Thursday, May 21, 2015

The Actuarial Approach—Periodic Matching of a Retiree’s Assets and Liabilities

As I said in my previous post, any spending approach that does not periodically match a retiree’s assets with her liabilities runs a significant risk of failing to achieve the retiree’s spending objectives.   What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.

This post will illustrate, with an example, the matching of assets and liabilities achieved by the Actuarial Approach advocated in this website. 

Let’s assume that we have a hypothetical retiree named Mary who is age 65.  She has $1,000,000 in accumulated savings, a fixed dollar pension of $15,000 per year, a Social Security benefit of $20,000 per year and no other sources of income.  She has determined that her essential expenses in retirement will be about $50,000 per year.   Since believes that these essential expenses will stay reasonably constant in real dollar terms from year to year.   She would also like to leave around $500,000 (in future dollars) to her daughter at her death or have that money available for long-term care or extra medical bills if needed.  She also believes that she will need something like $100,000 for unexpected expenses not included in her essential expense budget, such as purchases of new automobiles or gifts to her daughter. 

Mary goes to the “Excluding Social Security” spreadsheet to see how much of her accumulated savings it will take, together with her pension and her Social Security benefit to cover her $50,000 annual real dollar essential expense budget and still leave her with $500,000 at her expected death.  She enters $600,000 in accumulated savings, $15,000 in annual pension, $500,000 to be left to heirs at death and the recommended assumptions (including a desired annual increase rate applicable to future budgets attributable to savings and pension of 2.5% per annum).  The resulting spending budget when Social Security is added is $51,401.  Since this is close to her estimate of essential expenses she decides she will dedicate $600,000 of her accumulated savings to her “essential expenses” budget along with her pension and her Social Security benefits.  She may even invest these essential expense assets differently than her other accumulated savings. 

To cover unexpected expenses, Mary dedicates $100,000 of her assets to this budget item.  Since she feels that the amount she desires to leave to her daughter at her death can serve several purposes, Mary does not feel it is necessary to dedicate additional assets to cover rising health costs or long-term care expenses.  Finally, Mary wishes to travel early in her retirement and have an active social life.  She dedicates her remaining $300,000 of accumulated savings toward non-essential spending but she wishes to front-load this budget item.  Therefore, she enters $300,000 in the Excluding Social Security spreadsheet with 0% increase in the annual desired increase.  The result for the first year is a non-essential spending budget of $17,624.  Mary knows that this budget item will not increase in nominal terms from year to year and therefore will represent a declining real spending budget as she ages.

Mary’s first year spending budget is $69,025 (a total of $51,401 from Social Security, her pension and her essential assets) plus $17,624 from her non-essential assets.   The exhibit below shows Mary’s Actuarial Balance Sheet as of her date of retirement.  The present values are based on the recommended assumptions and results from the Excluding Social Security spreadsheet. 


Click to enlarge

Mary will revisit her spending budget thought process at the beginning of each new year.  She will use the Excluding Social Security spreadsheet and enter new data and new assumptions.  Investment experience may deviate from the assumptions she used.  Her spending may deviate from her budget.  Assumptions may be changed.  Her objectives and liabilities may change (or she may refine what is essential and what is not essential).  If she continues to use the Actuarial Approach, she has the flexibility to make informed adjustments in her budgets.  Each year, she will balance her assets and her liabilities.  If she uses the recommended smoothing algorithm, assets and liabilities may not be perfectly matched, but she knows that the match will be close enough. 

Mary knows that she has to crunch a few more numbers under the Actuarial Approach than she would have to under the 4% withdrawal rule or some other variation of this rule, but Mary feels much more comfortable with the control she has over her spending budget using this much more sophisticated (and not that much more complicated) approach.  Mary also finds comfort in the fact that the approach she is using is consistent with basic actuarial principles and is not just some simple rule of thumb approach.  

Thursday, May 14, 2015

Want to Really Take the Guess-Work Out of Your Retirement Spending Budget?

Once again we read in the popular press about the 4% Rule and the tinkering that will be necessary to make this rule (or some form of this rule) possibly work in retirement.   In his May 13, 2015 article, 4 Reasons Why the 4% Rule Isn’t a Hard and Fast Rule, David Ning tells us that spending needs to be adjusted in retirement.  His “hard and fast” advice for doing this is that “you will be tempted to spend more in bull markets” and “you should decrease spending in bear markets.”  In her May 8 article in The New York Times, New Math for Retirees and the 4% Withdrawal Rule, Tara Siegel Bernard quotes several industry experts with various opinions about the 4% rule and different adjustments that might make the rule work.  The experts in this area continue their search (using their Monte Carlo modeling) for a Holy Grail spending rule to replace the now-suspect 4% Rule.  So, what is a poor retiree to do now without a clear, simple spending rule of thumb?

Sorry folks, but a retiree’s budget problem is basically an actuarial problem that requires an actuarial solution.  The retiree (or the retiree’s advisor) needs to periodically match the retiree’s assets with her liabilities.  What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.  Any simple spending rule of thumb that doesn’t attempt to match these assets and liabilities (and most common approaches don’t) runs a significant risk of not meeting the retiree’s spending objectives.

Ok, we’ll does this actuarial solution come in the form of a simple rule of thumb like the 4% Rule?  No.  It doesn’t.   And while periodically matching assets and liabilities requires some number crunching, the Actuarial Approach and spreadsheets set forth in this website do most of the work for you.  The process is relatively straightforward and doesn’t require you to be an actuary.

As we said in our post of August 2, 2014, Are You “Most People”?, the Actuarial Approach is not for everyone.  It for someone who wants more than a questionable simple rule of thumb who is willing to do a little number crunching for the purpose of taking the guess-work out of developing a reasonable spending budget.

Sunday, May 10, 2015

Brief Explanation of How to Use the Actuarial Approach, Revised

The June, 2014 explanation of how to use the Actuarial Approach has been revised to incorporate necessary adjustments to the general process for those retirees who want to “front-load” their spending budgets instead of developing a spending budget that is expected to remain constant in real dollar terms from year to year.  Here is a link to the revised explanation.