Thursday, September 22, 2016

Got Those “Conflicting Social Security Deficit Estimate” Blues Again

This post is a follow-up to my post of January 22, 2016, where I noted that relatively small tweaks in assumptions about the future appeared to have a fairly large impact on Social Security’s 75-year actuarial balance calculation, and my post of July 30, 2016, where I called upon the actuarial profession to advocate adoption of automatic approaches to maintain Social Security’s actuarial balance as part of the next round of system reform to enhance the system’s sustainability. 

This week, Keith Hall, the Director of the Congressional Budget Office (CBO), appeared before the House Subcommittee on Social Security to explain why CBO’s calculation of Social Security’s 75-year actuarial deficit was so much higher than the deficit calculated by Social Security’s actuaries and included in the official Trustee’s report.  Here is a link to his testimony.  Mr. Hall explained that by tweaking a few assumptions, the CBO calculated the 2016 75-year actuarial deficit to be 4.68% of the system’s taxable payroll vs. the 2.66% figure calculated by the Trustees.  In other words, the CBO calculated deficit, when measured as a percentage of taxable payroll was about 75% higher than the deficit calculated by the Trustees.  It is also important to note that neither of these two calculations recognizes the significant deficits projected for years after the 75-year projection period under current law, and therefore both actually understate the long-term problem.

As discussed in my post of January 22, I have no idea whose assumptions are more accurate, and frankly that is not the point of this post anyway.   The point is that no one can predict the next 75 years accurately, and it is just foolish to believe that changes made today, tomorrow or five years from now based on 75 years of assumptions about the future are definitely going to solve the system’s long-term funding problems for 75 years or more.  Yet that is just what we heard when Congress supposedly solved the system’s problem for 75 years back in 1983, and that is just what we heard more recently from the Bipartisan Policy Commission when they proudly announced that, “the commission’s package of recommendations would extend Social Security’s ability to pay benefits without abrupt reductions through the end of the 75-year projection period” and “if adopted, the commission’s recommendations would secure the program’s trust funds for 75 years and beyond…”  Statements such as these are conditioned on future experience closely following the assumptions made by the Trustees.  So, if actual future experience is just a little worse (say like experience assumed by the CBO), all bets are off.  

Common sense tells us that rather than waiting to have Congress make very significant changes to the Nation’s retirement program every thirty years or so to put it back into actuarial balance, it would be preferable to have minor changes made on a more frequent basis.  This why I have recommended consideration of automatic adjustments to the system’s tax and/or benefit structure to maintain the system’s actuarial balance.  This is what they do in Canada for the Canada Pension Plan.  This is what is done in almost all financial programs funded using basic actuarial principles.   I believe that adoption of such an automatic adjustment approach would go a long way to enhancing the sustainability of and faith in this critical program.

So, in my post of July 30, 2016 I called on my profession to fulfill its duty to the public and advocate automatic adjustments to maintain the program’s actuarial balance.  I also sent a link to my post to all of the leaders of all of the U.S. actuarial organizations.  Despite my many years of volunteering for most of these organizations, I received essentially no response, and certainly nothing resembling an explanation of why the profession wouldn’t even consider suggesting or recommending such an approach to Congress. 

I believe that the actuarial profession fumbled the Social Security football back in 1983.   With potential and significant Social Security reform on the horizon, it looks like the actuarial profession will be given another chance to carry the ball.  Unfortunately, based on actions I’ve observed to date, it appears the profession will once again fumble the ball.  One has but to look at the American Academy of Actuaries’ Social Security Game for an example.  Simply make a couple of changes in the current tax/benefit structure to solve the 2015 Trustees estimate of the 75-year actuarial deficit and the Game congratulates you for winning the Game by fixing Social Security.  If only it were that easy.

Sunday, September 4, 2016

Recommended Assumed Annual Rate of Investment Return Lowered Again

From time to time I look at immediate annuity purchase rates for the purpose of possibly revising my recommendation for the expected annual rate of investment return assumption and the rate of inflation assumption to use in the Actuarial Budget Calculator.   The assumption for the expected annual rate of investment return is also referred to as the discount rate as it is the rate used in the Actuarial Budget Calculator to discount future expected payments to obtain present values.  Readers of my blog know that I like to recommend a discount rate that is roughly consistent with the discount rate implied in immediate annuity purchase rates, as this rate is approximately the discount rate at which a retiree could settle some or all of his or her retirement liabilities (generally the present value of future spending budgets).  It also gives a retiree a pretty good estimate of the relatively low-risk cost to fund their retirement.  Yes, investment in risky assets may result in higher investment returns (and a potentially higher discount rate), but risky assets also carry greater risk.  Therefore, while I don’t make recommendations on how you should invest your assets, I do recommend that you assume that your assets will earn a fairly conservative rate.  If your assets actually earn more than this conservative rate in the future, you can increase your future spending budgets (or you can increase your rainy day fund as discussed in our post of July 4, 2016). 

Historically, I have also recommended using a future inflation assumption that is 200 basis points below the discount rate as this is roughly the historical difference between inflation and returns on bonds; the investments used in annuity products.

Only the actuaries at the actual insurance companies know the assumptions and methods they use to price their immediate annuity products.   These assumptions and methods include mortality, mortality improvement, anti-selection, interest rates and other factors, such as desired levels of insurance company profits, commission schedules and whether they have already written their quota of business for the year.  So, I don’t claim to really know the discount rate (or more likely different discount rates by year) assumption they use.  I can only make a crude educated guess.   Historically in prior posts, I have done that by solving for the discount rate that is approximately consistent with age 65 annuity purchase rates using the age 65 life expectancy for a 65-year old male (22.9 years) or a 65-year old female (24.9 years) under the 2012 Society of Actuaries’ Individual Annuity Mortality Table with 1% per year mortality improvement. 

Recently I looked at how much monthly immediate fixed dollar annuity income could be purchased for $100,000 in California by 65-year old males and females from the following three online sources:

The table below shows the highest quoted monthly income for age 65 males and females and the respective implied discount rate for each quote based on the methodology described above. 

(click to enlarge)

As shown in the table, the annuity quotes and implied discount rates from annuityquickquote.com appeared to be significantly higher than those from incomesolutions.com, which, in turn, appeared to be higher than those from immediateannuities.com.  The annuity quotes from immediateannuities.com list the actual insurance company and their AM Best rating, while the quotes from the other two online sources do not.  For example, the quote from Met Life on immediateannuities.com on September 3rd for a 65-year old male was $490 per month and was $467 per month for a 65-year old female.  Under the methodology described above, this translates into about a 2.74% annual discount rate for the male annuity and a 2.84% annual discount rate for the female annuity offered by Met Life.  

Based on the data in the table above, I have decided to lower my recommended discount rate and inflation rate by 0.5% to:
  • Recommended discount rate: 4.0% 
  • Recommended inflation rate:2.0%
I would certainly not argue with you, however, if you wanted to use a lower discount rate and a consistent assumed rate of inflation.

What are the implications for your spending budget of using a lower assumed discount rate?  All things being equal (i.e., your future inflation assumption remains unchanged), it means that your spending budget will decrease somewhat, as the anticipated cost of your retirement will be more expensive.  If your assumed inflation assumption is reduced by 50 basis points as well, however, your spending budget may actually increase depending upon how much fixed dollar income you anticipate receiving and how you plan to spread the present value of your future spending budgets. 

Saturday, August 20, 2016

Planning for Constant Real-Dollar Spending in Retirement — Is It Setting the Bar Too High? Part II

This post is a follow-up to my post of March 31 of this year in which I encouraged you (or your financial advisor) to use the Budget by Expense-Type Tab of the Actuarial Budget Calculator to develop a reasonable spending budget that more closely meets your spending objectives with respect to the various types of expenses you expect to incur in the future.

Initial Spending Budget
 

Developing an initial spending budget using the Actuarial Approach is a two-step process:
  • The first step in the process is to determine the total present value of the assets you have to spend.  This present value includes your current liquid assets, the present value of your Social Security benefits, the present value of your defined benefit plan benefits, the present value of any annuity income you may have, the present value of non-liquid assets you may own that you plan to sell in the future, the present value of rental income from properties you may own, the present value of future wages you may earn, etc. 
  • The second step in the process is to determine how you want to spread this total present value of assets over your expected payout period.
The result, Current Year's Total Actuarial Spending Budget based on annual desired increase (shown in row 42 of the Input Tab of the Actuarial Budget Calculator spreadsheet), shows this year’s actuarially determined spending budget:
  • if you decide to spread the total present value of your assets, less Desired amount of savings remaining at death (input in row 33), over 
  • the Expected payout period (input in row 29), based on the assumption that future spending budgets will increase each year by the Annual desired increase in future budget amounts percentage (input in row 31).
If the same assumption is input for the Annual desired increase in future budget amounts (in row 31) as is input for Expected annual rate of inflation (in row 35), you are essentially planning for constant real-dollar spending throughout your retirement:
  • assuming all the assumptions input in the spreadsheet (including the mortality assumption) are exactly realized (and unchanged), and 
  • your actual spending exactly matches your spending budget each year.
We know, however, that all of the assumptions you input in our spreadsheet won’t be exactly realized (and/or unchanged) each year, and your actual spending will probably not be exactly equal to your spending budget.  That is why we added the 5-year Projection Tab, so that you could see how variations in investment returns and actual spending could affect your future spending budgets.

We also know that not all of your future expenses are likely to increase at the same rate, which is why we added the Budget by Expense-Type Tab to the spreadsheet.  This tab gives you the ability to spread the present value of your assets (which is also equal to the present value of your future spending budgets) between five different types of expense:

  • long-term care 
  • unexpected 
  • essential non-health (ENH) 
  • essential health (EH) 
  • non-essential (NE)
and to make different future increase assumptions for these expenses:
  • essential non-health (ENH) 
  • essential health (EH) 
  • non-essential (NE)
This is one of the many benefits of using the Actuarial Approach that you just don’t get with many other approaches — the flexibility to decide how you want to budget the spending of your retirement assets.

Planning for Constant vs. Decreasing Real-Dollar Spending
 

And the foregoing brings us to the inspiration for today’s post (with my apologies for taking so long to get here).

Three of retirement researcher Wade Pfau’s recent articles,

note that average spending appears to decrease consistently during retirement, until individuals become quite old, at which time their expenses (mostly health-related) increase.  Therefore, according to Dr. Pfau and other researchers, “Suggesting that retirees should plan for constant inflation-adjusted spending may overestimate the required retirement savings that many households will require for a successful retirement.”  Stated in another way, this research appears to support some degree of “front-loading” of the early years’ real-dollar spending budgets, relative to later years (i.e., larger early year budgets than later year budgets, measured in real dollars).  In his “Smile” article, Dr. Pfau cites research from David Blanchett that shows that real-dollar spending for a retiree whose initial spending is about $100,000 is expected to decrease by about 1% per year until the retiree reaches her early 80s, at which time health-related expenses will tend to increase real-dollar spending.
 

While I agree that non-essential expenses are likely to decrease in real dollars as we age in retirement, I also agree with Dr. Pfau that other types of expenses in retirement are likely to remain constant in real dollars or even increase.  It is for this reason that I recommended different rates of assumed increases for
  • essential non-health (ENH) expenses, 
  • essential health (EH) expenses and 
  • non-essential (NE) expenses
for determining 2016 spending budgets in my post of December 21 of last year.

It is important to note, however, that if we assume:

  • essential non-health (ENH) expenses will increase with inflation in the future, 
  • essential health (EH) expenses will increase faster than general inflation and 
  • non-essential (NE) expenses will increase at a rate less than inflation,
then the expected rate of increase or decrease in the total real-dollar spending budget will depend on the relative levels of these three separate budget components.

The larger the portion of the spending budget that is represented by non-essential expenses (using different rates of assumed increases for essential non-health (ENH) expenses, essential health (EH) expenses and non-essential (NE) expenses), the greater the annual decrease expected in future real-dollar total spending budgets.


Examples using James and Michael


Let’s take a look at two different retirees to illustrate this point.  Both James and Michael are:

  • 65-year old males 
  • with $20,000 annual Social Security benefits, 
  • a $10,000 annual pension benefit, 
  • no other sources of retirement income and 
  • no bequest motive.
The only difference between James and Michael is their accumulated savings:
  • James has accumulated savings of $500,000 and 
  • Michael has accumulated savings of $1,000,000.
Both retirees use the Actuarial Budget Calculator to develop their spending budget for this year and our recommended assumptions of:
  • 4.5% discount rate 
  • 2.5% inflation 
  • expected retirement period equal to age 95 minus attained age or life expectancy if greater.
Under these assumptions, the present value of assets are:
  • $1,129,966 for James, and 
  • $500,000 higher, or $1,629,966 for Michael’s.
If these present values are spread over their expected retirement periods as a constant real-dollar amount (increasing each year at the same 2.5% annual rate assumed for inflation), their spending budgets for this year would be:
  • $49,156 for James 
  • $70,907 for Michael.
 
Examples Using Budget by Expense-Type Tab

Both James and Michael have determined their expenses as:

  • essential non-health (ENH) expenses for the upcoming year are $30,000 
  • essential health (EH) expenses are $7,000 
  • essential non-health (ENH) expenses will increase by inflation in the future (2.5% as stated above) 
  • essential health (EH) expenses will increase by inflation (2.5%) plus 1.5%, or 4.0% 
  • non-essential (NE) expenses will remain constant in nominal dollars
For the sake of simplicity, we are going to assume that both have separately set up sufficient reserves for long-term care expenses and unexpected expenses.

If instead of planning for constant real-dollar spending, these retirees use the Budget by Expense-Type Tab of the spreadsheet and the increase assumptions for each budget expense type discussed above,

  • James will develop a total spending budget for this year of $51,351 (or about 4.5% greater than his constant dollar spending budget), while 
  • Michael’s total spending budget would be $80,725, (or about 13.8% higher than his constant dollar spending budget).
The reason for the different rates of increase is that non-essential (NE) expenses represent a much larger proportion of James’ total spending budget than for Michael’s.

Charts
 

The following two charts illustrate this concept by showing expected real-dollar budget components and total spending budgets for the two retirees by age, if all assumptions are realized.


click to enlarge

click to enlarge

It is important to note that we show expected budget components and totals only until age 90.  This is because real-dollar spending budgets developed as the sum of these three budget components under the Actuarial Approach are expected to decrease significantly once the retiree’s current age plus life expectancy starts to exceed age 95.  At that time, however, the retiree presumably has long-term care and unexpected expense reserves to dip into.
 

Over the 25-year period from age 65 to age 90, James’ expected total real-dollar spending budget decreases by about .25% per year, while Michael’s total real-dollar spending budget decreases by about 1% per year.  Thus, the results for Michael are very close to the results for the average retiree with initial income of $100,000 noted by David Blanchett.  However, it is important to look at your own situation to determine what is appropriate for you.