David Blanchett: Regret Optimized Portfolios, and Optimal Retirement Income (EP.254)

23:16So if I can't trust the default savings rate, I can't trust the default investment. When you have higher default savings rates, you actually encourage more individuals to just go with target date funds. So there's tons of evidence now. So like the problem though, to be clear, this was a full data set, but like most plans weren't going over 6%. And 6%, in my opinion, is still pretty low. And so what I hope to do at some point, it could take five years, is to do a refresh of the data when we have a lot more plans doing 8%, 10%, 12 % as default investment savings rates in 401k plans. So it's pretty clear, like three versus six, six is a no-brainer, but we already kind of knew that.

23:51I think the next step is when we move beyond six to eight, 10, and 12, how at some point things could drop off or change. Absolutely fascinating. So it's well known that investors chase attention grabbing assets. So what should financial advisors, like should we be catering to or moderating in some way the risk of regret? You know, I think my opinion on this has probably changed over time. I feel like a decade ago, I'd have been like, quiet you. No, you're not allowed to do that, right? Because I could be like, oh, you know, we know what's going to happen. But I think that what that doesn't acknowledge is how people will respond and what it can mean for that relationship if that asset does well.

24:26Like, let's call it a coin flip. Let's call it less than a coin flip. There's like a 30 % chance or 20 % chance it does well. And then the entire time the person's like, why did I listen to that advice? Like that was terrible advice. Right. And so I think to me, this is, it's just acknowledging these behavioral aspects of investing. I mean, if I were a client, I'd be like, I don't care about crypto. I just want to have a good portfolio. And I think that's how a lot of people are. Other folks would be like, you know, I follow this stuff. I love reading about it. And so I okay, this is important to you.

24:58Just to be clear, I think it belongs in a well-managed portfolio given the uncertainty. But I think no one knows what's going to happen and it wouldn't kill you to allocate a portion of your assets to it. We have to acknowledge it could go to zero. But if that makes you more comfortable saving, investing, and doing things, I think it totally makes sense. And I think that's a different perspective than even I would have had 10 years ago because I wouldn't have acknowledged the more behavioral aspect of investing as I'm increasingly focused on. Does it then make it harder? for the investors to choose a financial advisor?

25:29Because then you're kind of doing some sort of regret selection mechanism for the advice you'll be given? I mean, from my perspective, it's giving the investor permission to invest themselves in these things that they're passionate about. So I think that there's still areas for advisors to add a lot of value, to understand these assets, understand if someone's going to buy them, where and how they should buy them, checking in with the investor. So I think if anything, it gives the advisor a unique way to have a more meaningful conversation about investing. And what we've seen usually happen here is these don't tend to go well.

26:01A lot of these speculative assets tend to do well for a while, and then they tend to crash. And so I think that you don't want someone to fail, but having had that conversation with an investor, setting expectations, limiting their overall allocation to it, and then if the person experiences that eventually will decline, that's created kind of a really good way for them to have that relationship. But maybe it does, maybe it takes off. And you can even say, hey, I never would have thought this was going to happen, but this is why you hold a little bit up. I wouldn't necessarily recommend allocating more, but I think what it does is it gives a way to kind of have a more meaningful conversation about investing than just like, hey, this is the market portfolio.

26:39It's mean, very efficient, all that. Yeah, that's really interesting. We've had a lot of conversations like that over the last 10 or so years where we'd explain, listen, this is a highly speculative asset. The rational thing to do would be not allocated to it, like the mean variance approach or similar. But then we've given the explanation of the range of regret outcomes. If this thing does go to which of the moon or if it goes to zero, and we've seen people make decisions on that basis with that framework. And I think overall, it's been a pretty good decision-making outcome. Even if the financial outcome was the speculative asset did tank, I think people going into it with their eyes open, kind of like the way you've explained your framework is pretty successful.

27:16Do you agree, Cameron? You've observed the same kind of thing as me. For sure. Absolutely. Instead of just saying, no, don't invest in this. It doesn't make sense. It's like, here's what a rational model would predict, or here's what a normative model would predict. Here's why you might not do that in real life. But it also depends on who's driving the choice of that asset. Are people looking for the advisor to help them choose the regret asset or not. They're choosing on their own because they have a passion about crypto or a particular stock or something else. But you're saying, David, to go and do it on their own.

27:50Come with that choice, then acknowledge the regret decision around that asset choice. As opposed to saying, Ben, give me a long shot investment. That's why I wanted to ask David, which we did, how do you choose a regret benchmark? Because I don't think we can define it. I think we can't go to clients and say, you might regret not holding, you know, Ethereum. No, and I wouldn't recommend like, you know, walking, hey, there's like 20 things you could own. Which of these do you want to, I think it is more self-awareness of the investor. Like, you know, like which things, you know, I mean, investing in diversified multi-class portfolios is super, super fun.

28:23But like, are there other things that you're passionate about that you think have potential that maybe we're not going to own? I mean, yes, if it's individual stocks, are going to own those, but a small portion, maybe they think that biotech is the next greatest thing. And so then as opposed to crypto, it's biotech stocks or it's something else. And I think that it takes their preferences to know that. I mean, what you obviously don't want to get blamed for is not owning whatever does well, but as long as you kind of check that box, like, hey, do you have any things that you're really passionate about that you think could do well, that you want to trade more frequently in?

28:53And if so, then this is how you do it. Again, to me, it's just versus just saying, no, we don't do that. We don't recommend it. Own this portfolio and just leave me alone. Do you think the source of a lot of that regret is kind of story driven? Like my friend was invested in this or heard about this at a certain event or geographically, perhaps, like if you're from a part of the country, might be more oil and gas dominated or tech dominated or crypto dominated or whatever it might be. Well, I mean, hindsight's 20-20. I mean, like people don't talk about losing money and things, right? You know, like it's only the good stocks they bought or the, you know, they got in early on crypto or all these things.

29:31I think that that's just, that's just the nature of people, right? I mean, people don't tend to talk up their failures that they talk about their successes. And so, and you see this when you have assets that have done well, like when Bitcoin, the Superbowl a year and two, three months are like, that was the peak, like the floating QR code. I mean, you have this awareness in the media, I think, and that's where it becomes a lot more salient. And so, I mean, and I don't know that there's always just one thing when this happens. I think it's just certain circles, to your point, you could live in an area that's got a lot of folks to do oil and gas.

30:00And so that's the thing. There could be rental properties. There could be lots of different things. And obviously, some are easier to own than others. I mean, rental properties, that is a whole different ballgame. I think that's not what I'm thinking about in this. It really is where things that are kind of marketable type securities or investments that are easier to buy and sell and transact. Yeah. Just on having people around you doing something that might increase regret, the closeness to a counterfactual is one of the biggest drivers of feelings of regret. So instead of thinking about an asset that you might buy, if you're thinking about an asset like employer stock that you'd already own and you're making the decision to sell it as opposed to how much to sell as opposed to the decision to buy, that's as close as it gets to having owned that asset.

30:43Yeah. In that regret framework, that's even more interesting. I don't have as much as I used to, but I had tons of people that asked me about cryptocurrencies and they bought them and they made all this money. And there's all the social media stuff now. So I think the closeness and connectivity is a lot more real than it used to be. If in the past, we go back decades, you'd only really hear about people making tons of money in the newspaper or at a random party. That didn't seem very real. But when it's your connections, your circle that's talking about their winners, all their winners, and you didn't get it, it just becomes, I think it's becoming more of an issue because it's so much easier for individuals to communicate what they're doing to their closest friends instantly, right?

31:23We didn't have this as easily decades ago. We do now. And it's likely going to get worse. I mean, I think that we're going to become more connected. And so you just need to be, I think, more aware of, I mean, FOMO is a thing, right? This is related to FOMO. And this is just one aspect of FOMO that's for investing, not just other social experiences. Crazy. FOMO is a thing and one of the other big ones is social comparison. That's another big behavioral driver or happiness driver. All your friends get wealthy buying Bitcoin or whatever, then you might feel terrible. Okay. That discussion of regret was fascinating.

31:55Can we move on to your other recent stuff on optimal retirement income strategies? Sure. Excellent. What are the downsides of modeling the retirement liability as a single constant inflation adjusted amount? I'm going to get geeky here again. Do it. Do it. Love it. you know, I'm going to write a piece soon of the 1990s want their key assumptions back. Okay. And the point is, is like, so all the early research in retirement was like 1990s, like Bill Bingen was 92 or 94 and like, you know, more stuff. But like, if you look at the tools advisors are using in the assumptions, they're mostly identical.

32:27And I don't know if everyone knows this, but we've gotten a bit more powerful computers up there now than we used to have, you know, 30 years ago. But like the key assumptions in our financial plans are mostly the same, which to me is a bit disappointing. And so, for example, most research and the vast majority of planning tools assume that the retirement income goal is effectively a static number that increases every year by inflation. It's a single value. Well, that's nuts. In reality, people's expenditures have different levels of elasticity or flexibility. I'm going to make changes as the portfolio evolves.

33:03And incorporating these rules into a projection can really affect the outcome. And I've been talking about this for a decade. Advisors always say, well, David, that's what I do. I go in and I work with clients every year to tell them what they can afford to spend. And I'm like, well, that's spectacular, but here's the thing. If you account for a dynamic process in a model, it changes your advice today than just doing it over time, right? So if you can model the fact that you're going to make changes as changes are warranted, it actually changes what you should have done 10 years ago. To me, the goal behind the research was just in the Financial Analyst Journal is to kind of lay out a framework that I think better addresses reality in any kind of financial plan.

33:43I totally acknowledge it's like a hot mess of assumptions of like 50 years and all this stuff, but you can get radically different outputs, I think, using just more realistic assumptions around things like outcomes metrics around like spending and stuff like that. Why is it important to understand the composition of retiree spending as opposed to having that single spending number? So like utility is how economists quantify preferences. I think about utility. So Monte Carlo is a model that incorporates randomness, right? That's how most advisors today, when they do a financial plan, that's what it is.

34:15So the utility function in a Monte Carlo analysis that uses static projections and success rates, it's binary. It's ones and zeros. Okay. So did I accomplish my goal? I get a one or I get a zero. I get a one, I get a zero. So the problem with that is that a dollar short is a zero. Okay. There's no notion there of if I fail, how did I fail? Right. But in reality, and this is where things get a bit more complicated is that if I don't achieve my quote unquote goal, let's call it a hundred thousand dollars, what I can't do is going to have a huge effect on how I feel. Right. If I can't pay for my house, my healthcare, my food, I'm going to be really, really angry.

34:51Okay. Like If I have to wait a year to buy a new car, I'm upset, but I'm not really angry. And so I think understanding the composition of the spending goal, and then if you don't accomplish it where you are, is just important. Because let's say that all of your essential expenditures are covered from guaranteed income. You've got the defined benefit plan, you've got a public pension, whatever. Well, then a shortfall might not be that big of a deal. I can just adjust if I need to. But let's say that you have very little of your needs or essential expenses covered with guaranteed income, then all of a sudden a shortfall is more painful.

35:23I think if you don't really understand what you want to spend money on and what the flexibility is, and you do a traditional projection, you're going to get an output that might not reflect how you would actually feel across the different outcomes. And when you look empirically, what portion of retiree expenditure is elastic versus inelastic? 70-ish is the average, but there's massive differences. So you can look at this using expenditure data. I've done a bunch of surveys, you know, and like one of the surveys I asked all these people, like the main expenditure groups in the consumer price index in the US, it's like a consumption stuff, you know, like it food at home, food away from home, transportation, you know, an individual's willingness to cut back on those expenditures, right?

36:04No one wants to cut back on healthcare for the most part, but like there's some people will cut back on healthcare, but will not cut back on leisure activities, like vacations. That is so important to them, right? And so to me, like the key with this is that yes, there's our clear relationships where on average individuals who spend more tend to spend more and more on things that aren't essential or necessary. There's more choice there, but everyone is different. To me, you can generalize and I could say 70%, but what I would say more is it takes understanding what you spend money on, what you derive utility satisfaction from, and then figuring out how to do that in a financial way.

36:39Can you talk a little bit more about the district? What drives the differences empirically? You You mentioned higher expenses tend to be more variable. What else is there in there? So again, this is so hard to measure. And I've done it like two ways. One is just to observe expenditures. You can do this in, there's this called the health and retirement study. You can look at how individual expenditures, you know, towards not only like what they are, but then how they evolve over time. And you can ask them questions about what they perceive to be inflexible or flexible. I think to me here, just like the number one key is just moving away from a single static number to anything that somehow incorporates this notion that, okay, half of what I'm spending money on, I would not want to change.

37:19Other half I'm willing to. And then seeing how that maps out over time, because the biggest thing here is that a lot of Americans, a lot of retirees have a lot of their needs covered from guaranteed income. And so it dramatically changes what you should be doing in terms of investing their portfolio and funding retirement, because it's the once or the more flexible expenses that the portfolio is funding. And that's just not how we model retirement. A lot of the models that people use for retirement are from the pension space, like LDI. LDI is built in this framework of a hard liability. Pension plans, they have to make that payment every month, every year, hard stop.

37:57That is not going to change. People though are very different. So when I think about building portfolios for retirees, it's more like liability aware investing where you know the liability is there, you have to acknowledge the flexibility. The moment you introduce flexibility into the process, it just really changes anyone's perspective on what are the right decisions around retirement age, spending, saving, all that. Yeah. I got to give a shout out to your paper on that topic on liability-driven investing for individual investors. Fantastic paper. Such a good way to think about, well, basically what you just said, trying to model liability matching for households.

38:30It's just like, it's kind of crazy. I think it's a useful exercise to think about, right? It's useful. No one saves in their 401k because it's fun. I'm not like, oh, I'm going to sock away 20 % a year because it's fun to not spend money today. You do it to fund a goal, right? And so I think that the aspects of that goal should fundamentally drive the portfolio, especially as you get closer to that goal, right? The problem is, it's like a lot of famous economists have like these models that say, oh, retirees should invest all of their money in like inflation adjusted annuities. Well, you can't buy those, right?

39:00Or you should buy tips. Well, like, oh, assumes that retirement liability is like totally fixed to inflation. Well, it's not, right? And so like you're assuming that someone would never invest in equities because they're just super conservative. Well, there's a benefit to invest in equities over the long term. You have a higher return. And so most investors don't own all bonds because they say, hey, there's a compromise here. I'm willing to accept some risk for a higher expected return. In retirement, I'm willing to accept some flexibility for not having to put all of my money in cash. And so I think that acknowledging the trade-offs people make in real life, which you can make in a household, you can't make in a pension, can lead to, I guess, a very different perspective on, again, that kind of optimal portfolio definition.

39:39Yeah, the perfect hedge with tips is such a good example. And it's not just the discretionary expenses like we've been talking about, but you've got work also on how expenditure changes with relative to inflation over time. So you don't necessarily need perfect CPI adjustments for your income. Right. And so like all these models, you know, like most financial plans today, like they assume the retirement liability increases every year by inflation. OK, well, on average, and this is somewhat country specific because there's things like health care that kind of wreck the model. Like, you know, most people, as they get older, they don't tend to increase their spending by inflation.

40:10They just tend to slow down. Right. In the U.S., there's this interesting effect where I talk about the spending smile. Well, like the latter part of the smile is are these few households that have these like massive health care expenditures. If you run a regression on anything, outliers can really affect, the average and the median can differ significantly. That's what happens later on in life where the average gets pulled back up because you have a few folks that have these big expenditures. But for most people, there's this constant decline in today's dollars versus inflation. Let's say that inflation is 3%, and at least 1.5 % more per year.

40:42Well, here's the thing. If your public pension benefit is indexed to inflation, which most of them are, it actually reduces the inflationary needs of your portfolio. So the efficacy of things like tips or inflation-backed bonds changes when you kind of acknowledge the structure of liability and how it evolves during retirement. I know we've got one listener that does think this, so I want to ask you the question. Do you think any of that smile is driven by people running out of money and not being able to spend as much? Half, yes. And I don't think we have a retirement crisis. We have a retirement savings crisis.

41:12Developed countries have, for the most part, a really good public pension system. Old folks aren't living on cat food. Like, you know, things are pretty good, okay? But even if you look at some of the research, I've done this multiple times. What you find is that, yes, some people are cutting back because they have to. You can put them into groups. You can say, OK, this group, these people have tons of money. They have too much money. How does their spending evolve versus, say, the folks that don't have any money? People that have no money, they cut theirs a lot faster. But even the people who have tons of money, they still tend to cut, especially as you move past 70, 75.

41:47And I mean, I would say that anecdotally, like I see this with myself with my grandparents. I mean, sure, there are going to be some folks that want to go out and stay active. But I think a lot of people just don't want to do as much as they age. And so I think that's what you're seeing here, which is just that people don't tend to increase their full on spending by inflation every year. How did you set up your dynamic spending rule in your recent work on this stuff? So I've spent about maybe 10 or 15 years looking at dynamic spending rules. And here's the thing. So the vast majority of research out there, great research, it would never actually work in a financial planning software.

42:22Okay. And there's two key reasons here. Okay. One, there's like dynamic programming, which is like really cool. It like solves every possible state and tells you the answer. Well, that stuff can take like five minutes to do a financial plan. And let me tell you, in my experience, nothing angers a client more than you pressing a button and you say, oh, just wait five minutes. And then you get like the bad answer. Oh, I'm going to change this assumption. We're going to wait five more minutes. Like that's not going to work. To me, it's like five seconds or less. So that's why I think the most robust way won't work today.

42:49It might when we get to quantum computing, but right now, not a viable solution. There's lots of rules that exist. The problem with the rules is they're usually based upon a portfolio that exists with no uneven cash flows. So what happens if you retire at 60, you claim your public pension at 65, your wife retires at 70, you have a deferred income that kicks in at 85? Okay. That'll break the vast majority of existing dynamic rules to figure out safe withdrawals. Okay. So what you have to do to actually have this work in a financial planning software is to have a line of sight into all assets and liabilities, all income coming in and all outflows going out across the entire length of retirement.

43:27And how you can do that is a metric called the funded ratio. Okay. It's really common in pension plans. It's just, you know, the assets, like your portfolio, net present value of other inflows, like public pension benefits, whatever, over all your spending goal. And the idea is that you estimate that within a money color projection every year of every run. And based upon that value is how you would adjust the previous year's spending goal. So for example, in the first year of retirement, the goal is based upon the individual, the retiree, but then how that changes in the model over time would depend upon how that funded ratio evolves as you move through retirement.

44:01So if the funded ratio is high or increases, you can spend more. If it goes down, you'd spend less. And I totally acknowledge that life comes to you fast and what's going to happen. But I think like the goal there is just to say, hey, you're probably going to make changes over time based upon how things go. This is a way to model that and then give you context around the possible distributions of outcomes, right? So a static model, you have like all your gold and you fail. It just waterfalls off to nothing. This is like a tulip, right? Where you show like a distribution of income levels over time, which is I think a better conversation that's assuming that like, you know, oh, you're not going to make a change if your portfolio is going to zero.

44:37Yeah, I love that. Well, why do you think we haven't seen more dynamic spending rules in, I mean, you touched on it just now, it's hard to do, but I mean, there are smart people working on these softwares. Why do you think we don't see it in? I don't know. Like we have, in my experience, seen a large pivot towards advisors using Monte Carlo type tools. So like, I would argue there's like deterministic tools where you just have like a single run, a single assumed growth rate. You know, that's probably, when I do surveys, less than 20 % of advisors, right? I would argue that probably like, those are like the tiny advisors, like the big advisors that are doing like with bigger clients.

45:09A lot of them are doing some kind of like Monte Carlo stochastic analysis. And so I think that these companies are in the business of building better tools, but this isn't things that advisors have ever been like demanding. They don't know how this stuff works. I mean, you know, like they want to talk about their 78 % success rate. And I think that that's absurd. Like you shouldn't tell a client a success rate. Why? That doesn't help them make better choices. But advisors want to quantify this stuff. So I'm going to be on the soapbox yelling for the next few years, but it's the people that build these tools that need to build better tools.

45:38Advisors are not going to be software engineers. Some are. More props to you. But I think what we need is just a way to awareness of some of the key pitfalls and the existing tools and solutions, and then have the giants in this business build these. And I know that some are. I know that some are already doing this. And I think the good news, hopefully, is those that do it early get market share. It then results in other tools that exist to acknowledge this is important and figure out how to do it. This isn't top secret. If you read the paper, I've literally walked through step-by-step exactly how you can do it in a way that I know for certain can be done very quickly in a Monte Carlo projection, and it can give you useful outputs.

46:17And so I think where previously, well, how would you do this? How do you actually figure out how to make the adjustments that works in the context of projection? There are questions there. I'm sure there's other ways to do it. And I am certain that if you use the process I way out, you can do it using existing tools. The demand side is huge though. There are a lot of advisors that are still not using, in Canada at least, that are still not using Monte Carlo even. Conferences are very biased, right? People that go to conferences are like the best. Even when we do like, we've done surveys within PGMI where I work and we get about 80 % of advisors that answer the surveys consistently using Monte Carlo.

46:51So I think it really has kind of caught on as the framework to do financial plans. And I just said a piece that came out recently in advisor perspectives. And some advisors get all like bent out of shape about Monte Carlo because they're like, oh, it requires normal return distributions or uses a store for them. I'm like, no, like there's actually nothing inherent in Monte Carlo like whatsoever. It literally just means you have something that's random in your projection. Like the rest of it is totally up to you. And so I think what I want to, you know, what I try to like correct people on that kind of those shade on the idea is like, your tool might be crappy.

47:22you might have a crappy calculator. That doesn't mean that all calculators are bad. What you need is a better calculator. I think that advisors don't understand the fact that, yes, we built all the models in a similar way, but there's actually infinite ways to do them. I think the goal here is that we just have tools that offer a more robust modeling environment than exist right now. You talked earlier when we started this segment about the binary outcome that Monte Carlo gives you that it's like success or fail. How do you describe the utility metric that you use in this paper to evaluate retirement alternatives?

47:55So, you know, again, like Monte Carlo, it doesn't have to be binary. So like success rates are binary, right? Success is either you do or you don't, right? Ones and zeros, okay? Academics who do research in retirement, the good ones don't use success rates as their outcomes metric. They only think about like the full continuum of what it means to accomplish a goal, right? It's not a one or a zero. It's like a 0.9 or a 0.7 or a 0.6 or a 0.5 or a 1.3. So just real simply, as opposed to saying, did I accomplish my goal one or zero? I could say, well, what percentage of my goal did I accomplish? And that would be between, let's just say zero and one.

48:30Let's say you can't overrun a goal. So I got 90 % of my goal. So all of a sudden, that's a full curve. It goes to zero to one. It's not just ones and zeros. On top of that, you could further adjust the numbers. You could say, well, if it's 0.9, I'm okay with that. But if it's 0.3, I'm going to get really, really angry. So I'm going to make that like a 0.1. Okay. Then the key is how you aggregate them. And so, you know, I talk about this and the guys like David, like this is so complicated. Like, like advisors want to say this. I don't think they should. I don't think that with an industry, we should be showing clients numbers about outcomes in 50 year projections, right?

49:02All you're trying to tell someone is, are you in like really bad shape? Are you in bad shape? Are you in pretty good shape or really good shape? Like I'm not going to name the company, but let me add a hundred thousand Monte Carlo simulation. And I'm like, I'm like, what are you doing? It, maybe it's, it sounds cool, but like, you're not helping anyone with that kind of model. Like, and they were even using historical returns. I'm like, this is absurd. Like you're doing a hundred thousand runs with purely historical long-term averages. What's the point of that? I think the key should be relaying information a way that individuals can understand it.

49:31And, you know, so I like complicated models behind the scenes that do dynamic withdrawals, but I like, I don't know if it's like bunnies or like a thermometer gauge or whatever else it is, but like you're in terrible shape, you're in great shape. And that's really about all we can tell you. And so I think what's really important here is that yes, this stuff sounds complex. And I'm a fan of building things that I think better reflect reality, but how you communicate that to clients or advisors could be very different than the math behind the scenes. Bunny planning. There's a business plan. And a bunny is like, there's like, you can do clouds.

50:02It's like the group, I give them my input and they ignore me. So we're thinking about like how you do that. And my key is it's not a number. I don't think telling someone that there's a 90 % success rate really helps them make better choices because in reality, they're in really good shape. If you have a 90 % success rate, that means in this model, assuming good assumptions, you never have to make a change to your goal once. And then when you fail, you probably only fail by a tiny bit. But then because it's only 90, do they get nervous? Well, my God, what happens if I fail? I'm talking about failures in Monte Carlo are not playing crashes.

50:33Certain individuals who remain nameless have been you can't trust a financial plan because you don't want to get on an airplane if it's going to fail 10 % of the time. That's absurd. That's not what a failure in Monte Carlo means, but clients don't understand that. That's why I worry like, oh, some advisors are like a badge of honor. My clients have 98 % success rates. I'm like, that's ridiculous. Your clients aren't enjoying their lives because you're targeting a crazy high success rate. So I think that if you take the numbers out of it, at least out of the outcome, I think that could help advisors and retirees, households make better choices.

51:04Nobody wants to see a bunny failure. That's right. A bunny on a plane crash, that would just be terrible, right? Terrible. So how do first year safe withdrawal rates change when you incorporate needs and wants and dynamic spending and utility as opposed to static spending? Again, unequivocally, they go up. So think about a static goal with success rates, ones and zeros. I think where we're going to get into trouble and why now is more important is there has been a greater awareness among advisors that you have to plan for retirement that last 30 plus years, 30, 35 years. And when you do static projections and you assume retirement lasts 35 years, when the person fails, it's like in the 34th year of retirement, when they're like 99 and they fail by this much.

51:45So capturing the fact that, oh, okay, maybe they're going to fail eventually, but only by this much, what it tends to do pretty unequivocally is give someone the able to spend more today. You're taking the handcuffs off of like, oh, it's just ones and zeros. It's no longer ones and zeros. It's like ones and 0.99s, right? So you tend to see more aggressive portfolios than you would get using traditional LDI. You tend to see higher withdrawal rates. And one thing that's kind of interesting is there is actually some ambiguity around allocations to guaranteed income-like annuities. What you tend to see in these models is that it's really valuable to fund their essential expenditures.

52:20But beyond that, it's a lot more dealer's choice, right? So people out there seem like, you know, retirees all need more annuities, well, how are they going to feel about a shortfall? What is their capacity to adjust? I think having the essential expenditures covered is really important. But beyond that, that's more of a, how do you feel about creating income and everything else? That's kind of crazy. So you could have a model specified to output a large annuity allocation. Is that kind of what you're saying? Where if you modeled preferences a certain way? So let's just think about a more traditional immediate income annuity.

52:51Okay. Nominal, you give money to the insurance company, they pay you$7 ,000 a year for life. The problem with that and a Monte Carlo projection is that it tends to lead to like a, it's like a tipping point where based upon your assumptions, it makes it look really good or really bad. Okay. And so if you have like conservative CMAs and long retirement, like, you know, oh, it dominates, I should own all of this. And so I think like the key is annuities, they can improve outcomes, right? But it's understanding what most important thing is, what is the goal? The goal is to have income for life. Well, one, do you need it?

53:25What are your existing sources of guaranteed income? The problem with success rates, you can have a 0 % success rate, be on track to replace 98 % of your goal. You can have all of your needs, almost all your wants covered because your portfolio, that tiny piece, that's all success rates measure is what is your portfolio doing versus your goal? And so I think what that gives us this wrong context about like, oh, successful, unsuccessful. No, it's like you think about how you're doing more holistically again, like static withdrawals, success rates. I don't think it gives advisors that correct picture.

53:55Okay. To come back to Monte Carlo or traditional Monte Carlo, the way that it's generally used by financial advisors, how would a plan, a financial plan optimized for utility as we've been talking about with split out expenses for elastic and inelastic, if we optimize a plan in that framework, how would it look if we went back and evaluated it with a traditional typical framework? Yeah. So again, like what you would tend to see, so like if you're doing like a solver, right? And you said, okay, well, like how do things look? You'll typically get higher or much higher state withdrawal rates. If you incorporate flexibility and utility, you tend to get a little bit more aggressive portfolios, right?

54:29Because again, it's about trade-offs, right? Life is all about trade-offs. Like that's what it is. And so I think that a lot of the more traditional LDI focused models are all about conservatism and you want to have strong guaranteed annual returns. Well, go on to invest in equities if it means that there's a chance I can go on more vacations, right? If I'm kind of rolling the dice there, but then also it's to me, like the biggest thing is the role of guaranteed income and do people need more. If you use static assumptions in a base utility model, which is actually really common in the research, it just says everyone needs more annuities.

55:02Like that is like the takeaway that you hear all the time, like academics, you know, like, oh, more annuities. I like guaranteed lifetime income, just to be clear. The problem with that is that it's doing that whole static failure thing. It's like, oh, you're going to go from like all your goal to none of it. But if you glide down slowly, it really changes how efficient an outcome is. And so when you evolve a plan from static to dynamic and you overlay utility, you get very different results than if you can just assume those static withdrawals. Okay. That's super interesting. So we know empirically, like you talked about earlier, that people do spend dynamically or they do have flexibility in their spending.

55:35Could that help explain the so-called annuity puzzle? I think it explains part of it, right? I think that annuities are sold, not bought. Some are complicated. Some make a lot of sense. A lot of them have high commissions, high fees, they're opaque. There's all these problems. I think that if you take a step back, and we can all agree retirement is incredibly complicated, like the shift towards idiosyncratic longevity risk is not good for retirees, you have to manage it, right? And so I think that there's lots of reasons that people talk about why individuals don't allocate more to annuities. I think that we're seeing products that offer revocability, that offer cash refund provisions.

56:09We're kind of slowly moving away from these things that individuals clearly desire. But I think there's this larger question of, like, what am I guaranteeing? If I have a super strong preference for going golfing every day forever and doing all these different things, then by definition, I should buy an annuity if I don't have that already. But people already have a lot of public pension benefits, right? They already have social security. They might have other forms of guaranteed income. And so I think to your point, it does suggest part of the reason why individuals don't annuitize more is because they like the liquidity, the freedom, the flexibility of having a portfolio to fund those more flexible expenses, especially once they have those essential expenses covered for life.

56:51Wow. Where does this research go next? I really, well, I just hope people build more tools. I mean, like we're working on a tool that kind of does this within PGM. You know, there's other companies that do this that I think can do But I just, to me, like the most important thing here is a more realistic framework to give people advice and guidance. And again, Monte Carlo, 50 years, hot, massive stuff that's going to go wrong. But assuming that someone's going to make a change if they have to, you're not going to be giving them good advice out of the game. And so to me, I think that a lot of this is, you know, like the earlier regret.

57:23It's helping individuals achieve better financial outcomes across a variety of definitions of what it means to kind of achieve a goal. It's not just variance. It's regret invariant. With respect to this research around static, it's just a more realistic financial plan. And in reality, what it should do, hopefully we can communicate outcomes better to clients and we can actually make them more comfortable depleting their assets and using their portfolio to fund spending earlier in retirement. Super interesting. Okay, we got a couple more papers we want to ask about. Total change of topic, but they're just so good.

57:54I didn't want to leave them out. So you did some survey-based research on how advisor channel affects passive fund choice. Can you talk about that research? I have a few things that are related to this topic of how advisors are registered and how they're compensated and to the extent that it might affect decisions that they make with respect to clients, right? At the end of the day, I don't know that I have like super strong theoretical preferences to how an advisor gets paid, fee, commission, whatever, as long as it's fully disclosed and transparent. Okay. Where it becomes an issue though, is when there's research that suggests that advisors that are paid one way or do things another way, perhaps create better outcomes on average for their clients, where there's more kind of, okay, yeah, you're going to get paid, but it doesn't affect your decision-making.

58:51And so you can look at the selection of funds. I have another piece that's under review at a journal right now, looking at how equity allocations vary over time. So like, you know, based upon commission code. So there's A, B, C, D commission code, you know, do advisors who get paid more upfront, do they exhibit more time varying risk than they do? And so I think to me, what this larger body of research is saying is that, you know, again, theoretically, people get paid different ways, like, okay, but there is growing evidence that how they're paid might affect their decisions and not always in the best interest of their clients.

59:26So I think like that to me is the key behind this is that in a theory, it shouldn't matter, but in reality, it does appear to matter. How do you think clients should use this information? So the problem is, is that I don't know that clients can really figure out if an advisor is doing a good or bad job, right? Like it's so hard to know. There's a fancy term that I'm forgetting about the type of good that advice is where you can't, you don't know. You don't know even afterwards if they had a good job, right? So I think that you look for the positive signals, like are they a certified financial planner, right?

59:58You know, like are they transparent in their fees? But even then, I mean, just to be honest, like if I were like a crook, right? I would want to get a CFP because it would make me seem like I must have a crook. We can't just say that, oh, CFPs are all great because I would have an incentive to literally get one because it creates a halo effect. But by definition, if you have a CFP, you have taken some tests that are difficult. You have minimum education requirements. You should have relatively a clean regulatory history. So I think that there are things that households should be doing that are filtering out all advisor to those that at least appear to be more professional than just you meet someone at a cocktail party and they're your guy.

1:00:38I wouldn't recommend that. I think you need to do due diligence and understand what are the person's qualifications, things like that. Yeah. Yeah. We just did an episode on what are the measurable benefits of financial advice. And we talked a lot about that. That's why I had the credence good word in my head. There you go. So you got it. Yeah. There's a bunch of literature like you're talking about on how commission-based advice tends to be really not so good. So I think that compensation piece seems to be, all the education stuff, totally agree, but that compensation piece seems to be a pretty clear filter, at least as a baseline.

1:01:10To me, the one nuance there is I'm not convinced that commissions themselves are the problem. It's the individuals who tend to sell things that are commission-based. I mean, it's like a nuance there where like, because fees, if you do AUM, In any model that you can create, there's going to be negative incentives. But I think that at least structurally, the quality of advisors that are paid based upon commission are lower quality on average than those that are paid based upon asset center management, right? And so I think that, you know, like, so yes, you could say, well, then we should ban commissions.

1:01:42Well, like, then if it's the same advisors, they'll just find a new way to do things that aren't as good with AUM. So, you know, to me, there's this question of, is there like a signaling thing there where, you know, it's really not just the fact that how they're paid, it's because they're just not as good, CFP versus non-CFP. So I think that this is all really difficult to figure out until after the fact, do they actually do a good job? But I think that our profession has evolved a lot. I had internships in this business 20 years ago. Oh, you're a stockbroker? I mean, I guess that's what you do.

1:02:12You just buy and sell stocks. So we're evolving. There's higher standards. And so I think that it's all good, but there's still a lot of folks in this industry that don't do things that I think are always in the client's best interest. Yeah. One more big pivot in terms of topics. You had another paper on foreign revenue. How important is the country that equities derive their revenue from as opposed to their country of domicile and explaining returns? It depends. The quality depends. So I think what sparked this particular piece of research was there's actually a new data point in Morningstar Direct.

1:02:44This is actually when I was at Morningstar. I started working on this. that provide information on the percentage of revenue from a given index or fund from different countries, right? Because I mean, domicile is binary, right? You assign a company to a country and how that is determined, it could be totally like for tax reasons or something else. It's not like you weight companies across different countries. You usually put them in a single domicile. And I think there's this question of, well, does that accurately capture the true global risks of a company? And the answer is, it's obviously no, right?

1:03:17I mean, usually smaller companies have most revenue domestically, but as you get larger, you can have a larger and larger share that's international. And so I think that there's been other folks that have kind of analyzed this, but I think, do we need to, as our society becomes increasingly global, think about different ways to construct indexes or portfolios, given the vastly different revenue profiles that exist across countries in these indices and across countries. And so I clears to be a huge effect, possibly larger than domicile in terms of what drives the returns of a given index based upon location.

1:03:54And I forget some of the stats in the piece, but certain countries have most of their revenue from their largest companies come from globally. Well, if we go way back to LDI for individual portfolios, what you would want is if I live in the UK, I would probably want to own stocks to track the UK market pretty well. If inflation takes off and prices go higher, they do well. Well, if all the revenue from the companies in the UK come from Europe and China or just whatever else, then that doesn't help me as much. So I think that there's ways you could think about building portfolios of securities, whatever else that help better kind of track what you're trying to do with a given strategy that you would not capture necessarily at all in domicile.

1:04:35Yeah, that's super interesting. That's one of the home country bias arguments that it can be sensible for the reason you just said to hedge local consumption, but you're saying you can't just do that with a local index. You have to do it with the revenues from local companies, which could be totally different from the local index. Right. I mean, it tends to kind of all wash out, right? You tend to see like, some are very local, some are global, but like, but if you really wanted to do that, you could. I mean, like, I think MSCI like walked down this path a decade ago. I don't think they did anything with it, but like you really could create local focused indices that would give, I think, especially like retirees, a better exposure to the equity market, their local equity market, right?

1:05:14There's two pieces, right? There's the discount rate side and the cash flow side. So for long-term investors, you might be affected by foreign discount rates if you own foreign companies that derive most of their revenue from the UK in that example. So you're affected to foreign discount rates, but in the long run, the cash flow side is more driven by the local UK stuff, which is maybe what you care more about, at least in the example of selling wanted to hedge local consumption. Super interesting. Does this finding dramatically change people's home country bias? If you look around the world, do you know?

1:05:42Not really. I mean, so like small cap companies are really still mostly domestic, like US especially, right? And I think this is, and it has been a larger issue for smaller countries that don't have as large of a global footprint as the US, but that's just always been how it is. And so then I try to like build a diversified portfolio doing that. And it's kind of tough because, you know, like certain industries, everyone in the industry is global. So I think that to me, there's just this question, like, again, as we move forward in the future and we have this increasingly connected global economy, in theory, like domicile just becomes more and more meaningless as a metric.

1:06:20Considering other metrics could yield a very different perspective on like the global risks, for example, of an index. If you're not doing any kind of beta decomposition, like you're not doing RBS and all that, you might just say, oh, well, this is a US large cap fund. Well, yes, all the companies are domiciled in the US, but this fund in particular has 60 % of the revenues or 80 % of the revenues coming from other countries. So it really is an international exposure with domestic domicile. Okay. Now, that is often used as a reason, particularly by US investors, to not need international diversification.

1:06:54diversification? Do you think that this negates the need for international diversification? To some extent, it does, right? So like, and again, I forget the numbers, but like, if you own Coca-Cola, that isn't like they're just selling Coke here in the US. All these really large, really, really large Apple, they are truly global companies. And so I think that it does negate the need for owning an explicit sleeve international, right? Because there is significant revenue for most of these companies that is formed. Cool. Well, that's the last of our questions, David. This has been fantastic as usual.

1:07:25Thanks a lot for coming back on the podcast. Yeah. Thanks, David. Amazing. Sure. Thanks for having me.