adult family members and so forth — they require additional assets to cover that type of uncertainty.

Knowledge at Wharton:  You note in your book that two competing schools of thought exist about how finances should be managed during retirement. The first is what you call the “probability-based approach”; the second is the “safety-first approach.” What is the difference between the two?

Pfau: These [approaches] boil down to basic questions about retirement. The probability-based approach is more comfortable with investments and with the idea of holding stocks for the long run. This is the view that if you can hold on to your stocks for a sufficiently long time, they will generally outperform bonds. They should support more spending than just a bond portfolio could in retirement. The idea in the probability-based world is to use an aggressive investment portfolio. The baseline advice is hold 50% to 75% stocks in retirement. You fund your retirement from your portfolio earnings and also from the principal in your portfolio.

That contrasts with the safety-first approach. This includes investments like the probability-based approach, but it also leaves an opening for risk-pooling and insurance. When you pool a group of people together, you can better plan around how long the average person in that risk pool will live, and so you can support a higher spending level that way. That can become a more efficient way to cover baseline retirement expenses than just trying to rely on the stock market.

Knowledge at Wharton:  What are the pros and cons of these two approaches?

Pfau:  It boils down to how well the stock market performs. Historically it has been the case that stocks do well and outperform bonds. If there are downturns, subsequent recoveries happen quickly – and you can support a good lifestyle in retirement. Your portfolio may even continue to grow throughout retirement so that you can leave a big legacy. You can cover all your goals because typically stocks do outperform bonds.

The risk, though, is that past performance doesn’t guarantee future performance. If you get into a position where a market downturn lasts more than a couple of years, that could dig a hole in your portfolio and lead to a lower standard of living. It could make it harder to cover the financial goals of retirement. Those are the pros and cons of the probability-based approach.

With safety-first, some of the cons aren’t really cons. There’s this idea that if you use insurance and risk pooling — something like an annuity — that you’re giving up the upside of the market. The concern is that though you may get a guaranteed income for life, you will no longer benefit from stock market returns.

“When you pool a group of people together, you can better plan around how long the average person in that risk pool will live, and so you can support a higher spending level that way.”

The idea, though, is to have an integrated strategy. [With this approach] part of your assets go into the annuity, so the risk-pooling can support a higher standard of living or allow you to meet your spending goal with fewer assets. Your remaining assets, after you’ve got contractual protection to cover your baseline retirement expenses, can be invested aggressively. You can seek more upside growth exposure because your standard of living is not as vulnerable to market downturns. This integrated strategy can help you meet your spending goals and have legacy or maintain assets, as well, for other purposes. The downside is that annuities can be complicated, and there are many different types.

Knowledge at Wharton:  Do the two approaches you describe require an investment portfolio of a minimum size? Or would they work for retirees regardless of the levels of assets that they have for investment?

Pfau:  One has to be careful not to put all the assets into an annuity. For people with lower amounts of wealth, often Social Security will be enough annuity income. They may not have the resources to even consider more than that, because they do need some liquid investments. As a basic rule, if you don’t have more than $100,000 of investment assets, then Social Security is probably going to be enough annuity for you. You had better keep your investment assets as they are.

At the other end of the spectrum, often you hear that people can become wealthy enough that they don’t need the annuity. That can certainly be the case. It’s not just about wealth; it’s about spending relative to wealth. If you are able to live on, say, 1% of your assets as an annual spend-down, it’s true that you’re unlikely to run out of money. That doesn’t necessarily mean you can’t get the same sort of benefits I’m talking about. It’s just that a smaller portion of the assets could be earmarked to cover spending through the annuity, which protects your lifestyle and frees up other assets. You can have more comfort investing them because your lifestyle is not dependent on them.

Knowledge at Wharton:  Since you mentioned Social Security, I wonder what you think of a debate that one often hears. Some people think retirees should claim Social Security at the earliest opportunity. Others believe they should wait until they’re at full retirement age or even until age 70 to maximize their monthly receipts. What is better? What does the research show?

Pfau:  There can be some exceptions, but generally speaking, and especially for the higher earner in a couple, waiting until 70 is worth it. When you wait to claim Social Security at a later age, you get an increase in benefits. And if you claim before your full retirement age, you’re going to have a reduction to your benefits. The original idea was that was supposed to be fair in terms of it wouldn’t matter at what age you claimed. You’d get higher benefits if you wait, but for a shorter period of time, and it wouldn’t make a difference. But those rules were created in 1983, when interest rates were a lot higher, and when people weren’t living as long. Today, for the average person, interest rates are lower and people are living longer. It’s really in your favor to delay Social Security.

For the higher earner in a couple, the benefit is going to last even longer. Once one of the two spouses passes away, if it’s the higher earner who passes away first, that benefit gets turned into a survival benefit, and that will be provided for as long as at least one member of the couple is alive. That makes it more likely that you’re going to have at least one member of that couple live long enough that they get more benefits from waiting. There can be some exceptions, but for the most part, I think a good rule of thumb is that the higher earner in a couple or a single individual in reasonable health should wait closer to age 70 to claim Social Security.

Knowledge at Wharton:  In your book, you offer eight guidelines for safe retirement. Could you talk us through the top two or three?

Pfau: The first question to consider in building a retirement plan is how long should the money last? What age do I plan for? It’s easy for people to fall into the trap of thinking, “My parents didn’t live past 60,” or ” I’m never going to live past 65.” If that’s true, it’s easy to plan because you’re not going to have to fund a long retirement — but that’s not how retirement planning works. You have to anticipate the possibility of living to an advanced age. You have to strategize about being able to fund a more costly retirement because you’re living longer.

“As a basic rule, if you don’t have more than $100,000 of investment assets, then Social Security is probably going to be enough annuity for you.”

The other guidelines include trying to be efficient in terms of not wasting resources. That can apply to taxation, and making sure you have assets located in the proper types of accounts between taxable accounts, tax-deferred accounts like 401(k)s or IRAs, or tax accounts like Roth. You have to figure out the right way to spend from these accounts so that you’re not pushing yourself up into higher marginal tax brackets unnecessarily.

Also be realistic about portfolio returns. A lot of times you see, especially with the probability-based approach, that people assume the stock market will earn 12% a year, or even 10% a year. If you get a fixed 10% or 12% return, that makes retirement planning a lot easier. But the chances to get such returns are not as high as people think. Most retirees are not going to be invested 100% in stock. They have to account for bonds. They have to account for inflation, taxes, their asset allocations. Those are the top concerns.

Knowledge at Wharton: Given what you said about market volatility, what role should stocks play in the safety-first retirement strategy? How much of your portfolio should be in stocks, compared to, say, annuities?

Pfau: The way to approach that question is to first figure out how much of your assets should be in annuities. The rest can be in stocks. The way you look at that is to think about, “What’s my budget? How much do I want to spend every year? And how much of that would I like to have from reliable sources that don’t rely on the stock market to be able to fund those expenses?”

After that I look at my assets. Social Security is part of that. If I still have a traditional company pension — and that’s not a 401(k), but an actual pension providing a lifetime income — I add up those resources. Then, if there’s a gap — so if for example, hypothetically, I want to spend $80,000 and I have $60,000 of reliable income sources already, then I have a $20,000 gap. I would look to see how much of my assets would it take to fund that gap with an annuity. That would become — if that’s a reasonable portion of the assets — what I put into the annuity.

The rest of the assets don’t have to be in all stocks. But at that point, you now have more risk capacity. Your lifestyle is protected from market volatility, so you can invest the rest as aggressively as you want. You can have those assets entirely in stocks, but if you’re not comfortable with that, you could add in a bond exposure, as well.

Knowledge at Wharton:  You write quite a bit in the book about annuities. What is the case for and against annuities?

“Most retirees are not going to be invested 100% in stock. They have to account for bonds. They have to account for inflation, taxes, their asset allocations.”

Pfau: A lot of the writing in the book is just to explain how different types of annuities work. In terms of their advantages, or the case for them — whether it’s the simple income annuity or one of the more complicated annuities like the variable or fixed index annuity – if you add the guaranteed living withdrawal benefit to it to provide the lifetime income component, with either of those, you now have a way to fund lifetime income. No matter how long you live, you don’t have to worry about outliving the ability of that asset to fund your expenses.

The disadvantages of annuities relate to their complexity. The simple income annuity is not complex. That’s the kind where you pay a single premium, and you’re quoted how much income you’ll receive each month for the rest of your life. The complexity relates more towards what are called deferred variable annuities or deferred fixed index annuities. The reason they were created was to try to help people hold onto the assets so they’re not annuitizing the contracts. You still have liquidity, and you still have the ability to get some upside exposure through them, and you still have the ability to get lifetime income from them. But with all of those features, they can become quite complex. In addition, the fees can be high and it can be hard to understand what the fees are.

Knowledge at Wharton:  What is your view of charitable gift annuities? What trade-offs should retirees consider while deciding whether to make them part of their portfolio?

Pfau: There’s this academic concept of the annuity puzzle. Academics think annuities are great for funding retirement but the puzzle is why people don’t always want to use them. One of the explanations is about fairness. Though it’s not true, there’s a misconception that if somebody buys an annuity and dies early, the insurance company wins at their expense. That’s not really true, because it’s more about the risk pool. It’s those in the risk pool who live longer that win.

The charitable gift annuity can help to solve that sort of behavioral issue. You can frame that as, “Well, if I don’t live as long, then it’s the charity that will win at my expense.” For it to be true for the charity to win, the payout from the charitable gift annuity should be lower than from the commercial annuity, because that way they have more chance to win and to receive a charitable contribution. So that becomes the tradeoff, to the extent that they’re offering lower payouts, although that may not always be the case. I’ve heard about some cases where charitable gift annuities were competitive with commercial annuities. So you may not be sacrificing income to do that. But at least you have that psychological feeling that you are potentially helping that charity, and there can also be some tax benefits associated with the portion of that annuity that serves as a charitable contribution.

Knowledge at Wharton: How should retirees factor life insurance into their plans to buffer against the volatility of other investments?

Pfau: There is this notion that you should, “Buy term and invest the difference,” where you only need life insurance before you retire. And so therefore if you use a term policy, the premiums are lower, and that allows you to get the most savings into your investment account.

I compare that sort of approach against an approach that carries life insurance into retirement, where you have permanent life insurance, a permanent death benefit, and then I compare and contrast those different ideas looking at life insurance in four ways it might contribute to a retirement income plan.

The first is it can be a more efficient way to meet a legacy goal. If I have in mind, “This is the amount I want to leave to my heirs,” it can be cheaper to pay a life insurance premium to fund that than the alternative, which is, “I now have to spend more conservatively from my investments to increase the likelihood that I can meet that legacy goal through my investments.”

“The most important advice would be to think about liquidity.”

The second approach is that life insurance can make people feel more comfortable using an annuity, because of those concerns we talked about — the idea that if I die early, I would somehow lose out on the annuity. In such a situation, life insurance would replace that asset for the household, thereby integrating life insurance with an annuity and other investments.

The third approach is using the cash value of the permanent life insurance as a volatility buffer. So it’s a resource with whole life insurance that’s contractually protected not to decline in value. If there’s a market downturn, rather than selling portfolio assets at a loss, you can temporarily cover your spending through the life insurance and give that portfolio more chance to recover. There can be some tax advantages with doing that.

The fourth approach is simply the idea that when you consider the tax advantages of life insurance and the efficiencies of the insurance company being able to invest in a broader, fixed-income portfolio with longer maturities, more credit risk, less liquidity, the cash value of life insurance can outperform a taxable bond portfolio as a way to just think about, “Where do I want to invest my bond assets?” This would be more in the pre-retirement years.

Knowledge at Wharton: In order to retire with a sense of safety and security, people need to manage four Ls, as you describe them in your book — lifestyle, longevity, legacy and liquidity. What advice would you give retirees on how they should do this?

Pfau:  Those are the financial goals of retirement. The lifestyle and longevity are your retirement budget. Legacy is your legacy goal. The most important advice would be to think about liquidity. Liquidity is the idea that you have money to cover unexpected expenses. In a retirement income plan, to be a liquid asset, it can’t be earmarked for something else. You can’t double count assets. There’s this idea that just because you have a brokerage account with stocks and bonds, that it’s technically liquid. But it may not be truly liquid because that money has been earmarked for another purpose. If you spend it because you have an unexpected spending shock, that would reduce your ability to meet your future baseline retirement expenses. You have to be more holistic when thinking about liquidity. Your assets are only liquid if they have not been earmarked for something else in the financial plan.