Wednesday, November 19, 2014

So You Think You Are Financially Prepared to Retire? Use our Spreadsheet Tools to Test

Generally the focus of this website is to help individuals who are already retired establish an annual spending budget.  From time to time, however, I will venture into the "how much do I need to retire" side of the retirement challenge.   This post is aimed at individuals who are close to retirement but are unsure of whether they have sufficient financial assets to meet their needs throughout retirement.  

This exercise is very similar to what I wrote about in my August 31 post--Managing Your Spending in Retirement--It's Not Rocket Science, except the first step in testing to see whether you are financially prepared to retire is to determine your spending needs in retirement.  Generally this is done by looking at your normal expenses for a year, subtracting expenses that you don't expect to have in retirement (such as Social Security taxes and work-related expenses) and adding expenses you do expect to incur in retirement (such as increased travel and leisure expenses).  Don't forget to factor in taxes that you will need to pay in retirement.

The second step in the process is to determine your total expected income for a year from all sources, such as Social Security, accumulated savings, pensions, annuities, earnings from part-time work and other sources of income.  This is where the spreadsheet tools available on this website come into play.  If you are not going to defer commencement of your Social Security benefit, use the "Excluding Social Security V 2.0" spreadsheet and add in your estimated Social Security benefit (and any other fully inflation indexed annuity benefit and expected earnings from employment) to the total spendable amount.  If you do plan on deferring your Social Security benefit, use the "Social Security Bridge" spreadsheet.  Note that for this step you may wish to exclude some of your accumulated assets, such as home equity or other assets, on the theory that such assets will be available for unexpected (or lumpy) expenses in retirement.  I suggest that you input the assumptions we recommend in addition to your specific data.

The third step in the process is to compare the results of the second step with the first step to see if the two numbers line up.  If the result of the second step is significantly lower than the result of step one, you may not be financially ready to retire.  If you are not as conservative as I am, you can input higher investment return assumptions and/or lower inflation assumptions to see how these changes can affect your expected annual income.  But remember that there are no guarantees when it comes to expected income from accumulated savings and the more liberal (or wishful) you make the assumptions, the more likelihood that future real spending will have to be reduced.

Normally at this point in my posts I provide an example of how this test might work.  I'm not going to do that this time.  Having recently read the quote attributed to Benjamin Franklin, "Tell me and I forget.  Teach me and I remember.  Involve me and I learn", I'm going to encourage you to kick the tires on these spreadsheets.  Take a few minutes to crunch your own numbers.  You'll find it a worthwhile exercise.

Sunday, November 16, 2014

Does Your Financial Advisor Develop Your Annual Spending Budget Based on How Much Assets You Have and How Long You Might Live?

Lets assume that you and your Financial Advisor meet approximately annually to determine your spending budget for the year.  If you don't actually have a Financial Advisor, then you and/or your spouse are acting as your own Financial Advisor.  In a recent survey of Financial Advisors by Russell Investments, 234 Financial Advisors were asked how they develop spending budgets for their clients near or in retirement.  25% responded that they based their approach on levels of pre-retirement spending, 22% indicated that they used a rule of thumb like the 4% Rule, 19% indicated that they used some variation of the Bucket Strategy, 16% indicated that they compared assets with future liabilities and 18% indicated some other approach. 

The Russell Investments survey concluded that not enough Financial Advisors were using "math and science" to develop spending budgets for their clients and should be periodically comparing the client's assets with the client's liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans (which coincidentally is the basis for the approach recommended in this website).

Along the same line, in an interview for Advisor Perspectives, Nobel Laureate Bill Sharpe provided his views on developing spending budgets and the 4% Rule (and other Safe Withdrawal Rate Rules):

"What you spend should depend upon (1) how much you’ve got and (2) how long you think you might live, or the range of possible lengths of life. The 4% rule is fine on both fronts on day one. For example – you’ve got $1 million and you’re 65. Spend $40,000. This may be just fine.


After the initial year, however, what you spend with this rule has nothing to do with how much you have, or for that matter, how long you expect to live. Most importantly, it doesn’t depend how much you have at the moment. Any rational person would say, “What you spend ought to depend upon how much money you have.” Isn’t that self evident?  A rule that doesn’t do that after year one doesn’t make any sense. And this should be the end of the discussion. But we see such an approach advocated in many places."


Finally, Dirk Cotton provided similar views in his entertaining blog of October 27,2014 entitled "Spherical Cows."  Commenting on the use of Safe Withdrawal Rate approaches, Dirk said,

"One of my favorite Spherical Cows is the one used to calculate sustainable withdrawal rates. SWR models assume that a mythical investor will continue to spend the same amount of money each year from savings, even after it becomes obvious that he or she is about to deplete their retirement savings. The models take a percentage, say 4%, of initial portfolio value and subtract that fixed dollar amount ($4,000 from a $100,000 portfolio in this case) from the portfolio balance every year, counting the number of years before the portfolio is depleted.

Many financial writers argue that no one really "does it that way", meaning everyone adjusts spending based on their remaining portfolio balance instead of spending a flat amount, but I have two responses to that. If no one does it that way, then everyone in the financial press should stop saying that you can do it that way.  And second, the SWR models predict outcomes for you only if you do "do it that way". (Operations Research guys say that a model is predictive only to the extent that its policies are followed.) The SWR results aren't predictive if you do something else, like adjust spending to portfolio value changes – which apparently is what everyone is actually doing."


Bottom Line:  If you act as your own Financial Advisor, you should spend the time to learn the pros and cons of alternative withdrawal strategies.  The Actuarial Approach recommended in this website uses established actuarial principles that consider how much assets you have each year and the expected payout period.  If you do work with a Financial Advisor, you should compare the budget recommended by your Financial Advisor with the budget developed using the Actuarial Approach and discuss any significant differences with your Financial Advisor.  If you are a Financial Advisor for others, you may wish to consider employing the math in the Actuarial Approach for your clients to see how it compares with whatever method you are currently using. 

Friday, November 14, 2014

100th Post--Nice Write-Up of the Actuarial Approach in the Toronto Globe and Mail

Time for a brief celebration!  This is our 100th post in our ongoing effort to help retirees develop a spend-down strategy for their self-managed assets as part of an overall process of developing an annual spending budget in retirement.  As we approach the end of 2014, I remain just as convinced as I was in 2010 with post #1 that the Actuarial Approach recommended in this website represents a better systematic withdrawal strategy than most approaches that are commonly used.

And what better way to celebrate than to have a reporter say some nice things about what we are doing.   Read Ian McGugan's recent article in the Globe and Mail.


Mr. McGugan took such an interest in the spreadsheet tool recommended in this website for determining a spending budget in retirement (Excluding Social Security V 2.0) that he kindly offered to write a "less actuarial" explanation of it.  Click here to see Mr. McGugan's nice write-up. Thanks Ian.

Our 100th Post celebration must also include special thanks to my buddy, Kin Chan, for his assistance with managing the website and pointing out all the sentences that don't make any sense.