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The Smart Take:
Dr. David Blanchett is Head of Retirement Research formerly at Morningstar and currently at Prudential’s asset management arm PGIM. He is also an adjunct professor at The American College of Financial Services. David has been a voracious and accomplished researcher, being published in a variety of peer-reviewed articles, and receiving many ‘best paper’ awards. Today he conducts research primarily in the areas of financial planning, tax planning, annuities, and retirement.
Listen to Kevin and David do a deep dive into key assumptions made in your retirement planning – investment returns, spending assumptions, longevity, and inflation. Learn from David’s original research on retirement spending and how it is likely to decline as you age, including the positive implications it has on your planning. (Hint: you may be able to retire earlier than you think.)
Be sure to pay attention to the end where David and Kevin discuss guaranteed income, cryptocurrency, and empirical studies on quantifying the benefits of working with a trustworthy and competent advisor.
A big “thank you” to Dr. Blanchett for sharing his research and wisdom. To read David’s research, visit https://www.davidmblanchett.
Need help making sure your investments and retirement plan are on track? Click to schedule a free 15-minute call with one of True Wealth’s CFP® Professionals.
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The Host:
Kevin Kroskey – About – Contact
Intro:
Welcome to the start of a two-part series here on Retire Smarter, where Kevin interviews retirement researcher Dr. David Blanchett. In part one, David and Kevin take a deep dive into some key assumptions made during retirement planning. They’ll touch on things like investment returns, longevity, inflation, and much more. Let’s kick it off and get things over to Kevin to get today’s show started.
Kevin:
On today’s episode, I’m really happy to talk about some of the retirement evidence that belies our Retire Smarter solution. We’ve talked about a lot over the years and probably more so on the investment side than anything about the importance of having a science-based process, of having a process in general, but having empirical evidence behind it to support it. The joke that I always like to make is if you’re going to have surgery, do you want to have exploratory surgery where somebody’s going to try to figure it out when you’re cut open, or do you want to have a predetermined surgical plan from a very experienced surgeon who’s been treating patients like you for many, many years with a lot of success?
Kevin:
Today, we’re going to dive into the retirement research, and we are very, very lucky to go ahead and have Dr. David Blanchett on the podcast today. David is currently the Head of Retirement Research at Prudential’s asset management arm, or PGIM for short. And correct me if anything I say is wrong here, David, but I think previously, you were at Morningstar with the same title, so Head of Retirement Research. Very smart guy. MBA from Gold Standard at The University of Chicago and PhD from a similar Gold Standard for financial planning from Texas Tech University. I did I get that right, David?
Dr. David Blanchett:
All right. Well done.
Kevin:
All right, awesome. The one negative, sorry, I did know this from your Twitter profile, but you are a Bengals fan. I guess that could be forgiven, being that you’re in proximity to Cincinnati, but we have offices in Pittsburgh and in Northeast Ohio, so you’re probably not getting a lot of love from those areas.
Dr. David Blanchett:
Well, now, I mean, to be fair though, a long-suffering Bengals fan. It’s been a rough life for me up until this year.
Kevin:
That’s fair, and I think most people can get behind Joe Burrow. He’s an easy-to-like guy.
Dr. David Blanchett:
Yeah, he is.
Kevin:
I remember reading I think this was when you were at Morningstar, but one of the first papers that I remember seeing on retirement spending, and I just went through your historical papers here and just pulled a few of those off. I thought we could maybe just talk about those and what you found and what are some of the key implications for retirees. Some of them, Estimating the True Cost of Retirement in 2013, Exploring the Retirement Consumption Puzzle. Really intriguing title there. Can you share a little bit about the work that you did in those papers?
Dr. David Blanchett:
Yeah. I think you could argue they’re a bit dated, but I think that even today it makes sense, because retirement is the most expensive purchase that a household makes, right? I think the average cost of a home in the US now is 350K. iPhones are going to cost $10,000 at some point. But retirement is going to cost over a million dollars for most people. I think that the assumptions that we use as financial planners and even just normal households used to figure out what it costs is really, really important. In that research and even in future research, I’ve explored, well, what assumptions do you use for things like the growth of the assets? What do you use for the assumed inflation rate?
Dr. David Blanchett:
But the goal of that research is really going to ask these questions, are the assumptions that planners use in financial plans really the best that they should be? A lot of times the answer is yes, and other times the answer is no.
Kevin:
You talked about assumptions, so maybe we’ll go there for a moment. If we think about like a retirement plan, there’s maybe a few key variables, right? How much are we going to earn? What’s inflation going to be? What are we going to spend? How long are we going to live? Do you feel that any of those variables are more important than the others when you’re constructing a plan?
Dr. David Blanchett:
Well, they’re all like levers, right? When you think about the way that the assumptions, any plan, or even any model affect things, they all can move things up and move things down. One example of something that’s important, especially right now, is the fact that we’re in a lower-return environment than we have been on average historically in the US. The US has had some of the best returns, globally, over the last 150 plus years. Oftentimes, a lot of retirement planning research, and even in financial plans, you see people use historical long-term averages as the return assumptions. What I’ll often hear someone say is, “Oh, I do that because we have 90 years of history or 100 hundred plus years of history.”
Dr. David Blanchett:
My concern there is that individuals use financial plans to create reasonable expectations, right? We’re doing this exercise because we want to give someone some idea about how much they have to, for example, save or spend. A problem there is that the long-term average yield on 10-year government bonds is over 5%. Obviously, interest rates have kicked up recently, but we’re still well below that long-term historical average. I think that, for example, with respect to returns, it makes a lot of sense to make sure you’re using something that’s more forward-looking, versus a pure historical average.
Kevin:
We’re going to predict the future here and look at some of these expected returns, if you will. What do you think is reasonable these days if we just look at maybe broad asset classes for stocks and high-quality bonds?
Dr. David Blanchett:
10-year government bonds are the standard yield that people look at. I think that where yields are today is really the best guess of where they’re going to be. If I’m thinking about the next 10 years, I want to use a relatively low return assumption. Let’s just say we’re using three or 4%. Now, what no one knows, though, is where yields might be in 10 or 15 years. I’m not opposed to having return assumptions revert back to the long-term historical average, but I think it’s really critical to factor in today’s market environment for near-retirees because they’re not going to earn 5% on government bonds.
Dr. David Blanchett:
Now, if we assume that, for example, government bonds are going to yield 3%, you probably can’t assume that the return on stocks is more than say 8% or 5% above bonds. Those numbers are well below historical long-term averages. When you factor in the impact of volatility on those, it still means that you’re going to have about a 3% realized return in bonds, but the realized return on stocks drops to about five or 6%. I think that any a meaningful impact on a plan in terms of using, especially for the near-term, more forward-looking estimates versus historical long-term averages.
Kevin:
One of the things you shared, I think, is really important maybe to reemphasize, but you talked about I’ll say average expected returns, but the fact that mathematically because things vary and it’s going to be the math of compounding, right, that the compounded return is always going to be less than the average return. I think you mentioned in stocks maybe eight on an average basis. But when you factor in the compounded returns, maybe we’re more looking at something closer to 6% or so. I think this is one of those things where people sometimes forget or we have a lot of engineers that we serve, and engineers love spreadsheets, as do I, and put a return assumption into Excel, we can make some projections over time with no variability.
Kevin:
It looks awesome. Look how much money I have at the end of my plan. But that variability or… Maybe sound a little wonky here, but a volatility drag, the compounded return is always going to be less than the average return. I think that is worth repeating. One of the things that looking at this… I went back and looked at some of the historical stuff that you had done. I won’t say I’m going to call you out here, because you are in the vast majority and I don’t know if anybody really would have predicted what happened to actual returns over the last several years, but I was looking at a 2016 presentation that you did while at Morningstar and it was the best guess 2015 return expectations.
Kevin:
I certainly don’t expect that you’re going to remember this unless you’re Rain Man definitively, but would you maybe take a stab at what you would have guessed the 2015 return expectations were back then?
Dr. David Blanchett:
Probably pretty low. I’m guessing that I undershot the ball well. I don’t know if it’s that under where we are right now, given what’s happened in 2022, but probably a pretty low estimate in the grand scheme of things.
Kevin:
Oh, yeah. Bonds were… They were staged, as you said, so I’ll call them dynamic. You had them broken down between one and 10 years and then long-term, 20-plus years, what have you. But for stocks, it was basically between one to 8%, Depending on the asset class, whether it’s small stocks, large stocks, value or growth, what have you. And then emerging markets were the highest at 8%, and then bonds were a -1%. Those were the shorter-term one to 10 year. What? We’re seven or so years into right now. Candidly, I mean, from what I was reading and looking at the time, I mean, I think you were in the majority.
Kevin:
But the reason why I’m bringing this out is just to emphasize to people just the uncertainty and how difficult this is. Looking back over the last several year… Well, I tell you, when you think about those return expectations, maybe the building blocks that you would get to say having a stock expected return, not to get too wonky, but what are some of those building blocks that go into forming those expectations?
Dr. David Blanchett:
First, if it was a negative return, it was probably a real return, which is the return after inflation. Why that’s I think really, really important is what we’re seeing so far in 2022, right? You’ve got stock markets are down, bond markets are down and inflation is up. For example, even if bonds are down 10%, inflation’s up 5%, your realized return on an after-inflation basis is actually negative 15%. Thinking more about like what are the building blocks of returns, well, there is things like the expected return on the risk-free assets. For example, like 10-year government bonds. There’s also things like inflation. There’s expected growth, but those are what the pieces you tend to see are used in these models.
Dr. David Blanchett:
Now, what’s cool is… I work at PGIM, which is the asset management group of Prudential. We actually have a group that releases quarterly capital market assumptions. Our expected return for bonds and fixed income has increased dramatically for this quarter versus the previous quarter. Well, what happened? Well, bonds have gone down like let’s just say by 10%. Because they’ve gone down, that means that, if how bond mechanics work, there’s an inverse relationship between returns and yield. Interest rates have gone up. Going forward, the return on fixed income should be higher because we have a higher yield, but investors had to realize a negative return along the way.
Dr. David Blanchett:
What you tend to see out there is that the higher the markets go, especially for stocks and bonds, for example, the lower the future expected returns, but then those can correct themselves based upon maybe like a drop or an increase.
Kevin:
Right. What I’ve been telling clients and even saying on the podcast so far this year, at least to date, it seems like we’ve had a repricing of risk, if you will. Going back from those 2015 expectations and a lot of other very I would say smart, well processed people and firms had these market expectations where, hey, these are our assumptions for growth and for inflation, and here’s the risk-free rate, which is fairly easily observable.
Kevin:
But one of the biggest ones I think that impacted over the last several years was really just the change in valuation and really predicting that people were going to bid up the price of stocks as much as they did, whether it’s exemplified through something like a price to cash flow or price to sales or a smooth version of that, or what have you, but it was just pretty remarkable. I think a lot of people, the mantra was, hey, the market’s looking pretty expensive. We have to go ahead and temper our return expectations.
Kevin:
And now looking back say over those seven-year period, yeah, we did grow a little bit more than I think expectations generally were, but it was really that call it animal spirits, just the fact that people really bid up prices of those assets. Is that what you have observed as well?
Dr. David Blanchett:
I’m a pretty practical guy. I mean, I also remind myself that I don’t have that crystal ball. I mean, if I was very good at predicting market movements, I wouldn’t be in research. I’d be running a hedge fund, right? I think that to me, it’s just more of like what are the right general expectations, right? I think that no one knows what’s going to happen, but we have to take that best guess of where things are headed. That being said, I’ve been shocked at where rates have gone in the last say three months. I have no idea where they’re going. I think lots of folks could say they’re doomed to increase, or they’re going to increase.
Dr. David Blanchett:
Others would say that they’re going to fall. I think that the key is just having a plan to understand, well, based upon where things go, which no one knows what’s going to happen, this is what you’re going to do.
Kevin:
Yeah, no, I completely agree. One of the…If we circle back the assumptions that go into a plan, so returns, which we just talked about, spending, which we haven’t gotten to just yet, longevity, inflation, you mentioned. If we circle back to spending and some of the research that you did about those spending patterns, what were some of the implications or just some of the observations, as well as the implications that you gleaned from the research back in like ’13, ’14?
Dr. David Blanchett:
I’ve actually done quite a bit on this since then. It’s still very much current. Others have done a before and after, but I think one of the most important takeaways was just this notion that almost every retirement research project out there and the vast majority of financial plans assume that retiree spending increases lock step with inflation every year and doesn’t change no matter what happens. That’s not very realistic, right? I mean, the first thing we observe is that retirees actually don’t increase their spending by inflation. I mean, literally, in these models, it almost assumes that inflation for a given year was let’s just say it was 4.1%. But the next year that retiree household spends 4.1% more.
Dr. David Blanchett:
They literally call their advisor and say, “Hey, I need a 4.1% raise.” In reality, what you see is that retiree households tend to actually reduce their spending by one to 2% a year versus inflation. If inflation is say 4%, they only increase their spending by say 2% in the next year. That can make a really big impact on the longer-term implications of how much someone spends. Because if that number’s dropping by say one and a half percent in today’s dollars every year, that can really add up over the span of say 20 or 30 years. Now, the one interesting kink to it is, is that if you’re still alive when you get to these older ages, say 90, 95, the median person actually continues to see a decline.
Dr. David Blanchett:
The problem though is the average increases because of the… The average is if you add up everyone and divide by the number of people, it actually starts to rise again because some folks have effectively incredibly expensive medical costs. What you observe looking at this relationship, in general, is this thing that I call the retirement spending smile, which is just that spending tends to decline in today’s dollars early on in retirement. But if you’re still alive at older ages, say 90-95 plus, there’s a decent chance you might actually have increases in your spending just because of medical costs.
Kevin:
Okay. Yeah, that’s great. There’s a lot there. I’d like to unpack that a little bit. I guess said another way, let’s say that I’m 62. My wife and I are retiring. Whatever our lifestyle was at age 61, it’s going to be pretty similar to age 62 on average, assuming that we are that average 62-year-old married couple. I’m curious, as you peel that back a little… Well, two things initially. Can you just share about like how do you actually… What sort of data sources do you use? How do you actually arrive at these observations? And then also, I’m curious about like specific maybe spending categories that may really change over time.
Kevin:
I know you mentioned healthcare towards the end of the lifetime, but how do those spending categories when you peel the onion of spending back, how do those change going through the sixties, seventies, eighties, nineties?
Dr. David Blanchett:
There’s like a really fun model that came out probably 20 years ago about this idea of the different phases of retirement. You actually see this in the data. When I’m looking at data, there’s a study called a Health and Retirement Study that’s been done ever since 1992. It’s biennial, where every two years they go back and ask the same people like a thousand questions. I don’t know how they get folks to actually participate in the survey. But what it allows you to do is track the households over time to see like how they’re changing. A lot of surveys are what’s called cross-section where you just ask one group of folks the question once, then a new group of folks the questions at some point in time in the future.
Dr. David Blanchett:
The fact that you can track the same households over say a 20-year time horizon really lets you understand better the decisions that retirees make over time. I think that’s a really important. It’s been a huge benefit for individuals that do research on retirement. I would say that most academic papers that are exploring retiree decisions over time are using what’s called a Health and Retirement Study. Now that being said, your second question is there are some interesting changes in how spending evolves over time. If you were to ask the average retiree, “Hey, how do you think retiree spending changes over time,” if they didn’t think about it, they would say, “Oh, well, my guess is it rises faster than inflation,” right?
Dr. David Blanchett:
The reason that I’ve actually gotten that response is because people say, “Hey, I know that individuals, as they age, spend more on healthcare. Everyone knows that healthcare spending has risen faster than base inflation. Therefore, it would stand a reason that individuals spend more over time, right?” But in reality, what you see is that while individuals do devote a larger share of total expenditures towards healthcare expenses, they spend a heck of a lot less than on everything else. What you have is a situation where if you’re a younger retiree, you have the capacity and the desire to go out and do stuff. But over time, that desire to go on the cruises, the vacations, whatever, declines at a pretty sharp rate, especially if you have healthcare issues.
Dr. David Blanchett:
When I talk about assumptions to using a financial plan and the fact that spending has declined over time, what I’m really trying to do is help people understand how to best utilize their savings, where it actually might make sense to take that vacation or that cruise when you’re a younger retiree, say 62 or 65. Because odds are, if you’re still alive at say 90, you’re not going to do that same cruise, have that same expense.
Kevin:
Yeah, no, that makes sense. In practice, it’s one of those things too where usually it takes I think a little while just to be comfortable with that transition. There’s always… I don’t want to say always. Absolutes are never a good thing, I guess. But generally, maybe a little bit of transition skepticism, I would say, where yeah, sure, people want to do things, but it… Well, I’ll say it another way. I’m surprised at how often we’re nudging people to spend. I think they’re just as surprised that we’re nudging them to spend. In practice, the spending behavior has become ingrained over time. They’ve continued to do well, save earn, invest, and maybe had reasonable returns and their wealth continues to create over time.
Kevin:
And then they’re in a completely different financial paradigm, but they still have the same ingrained spending behaviors. It’s just one of those interesting sort of catch-22s where the same behaviors that cause them to be in the very envious position financially that they’re in are the same that pretty much preclude them from maybe doing a little bit more and enjoying a little bit more. Curious, do you get into the behavioral aspects at all about helping people spend and consume and enjoy things a little bit more?
Dr. David Blanchett:
I think that’s a really great point because I’m not going to say that financial plans are like fear-based, but it always focuses on one risk, which is going broke at some point in older age. That is a risk. I totally agree with that. But what often worries me too is the other risk, which is I worked for 30 or 40 years to save for retirement. I’m so afraid to spend my money, I don’t enjoy it. I think that what that takes is realistic perspectives on how long you have to plan for what you have to do. Maybe this is somewhat counterintuitive, but the more money that people have in guaranteed lifetime income sources like social security, the more that they tend to spend because they’re less afraid of going broke.
Dr. David Blanchett:
I mean, it is so hard to figure out how much you can spend from a portfolio when you have no idea how long you’re going to live. I think there really is at least an academic argument there that it does make a lot of sense to simplify that equation by allocating potentially more than the average person does to some form of guaranteed lifetime income.
Kevin:
Yeah, that’s great. I definitely want to go there. I guess before we move on from the spending part though when you look at the data, do you observe differences between say high income or high spenders or low income and low spenders? And if so, what are those?
Dr. David Blanchett:
Well, the interesting thing is that there’s a few effects here. One question that I got a lot was that “Oh, David individuals spend less as they age in retirement. Is that just because everyone’s broke? Is that because people realize that they can’t afford to keep spending?” And if you actually break out the different households and the different groups based upon what they spend and how much they have, even the folks that have lots and lots of money tend to reduce their spending on average. It’s not an effect, one, where people are just so broke, they can’t afford to spend more, so they have to spend less.
Dr. David Blanchett:
The second thing to your question is that you do tend to see smaller declines in smaller reductions among those who have lower overall spending levels. If you think about it, you’ve got someone that spends say $25,000 a year in retirement. A lot more of what they’re spending money on is non-discretionary. They have less room to cut back if they want to. But someone that’s spending say 250K in retirement a year, a lot of that probably won’t be there when the person’s 95 years old, because it’s more things that are leisurely or non-discretionary that they can cut back on if they want to.
Kevin:
Yeah, no, that’s great. I think that sort of framework between, whether you call it discretionary or non-discretionary or needs or discretionary or some form of that, that framework in practice and working with people, just, one, everybody’s different. Some people will put charitable goals in the non-discretionary or the needs. Others will put it a little bit lower down the totem pole in rankings. Everybody has a little bit different priorities in life. But just to sort through those priorities, one, I would say first to really truly measure their lifestyle.
Kevin:
Candidly, that’s probably the most difficult part of the whole financial planning process, at least getting good data and then massaging the data and throwing out any true one-time extraordinary expenses and really deducing what that lifestyle is. Sure, we have some technology that’s starting to make that better over the last several years and we’ve availed ourselves and our clients of it, but you still have to clean up the data, make sure things aren’t double-counted, throw out those one-time expenses, things like that.
Kevin:
But then after we have that, just to have the client sort of frame it with their own values and in their own terms what is truly a need and is non-negotiable is non-discretionary in those things where, “Hey, if things don’t go maybe the way that we hope, we can go ahead on a predetermined plan. This is where we’re going to cut them back from.” That sort of mental accounting or that framework, I haven’t seen any studies on.
Kevin:
I’ve certainly seen studies about mental accounting, but it just really seems to help people, particularly in times like we’re going through now when the markets are down and maybe they see their success rates or safety margins or funded ratios or whatever we’re using to measure their financial planning success likelihood, it just really helps them practice to go ahead and do that.
Walter Storholt:
That concludes part one of our conversation with Dr. David Blanchett. If you have any questions at all for David or especially for Kevin, you want to talk about your financial or retirement plan, a great way to get in touch is to go to truewealthdesign.com. You can click the “Are we right for you?” button to schedule your 15-minute call with an experienced advisor on the True Wealth team. Again, that’s truewealthdesign.com, or by calling 855-TWD-PLAN. That’s 855-TWD-PLAN. We’ve put that contact information in the description of today’s show so it’s easy for you to find. Join us again in a couple of weeks when we release part two of this conversation, where David and Kevin will get into a couple of additional topics.
Walter Storholt:
They’ll be talking about Monte Carlo simulations and their role in proper planning for your financial future. They’ll do a deep dive on guarantees in retirement income planning, things like annuities, and that family of the investing and saving world, and they’ll touch a little bit on cryptocurrency as well. All that and a few other topics on the agenda for part two. Come back and join us for that. For Kevin and David, I’m Walter Storholt. Thanks for joining us and we’ll talk to you next time on Retire Smarter.
Disclosure:
Information provided is for informational purposes only and does not constitute investment, tax, or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.
