Budgeting for Real-World Situations

This post is a follow-up to our post of March 3, 2018 where we discussed the distinction between Systematic Withdrawal Plans (SWPs) and Sustainable Spending Plans (SSPs).  In that post, we discussed why we believe it is important for you (or your financial advisor) to develop a SSP (and not use a SWP), particularly if your situation differs from the frequently overly-simplified situations assumed by many SWP advocates, academics and other retirement experts.  This post will discuss how the Actuarial Budget Benchmark (ABB) can be used together with our recommended smoothing algorithm to help you develop a robust SSP to properly handle most real-world situations.  We will also present an example to demonstrate how this SSP can work over a ten-year projection period and will encourage you (or your financial advisor) to model what your future spending budgets might be under reasonable assumptions so that you can test your financial plan.

Unfortunately, Good Budgeting is Not That Simple

Developing a reasonable spending budget is not as simple as we are sometimes led to believe.  Real-world complications frequently ignored by retirement researchers and other retirement experts include:

• Many individuals are part of a couple and plan as a couple 
• The individuals in a couple may not be the same age and may not retire at the same time 
• Income sources before retirement don’t always stop the same time and income sources after retirement don’t always start (or stop) at the same time 
• Couples generally don’t live the same period of time and income needs will frequently change upon the first death within the couple 
• Future expenses may not be the same each year.  Some expenses may be non-recurring, some may be recurring, some may increase at a rate higher than general inflation and some at a lower rate.  
• Some income sources in retirement may be paid in fixed dollars and some in inflation-adjusted dollars 
• Individuals will generally not spend exactly their spending budget each year.  
• Individuals experience one pattern of future investment returns, not an average of 10,000 patterns generated for Monte Carlo modeling based on historical returns
  

Because SWPs don’t coordinate with other sources of income and are simply drawdown algorithms, their use is frequently inconsistent with a couple’s (or single individual’s) retirement goals in these real-world situations.  Since SSPs focus on spending and not withdrawals from accumulated savings, they can be tailored to address these real-world situations to better meet retirement objectives.  And while the SPP we discuss below is more complicated than most simple SWPs, you can use our spreadsheets to perform the annual present value calculations necessary to make it work and obtain a better result. 

Using the ABB and Our Recommended Smoothing Algorithm to Develop a SPP

As discussed in the Overview sections of our Actuarial Budget Calculators, the ABB is an important “data point” in the budget development process, but it can sometimes produce volatile results from year to year primarily due to asset fluctuations.  As discussed in our post of January 2, 2017, these undesirable fluctuations can be mitigated by smoothing the results.  The smoothing algorithm that we recommend involves taking the recurring spending budget amount from the previous year, increasing that amount by the desired increase in spending budget for the previous year (generally the actual increase in general inflation for the previous year) and testing that the resulting amount is not more than 110% of, and not less than 90% of, the ABB for recurring expenses.  If the previous year’s adjusted value falls within this corridor, that adjusted value becomes the recurring spending budget for the current year.  If the previous year’s adjusted value falls above or below the corridor limit, the applicable corridor value is used as the current year’s budget.

Using the ABB and our recommended smoothing approach will help you achieve the goals discussed in our March 3, 2018 post:

• Maximizing current levels of spending without jeopardizing ability to meet future anticipated expense needs 
• Not spending too much and not spending too little 
• Avoiding year to year spending volatility 
• Having spending flexibility 
• Leaving approximately desired amounts to heirs at death
  

Example:  10-Year Projection of Spending Budgets

To illustrate how this SSP works to achieve these goals, we performed a ten-year projection of spending budgets for a hypothetical couple, Bill and Betty.  We will warn you in advance that this example is fairly complicated because it involves making “valuation assumptions” to be used in calculating the ABB in each year of the ten-year projection period and different “projection assumptions” with respect to “actual” experience during this period.

Data/Goals

Bill is currently age 65 and Betty is age 60.  Bill has retired from his previous employer and plans to work in part-time employment for five years.  He will be earning $15,000 in the current year for his part-time employment.  Betty is still employed and is currently earning $50,000 per annum.  Based on their current year’s valuation inflation assumption of 2% per annum, Bill has projected his age 70 Social Security benefit to be $30,000 per annum and Betty projects her age 65 Social Security benefit to be $20,000 per annum.  Bill also has a company sponsored pension benefit that currently pays him a fixed amount of $1,000 per month for the rest of his life with no benefit upon his death to Betty. 

Bill and Betty currently have $750,000 in assets, invested fairly aggressively. 

Bill and Betty have five years remaining on their home mortgage, but want to treat this cost (estimated to be a fixed amount of $18,000 per year) as a non-recurring expense.  Additionally, they would like to travel over the next 15 years and have estimated that they might spend an extra annual amount of $15,000 (in real dollars) for these non-recurring travel expenses.
Both Bill and Betty plan to fully retire in five more years.   Bill has decided to defer commencement of his Social Security benefit until age 70, while Betty has decided to collect hers at age 65 when she retires.  Bill and Betty have determined that the equity in their home should be sufficient to cover their anticipated long-term care costs.  They have also set aside sufficient separate reserves for unexpected expenses and burial expenses.  They have no desire to leave a large estate to their children. 

Projection Assumptions

For the ten-year projection, we will assume Bill and Betty’s employment earnings will increase with general inflation each year and they will both fully retire in five years as they plan.  We also assume that Bill and Betty’s pre-commencement Social Security benefits will be adjusted for higher than initially assumed levels of actual inflation and their post-commencement benefits will be increased by “actual” inflation.  Assumed future rates of inflation for projection purposes are shown in Column C of the chart below and future rates of investment return are shown in Column Q.  We also assume that neither Bill nor Betty would die during the 10-year projection period.

Calculations/Valuation Assumptions

We have used the Actuarial Budget Calculator (ABC) for Retired Couples to calculate Bill and Betty’s current year spending budget and their ABB for the current year and each of the next ten years.  For purposes of determining their current year spending budget, Bill and Betty decided to use the current default assumptions (4% investment return/2% inflation/2% future spending budget increases/lifetime planning period based on healthy, non-smoker with a 25% probability of survival), except they believe their current investment mix will produce at least a 3% real rate of return over their expected retirement rather than the default assumption of 2%.   To calculate their current and future projected ABBs, we assumed that the current default assumptions will remain unchanged during the projection period.  We also assumed Bill and Betty are comfortable assuming their recurring expenses will increase with general inflation in future years and decrease by 33% upon the first death within the couple.  Finally, we used the Present Value Calculator workbook to calculate the present values at the beginning of each year of the 10-year projection period of Bill and Betty’s future mortgage payments, travel expenses and estimated future Social Security survivor benefits payable to Betty upon Bill’s expected earlier demise.

(click to enlarge)

Results

The above chart shows that:

• While the ABB for recurring expenses (in Column J) may bounce around a bit from year to year depending on  projected investment returns and inflation, Bill and Betty’s recurring spending budget (in Column L) is expected to remain constant in real dollars over the next 10 years under these projection assumptions (as the ratio of the preliminary recurring spending budget to the ABB for recurring expenses shown in Column K does not fall below 90% and does not exceed 110% over the projection period).  Note that this result could be different under different projected investment experience, but the recommended smoothing algorithm is effective in avoiding year to year spending budget volatility, while at the same time keeping spending on track. 
• By treating their home mortgage and travel expenses as non-recurring expenses, Bill and Betty have maximized their recurring expense budget without jeopardizing their ability to meet future recurring expenses.  The Total Spending Budget in Year 1 dollars in Column O shows that they have “front-loaded” their total spending budget to cover these non-recurring expenses without unnecessarily increasing their expected future recurring expense budgets.  
• They have flexibility to deviate from their annual spending budget.  Column P shows that, like most real-world couples, they are sometimes going to spend more than their spending budget and sometimes less.  
• Withdrawals from accumulated savings in Column S are equal to the total amount actually spent by Bill and Betty in Column P minus their income in Columns F, G and H.  Contrary to results obtained using systematic withdrawal plans (SWPs), there is nothing “systematic” about Bill and Betty’s withdrawals from savings under this sustainable spending plan. 
• Under these projection assumptions, the ABB combined with our smoothing algorithm SSP produced results consistent with Bill and Betty’s spending goals.  However, they may wish to look at projections involving longer (or more pronounced) investment boom and bust cycles to further stress test their SSP. 
  

Conclusion

Developing a reasonable spending budget is not necessarily a simple task for “real-world” people in “real-world” situations.  While the calculations necessary to develop a reasonable budget in these circumstances may be complicated, we have simplified this process for you by providing Actuarial Budget Calculators (ABC) and Present Value Calculator (PVC) spreadsheets for you to use annually to calculate the necessary present values and ABBs.  We encourage you to use our workbooks to develop your own sustainable spending plan.   We also encourage you to model what your future spending budgets may be under reasonable projection assumptions for the future.  
 
If you are a financial advisor, we encourage you to kick the tires on this SSP to see if it just might do a better job of developing spending budgets for your “real-world” clients (and therefore benefit your bottom line).  At a minimum, you may wish to consider using this more robust SSP as a spending algorithm in your Monte Carlo models.

Retired Actuary Comments on Proposed Changes to Actuarial Standard of Practice No.32 (ASOP 32) Applicable to Social Security

Because Social Security benefits are, for most people in the U.S., a major component involved in determining how much they can afford to spend in retirement, we periodically focus on Social Security financing issues in this blog (with apologies to our non-U.S. readers).  Most recently, we addressed some of these issues in our post of June 27, 2018, “A Slightly Different Actuarial Perspective on the 2018 Social Security Trustees’ Report”.

On October 23, the Actuarial Standards Board (ASB) released Proposed Revision of Actuarial Standard of Practice No. 32—Social Insurance.  This standard sets forth appropriate practices for actuaries who provide actuarial services for programs defined to be Social Insurance programs, including the Social Security program.  The proposed standard revises the original standard adopted by the ASB in January, 1998 (and slightly modified in 2011).  As with all proposed changes in ASOPs, this proposed revision is being released as an Exposure Draft for comments and suggested changes by actuaries and the general public.  The comment deadline for this Exposure Draft is February 1, 2019. 

I have submitted my comments and suggested changes on the proposed revisions. 

My general comments on the proposed ASOP 32 revisions may be summarized as follows:

• The ASB should consider reviewing guidance provided in other ASOPs for consistency with proposed ASOP 32 guidance. 
• To quantify program shortfalls projected after the 75th year of an annual valuation, the ASB should retain the guidance in Section 3.7 of the current version of ASOP 32, which states,

“The actuary should note any significant differences between program income and cost toward the end of the valuation period. Further, the actuary should disclose the expected impact of such differences on the actuarial status in future valuations.”

If the Social Security actuary expects the long-range actuarial balance to deteriorate over time solely because of changes in the valuation period used in future valuations (which has been the case in every year for at least the past 50 years), this expectation should be quantified.  In my opinion, the existing guidance in Section 3.7 implies that the Social Security actuary should project future expected long-range actuarial balances as part of the Program’s annual valuation.  Such a projection would be helpful to the general public and to members of Congress in assessing the program’s long-range financial adequacy.  Therefore, I strongly believe the guidance in this section should not be deleted, as proposed.

• To avoid misinterpretation of the actuarial calculations used to measure Social Security’s financial status and test it for long-term financial adequacy, the standard should discourage use of the term, “Sustainable Solvency.”   Instead, this condition should be described as one where the long-range actuarial balance is projected to remain in balance for a period of “n” years if all assumptions are realized.

It is not “Absurd” to Express Expected Future Healthcare Costs as a Lump Sum Present Value

In his October 17 post, “Getting Real About (Annual) Health Care Costs in Retirement”, Michael Kitces discusses that, while the lump sum present value of expected healthcare costs in retirement may be “scary”, expected healthcare costs can become more manageable (or “plannable”) and less scary, to the average person, when expressed as a stream of annual costs with an equivalent present value.  He states “recognizing that health care costs may be ‘just’ about $5,000/year per person (or $10,000/year for a couple) for 20+ years of retirement is not necessarily as daunting as a $273,000+ lump sum obligation for retiree health care costs!”

As actuaries, we employ present value calculations in annual spending budget determinations (converting lump sum present values of assets and spending liabilities into annual spending budget streams). While we agree with Mr. Kitces that converting lump sum present values into equivalent annual cost streams can be more meaningful to individuals for retirement planning purposes, we reject Mr. Kitces’ claim that calculating a reasonable lump sum present value of expected future healthcare costs could be considered absurd. 

In this post we will:

• Defend present value calculations for planning purposes, and 
• Discuss how Mr. Kitces really makes healthcare cost planning more “manageable”
  

In defense of present value calculations for planning purposes 

As actuaries, we believe retirement planning should involve:

• making best-estimate (or conservative) assumptions about the future, 
• adjusting your retirement plan when your assumptions turn out to be incorrect, and 
• using the same lifetime planning period when determining the present values of income items, such as Social Security, as is used in determining the present values of expected expense items, such as medical costs, housing costs, etc. 
  

Therefore, if an individual (or financial planner) selects a conservative lifetime planning period as part of the retirement planning process, this selection will result in a higher present value of healthcare costs for planning purposes, all things being equal.  As noted by Mr. Kitces, use of the same conservative lifetime planning period for expected Social Security benefit payments will also produce a higher present value of these benefits for planning purposes.  These higher values are consistent with each other and 100% accurate if the “best estimate” assumptions are realized.  This same conservative lifetime planning period assumption is also used by many retirement planners to convert a “lump sum” present value of accumulated savings into lifetime retirement income.

Mr. Kitces notes that medical costs have historically increased at a rate faster than general inflation.  He says “[Since] medical expenses inflate at their own higher-than-the-general-rate-of inflation (at 3.6% vs 2.2%, respectively, over the past 20 years), arguably health care costs should really be projected separately from the remainder of retiree expenses in analyzing a retirement plan.”  We absolutely agree.  That is why we provide a separate tab in our single retiree ABC workbook to permit inputting separate increase assumptions for different types of retirement expenses.

For example, if we use all the default assumptions in our workbook, except we assume a 3.4% annual increase in medical costs (1.4% higher than the default inflation rate of 2% as suggested by Mr. Kitces), and we assume a current annual medical cost of $5,200  (the median medical cost for a 65-year old woman with income under $85,000 from Mr. Kitces’ article), we develop a present value of future medical costs for this female of $148,000, or roughly half of the $280,000 present value cost estimated by Fidelity for a 65-year old couple. 

Thus, under the default assumptions used in our workbooks and a 3.4% per year increase in medical costs, the calculated lump sum present value of $148,000 for Mr. Kitces’ hypothetical 65-year old female is equal in present value to a stream of annual costs starting at $5,200 this year and increasing by 3.4% each year for 31 years.  This $148,000 lump sum present value is the amount that she should have reserved today to fund all of her future expected healthcare costs.

By comparison, if she is currently receiving a Social Security benefit of $1,294 per month or $15,528 per year (the average Social Security benefit from Mr. Kitces’ article), the lump sum present value of this benefit, using the same default assumptions in our workbook, would be about $365,200.  When considered together in a consistent manner for planning purposes, both the lump sum present value of the future healthcare costs for this female and the lump sum present value of her future Social Security income seems to us to be perfectly reasonable.  Nor would it be any more “scary” or “absurd” than a recommendation from her financial advisor, if she had accumulated savings of $100,000, that such savings might produce only an annual income of $4,000 per year under the 4% Rule. 

If these default assumptions and a 3.4% per year increase in medical costs assumption are accurate and this hypothetical female has no other assets at retirement, she can expect to spend about 40% ($148,000/$365,200) of her assets (Social Security benefits) on healthcare costs on average over her period of retirement, leaving 60% of her assets for her remaining expenses.  And because of the different rates of increase as she ages, she can expect her healthcare costs to consume an increasing proportion of her Social Security check over time (starting at about 33% [$5,200/$15,528] at age 65 and increasing to close to 50% in her 90s).

Of course, as noted by Mr. Kitces, the present values of assets and spending liabilities do become more meaningful when they are compared with each other and converted into a stream of current and future spending budgets.  This is exactly what is accomplished under the Actuarial Approach. 

How Mr. Kitces really makes healthcare cost planning more “manageable”

While Mr. Kitces acknowledges that it is reasonable to assume that future medical costs will continue to increase at a faster rate than general inflation, he cites research that shows that total spending in retirement (including real increases in healthcare costs) tends to decline in real dollars as we age, thus justifying planning for level, rather than increasing, real dollar total spending in retirement.  By planning for level real dollar total spending in retirement, Mr. Kitces is able to focus on total spending and does not have to worry about the components of expected future expenses and how these components may increase or decrease relative to general inflation increases as individuals age.  And this may not be an unreasonable approach.  In fact, even though our Actuarial model permits the use of different increase assumptions for different types of expenses, our default assumption is that total expenses increase each year with general inflation—the same approach used by Mr. Kitces.  With our model, however, you can override this assumption if you believe a higher or lower increase rate would be more appropriate in your personal circumstances.

Conclusion

Under the Actuarial Approach, the lump sum present value of healthcare costs is an important component of determining your annual recurring spending budget in retirement.  If you are retired, it is the amount that you should have reserved today to cover your expected future healthcare costs.  If reasonable assumptions are used to estimate this amount, the result, while it may be higher than you like, is certainly not absurd.  We agree that streams of future spending budgets developed from reasonable present value of assets and spending liability calculations generally are more meaningful than the lump sum present values of the assets and spending liability components used in the calculations.  The Vanguard/Mercer study cited by Mr. Kitces recommends that healthcare costs should be considered as an annual payment stream rather than as a lump sum for “framing purposes.”

We also agree with Mr. Kitces that healthcare costs will vary from individual to individual, and you will probably need to develop your own best-estimate assumptions based on your own fact situation.  Whether you consider your future healthcare costs as a lump sum present value or equivalent value stream of annual costs, we encourage you to factor reasonable medical cost inflation expectations into the assumption you use (or your financial advisor uses) to project expected increases in your total future spending budgets.

ALRIE is a Better Nest Egg to Lifetime Income “Translator”

In his October 10, 2018 article, “Retirement savings:  How to translate your nest egg into monthly income,” Robert Powell suggests two possible ways of expressing accumulated savings as lifetime income.  According to Mr. Powell, the easiest way to do this is to obtain a quote for a single premium immediate annuity (SPIA) as, “Doing so will give you a sense of how much monthly income you would receive for life from an annuity based on the value of your retirement nest egg.” 

While we support using life insurance company annuity pricing to estimate lifetime income of equivalent value, we believe that the life annuity quotes used for this purpose should be for inflation-indexed life annuities, not fixed dollar life annuities, as most retirees expect their expenses to increase with inflation (at least to some degree) after retirement.  The approach suggested by Mr. Powell considers neither post-retirement inflation nor pre-retirement inflation and is therefore not particularly realistic.  For this reason, we believe that the Actuarial Lifetime Retirement Income Estimator (ALRIE) Excel workbook that we released in our post of June 9, 2018 (and made available in the Spreadsheets section of our website) is a better and more robust “translator” of your nest egg into real lifetime income than the approaches discussed in Mr. Powell’s article.

Using inflation-indexed annuity pricing assumptions, ALRIE provides answers to the following questions:

1. How much real dollar monthly lifetime income commencing X years from now will my current nest egg of $Y support? 
2. How much real dollar lifetime income commencing X years from now will my projected future nest egg of $Z support? 
3. What percentage of my future wages will I need to save over the next X years to increase my nest egg from $Y to $Z?
   

And, ALRIE does all of this without having to actually obtain an annuity quote.   It also provides these answers for couples as well as single individuals.  ALRIE is based on sound actuarial principles and is very easy to use.  It also flexible and permits entry of assumptions that differ from the inflation-indexed annuity default assumptions.  Therefore, users can get sense of their projected lifetime income under different future investment return, inflation or longevity assumptions.

We agree with Mr. Powell that there are benefits of expressing accumulated savings in the form of lifetime income, and we support the general intent of the proposed legislation mentioned in his article requiring that account balance to lifetime income translations be made available to defined contribution plan participants.  In our post of July 11, 2018, we challenged the American Academy of Actuaries to either improve ALRIE or endorse it in furtherance of their missions to serve the public and to provide actuarial expertise on legislative proposals.  We have also separately suggested to the Department of Labor that they consider replacing the current translator on their website with something more robust, like ALRIE. 

What’s the Plan, Betty and Stan?

Periodically in our blogposts we take the time to remind you that in addition to using the Actuarial Approach to help you develop a reasonable spending budget and keep it on track over time, you can also use it to model deviations from assumed future experience.  As discussed in our post of November 26, 2017, modeling deviations from assumed future experience can be valuable in helping you develop a more robust personal financial plan.  It gives you the opportunity to think about what you would do, for example, if:

• Your equity investments suffer a significant loss, 
• Your spouse dies, 
• Your or your spouses’ health deteriorates rapidly, 
• Your children need money, 
• You lose a source of income, or 
• Your house needs significant repairs
  

Will You Really Need to Generate More Lifetime Income in Retirement Than You Think?

Last week, the Wall Street Journal published an article questioning the fairly common rule of thumb recommended by many retirement experts that individuals need to replace about 70% to 80% of their pre-retirement pay in retirement.  The WSJ article, written by Dan Ariely and Aline Holzwarth, was titled, “How Much Money Will You Really Spend in Retirement?  Probably a Lot More Than You Think.”  For those unable to read the WSJ article, you can read a related article in MarketWatch entitled, Retirement is going to cost a lot more than you think—here’s what to do.  The authors of these articles argue that instead of needing to replace 70% to 80% of pre-retirement pay in accordance with the commonly used rule of thumb, you should be looking at funding income replacement of 130% or more of your pre-retirement pay.  This post will respond to these articles.  In summary, even though we are not particularly big fans of using the 70%-80% of pre-retirement pay rule of thumb, we are even less impressed with the authors’ recommended 130% of final pay rule of thumb.