In my post of March 1, 2015, I briefly discussed Social Security’s financial problem. In this post, I will once again mount my steed and tilt at the Social Security financing windmills by advocating adoption of a more actuarial approach to solving the problem. Readers who desire more background on the problem, the confusion resulting from the different approaches used to measure the size of the problem, how the problem came about and how Canada solved a similar problem can read my article in the May/June issue of Contingencies Magazine, the magazine for the actuarial profession.

Briefly, the 1983 Amendments to Social Security solved the financial problem that existed at that time, which was measured using the 75-year Actuarial Balance. This measurement is still around today and is widely quoted in the press as representing the size of the problem that needs to be solved today, but it was defective as a measure of the size of the problem in 1983, and it remains defective today. The 75-year Actuarial Balance calculation fails to reflect the future deficits expected after the end of the 75-year projection period. For this reason, the Social Security actuaries have proposed a stronger measure they refer to as “Sustainable Solvency” which would also require, at the time of a measurement, that trust fund ratios at the end of the 75 year projection period be expected to remain stable or on an upward trend. Unlike the 75-year Actuarial Balance calculation, the stronger requirement for Sustainable Solvency is not well quantified in the annual Trustee’s Report and therefore, it tends to get ignored when discussing reform options.

As noted in the article, Canada faced a similar financing problem with The Canada Pension Plan and implemented sweeping reforms in 1997. These reforms included self-sustaining provisions (automatic adjustments) to safeguard desired levels of funding, which resulted in Sustainable Solvency not only at the time of adoption of the changes, but also provided a mechanism for maintaining Sustainable Solvency in the future. I call this even stronger requirement, “Self-Sustaining Sustainable Solvency.” Actuaries, who work with the concept of automatic adjustments every day, may simply call this approach “actuarial financing.” I believe that the approach adopted in Canada provides a good blue-print for similar action in the U.S.

From time to time, we hear someone call for a national conversation on retirement in light of the retirement “crisis” in this country. Without a doubt, the first step in addressing this issue has to be making sure that Social Security, the foundation of retirement security for most Americans, is solid. I believe adoption of actuarial financing for Social Security is important for keeping that foundation strong for the future.

I want to thank Jean-Claude Menard, Chief Actuary for The Canada Pension Plan, for his thoughtful comments on an initial draft of the article and for his patience with me in explaining the process used in Canada.

Regarding the Don Quixote reference above, this is not the first time that I have advocated consideration of a more actuarial approach for Social Security financing (anticipating a tax rate expected to remain level indefinitely). Back in 1982 when the National Commission on Social Security Reform was working on what would become the 1983 Amendments, I wrote a paper that was subsequently published in the 1983 Transactions of Society of Actuaries entitled, “A Better Financial Approach for Social Security.” While this paper may be available from the SoA library, it is very difficult to find (and probably worth a lot of money). If you are interested in reading my thoughts on Social Security financing from around that time, a staff member of the Conference of Consulting Actuaries was able to provide me with a pdf version of the transcript of my paper and presentation, “Social Security--There Will Be No Long-Term Solvency With Pay-As-You-Financing” from a 1984 meeting of what was then the Conference of Actuaries in Public Practice.

# How much can I afford to spend in retirement?

This site has been established to help those retired individuals who have decided not to annuitize all of their accumulated retirement savings develop a spend-down strategy for their self-managed assets as part of an overall process of developing an annual spending budget in retirement.

## Sunday, May 3, 2015

## Sunday, April 26, 2015

### Revisiting the Guyton Decision Rules

To err is human, and I am very human. In this post I will issue not one but two corrections of errors made in prior posts.

In our post of April 18, 2015, we showed a graph that compared the expected pattern of future spending budgets for a hypothetical age 65 male retiree who buys a fixed income annuity (Single Premium Income Annuity, or SPIA) under the Actuarial Approach (assuming desired increases in the annual budget equal to the assumed future annual rate of inflation) with budgets produced using the Guyton Decision Rules. Budget amounts shown were total budgets, including Social Security, payments from the annuity and withdrawals from accumulated savings.

Subsequent to the April 18th post, I received a nice note from Dr. Wade Pfau indicating that I appeared to have incorrectly applied the Guyton Decision Rules in the example. Instead of increasing the prior year’s budget with inflation (the preliminary withdrawal amount for the year), the Guyton Decision Rules impose a 10% reduction in the withdrawal amount for a year in which the preliminary withdrawal amount divided by accumulated savings at the beginning of the relevant year exceeds 120% of the initial withdrawal rate. Mr. Guyton refers to this decision rule as the “capital preservation rule.” I correctly applied this reduction, but I was unaware, however, that this capital preservation rule is not applied if the retiree is “within 15 years of the maximum planning age.”

Graph #1 below corrects the graph provided in the April 18th post by ceasing application of Mr. Guyton’s capital preservation rule at age 80. I will also add a warning to my post of July 3, 2014 cautioning those who may visit that post that the graph shown is not based on a correct interpretation of the Guyton Decision Rules.

Dr. Pfau also indicated that since many retirees like higher real dollar spending early in retirement, it wasn’t so obvious to him that the constant spending budget produced under the Actuarial Approach was more desirable. I’m was actually a little surprised to hear this from Dr. Pfau, as most withdrawal strategies appear to have constant real dollar spending as an objective, and I was somewhat curious as what there was about buying a fixed income annuity that would significantly change someone’s spending objective. But, be that as it may, as indicated in my previous post, it is easy to change the shape of expected future real dollar budgets under the Actuarial Approach to satisfy a retiree’s objectives. For example, Graph #2 shows expected future real dollar spending budgets if the same hypothetical retiree makes the conscious decision to front-load his spending budget by inputting 0% desired increases in the portion of his total spending budget attributable to accumulated savings and annuity payments (the Social Security component of his spending budget would still be expected to increase by the inflation assumption of 2.5% per annum).

While the spending budgets shown in Graph 2 for the two approaches are close, the important distinction between the two approaches is that the decision to front-load under the Actuarial Approach is a conscious one where the retiree is fully aware of the out-year implications if future experience is close to assumed experience on average (and the retiree is aware that he has made a commitment not to give himself inflation increases in future years, at least with respect to the portion of his spending budget attributable to the annuity and withdrawals). The same cannot be said if he uses the Guyton Decision Rules because the retiree doesn’t know what the assumptions for future experience are under that approach.

Even though ceasing application of Guyton’s capital preservation rule when the retiree is within 15 years of the maximum planning age may improve the Guyton’s Decision Rules, I am still not a fan of them. They are unresponsive to changes in expected future investment returns (nominal or real), changes in expected future levels of inflation (as inflation may affect fixed dollar income components of a retiree’s portfolio), or changes in expected life expectancy. As previously mentioned, the Guyton Decision Rules do not coordinate with fixed income annuity/pensions and they do not directly consider a bequest motive. If experience is unfavorable, the retiree can run out of accumulated savings if the rules are blindly followed. For example, under the Actuarial Approach, a 5.5% withdrawal rate for a retiree with a 30-year expected retirement period with no other sources of retirement income is consistent with an investment return assumption of 6% per annum and an inflation assumption of 2% annum (assuming the retiree desires constant real dollar spending in retirement). If actual experience is less favorable than these assumptions, real dollar withdrawals under the Guyton Rules will be reduced frequently prior to reaching the 15-year cut-off mark (real dollar withdrawals are expected to be reduced in the 9th year even if experience exactly follows these assumptions). After the 15th year, there are no cut backs, but there is a risk of running out of money. Alternatively, if experience is more favorable than these assumptions, it is unlikely that withdrawal rates under the Guyton Rules in later years will fall as low as 4.6%, the approximate threshold for increasing withdrawals under Guyton’s “prosperity rule.” Therefore, a retiree who experiences favorable experience will likely underspend relative to his objectives. Finally, my actuarial training causes me to seriously question any approach that doesn’t periodically match assets with liabilities (the present value of the future expected/desired withdrawals and annuity payments) under a reasonable set of assumptions about the future.

As a further illustration of how the Guyton Rules fail to coordinate with other fixed income sources of retirement income, Graph #3 shows expected future real dollar spending budgets for our hypothetical retiree under the assumption that instead of buying the immediate annuity at 65 (SPIA), he spends $150,000 of his accumulated savings on a deferred income annuity (DIA) with benefits commencing at age 80. According to today’s Immediateannuities.com website, he would be eligible to receive payments of $40,776 for life starting at age 80 (and nothing if he dies prior to age 80) for a premium of $150,000. Using the Excluding Social Security spreadsheet on this site and inputting the recommended assumptions, $850,000 in accumulated assets ($1,000,000 minus the $150,000 used to purchase the DIA), $40,776 in deferred annuity payments and 16 years as the deferred annuity commencement year [Note, since the retiree in this instance is age 65 in year 1, he is assumed to reach age 80 in year 16, 15 years later. This is correction #2 of this post as I myself haGraph 1 (click to enlarge)ve made the mistake of inputting 15 years for a deferred annuity starting at age 80 or twenty years for a deferred annuity starting at age 85 for a 65 year old retiree in prior posts discussing deferred annuities/QLACs]. Finally, this graph also assumes that the retiree makes the decision to front-load spending in the same manner as for Graph #2 by inputting 0% desired increases in future spending budgets attributable to the annuity and withdrawals from accumulated savings.

Graph #3 shows that the Actuarial Approach produces an expected total spending budget pattern that is comparable to the pattern it produced in Graph #2, while the expected spending budget pattern produced by the Guyton Spending Rules under these assumptions doesn’t appear to be consistent with the retiree’s front loaded spending objectives.

In our post of April 18, 2015, we showed a graph that compared the expected pattern of future spending budgets for a hypothetical age 65 male retiree who buys a fixed income annuity (Single Premium Income Annuity, or SPIA) under the Actuarial Approach (assuming desired increases in the annual budget equal to the assumed future annual rate of inflation) with budgets produced using the Guyton Decision Rules. Budget amounts shown were total budgets, including Social Security, payments from the annuity and withdrawals from accumulated savings.

Subsequent to the April 18th post, I received a nice note from Dr. Wade Pfau indicating that I appeared to have incorrectly applied the Guyton Decision Rules in the example. Instead of increasing the prior year’s budget with inflation (the preliminary withdrawal amount for the year), the Guyton Decision Rules impose a 10% reduction in the withdrawal amount for a year in which the preliminary withdrawal amount divided by accumulated savings at the beginning of the relevant year exceeds 120% of the initial withdrawal rate. Mr. Guyton refers to this decision rule as the “capital preservation rule.” I correctly applied this reduction, but I was unaware, however, that this capital preservation rule is not applied if the retiree is “within 15 years of the maximum planning age.”

Graph #1 below corrects the graph provided in the April 18th post by ceasing application of Mr. Guyton’s capital preservation rule at age 80. I will also add a warning to my post of July 3, 2014 cautioning those who may visit that post that the graph shown is not based on a correct interpretation of the Guyton Decision Rules.

Graph 1 (click to enlarge) |

Graph 2 (click to enlarge) |

Even though ceasing application of Guyton’s capital preservation rule when the retiree is within 15 years of the maximum planning age may improve the Guyton’s Decision Rules, I am still not a fan of them. They are unresponsive to changes in expected future investment returns (nominal or real), changes in expected future levels of inflation (as inflation may affect fixed dollar income components of a retiree’s portfolio), or changes in expected life expectancy. As previously mentioned, the Guyton Decision Rules do not coordinate with fixed income annuity/pensions and they do not directly consider a bequest motive. If experience is unfavorable, the retiree can run out of accumulated savings if the rules are blindly followed. For example, under the Actuarial Approach, a 5.5% withdrawal rate for a retiree with a 30-year expected retirement period with no other sources of retirement income is consistent with an investment return assumption of 6% per annum and an inflation assumption of 2% annum (assuming the retiree desires constant real dollar spending in retirement). If actual experience is less favorable than these assumptions, real dollar withdrawals under the Guyton Rules will be reduced frequently prior to reaching the 15-year cut-off mark (real dollar withdrawals are expected to be reduced in the 9th year even if experience exactly follows these assumptions). After the 15th year, there are no cut backs, but there is a risk of running out of money. Alternatively, if experience is more favorable than these assumptions, it is unlikely that withdrawal rates under the Guyton Rules in later years will fall as low as 4.6%, the approximate threshold for increasing withdrawals under Guyton’s “prosperity rule.” Therefore, a retiree who experiences favorable experience will likely underspend relative to his objectives. Finally, my actuarial training causes me to seriously question any approach that doesn’t periodically match assets with liabilities (the present value of the future expected/desired withdrawals and annuity payments) under a reasonable set of assumptions about the future.

As a further illustration of how the Guyton Rules fail to coordinate with other fixed income sources of retirement income, Graph #3 shows expected future real dollar spending budgets for our hypothetical retiree under the assumption that instead of buying the immediate annuity at 65 (SPIA), he spends $150,000 of his accumulated savings on a deferred income annuity (DIA) with benefits commencing at age 80. According to today’s Immediateannuities.com website, he would be eligible to receive payments of $40,776 for life starting at age 80 (and nothing if he dies prior to age 80) for a premium of $150,000. Using the Excluding Social Security spreadsheet on this site and inputting the recommended assumptions, $850,000 in accumulated assets ($1,000,000 minus the $150,000 used to purchase the DIA), $40,776 in deferred annuity payments and 16 years as the deferred annuity commencement year [Note, since the retiree in this instance is age 65 in year 1, he is assumed to reach age 80 in year 16, 15 years later. This is correction #2 of this post as I myself haGraph 1 (click to enlarge)ve made the mistake of inputting 15 years for a deferred annuity starting at age 80 or twenty years for a deferred annuity starting at age 85 for a 65 year old retiree in prior posts discussing deferred annuities/QLACs]. Finally, this graph also assumes that the retiree makes the decision to front-load spending in the same manner as for Graph #2 by inputting 0% desired increases in future spending budgets attributable to the annuity and withdrawals from accumulated savings.

Graph #3 (click to enlarge) |

## Friday, April 24, 2015

### Expected Real Dollar Spending Budget Shaping

As indicated in previous posts, retirees and their financial advisors can use the Actuarial Approach to provide different patterns of future expected real dollar spending budgets. If the user of the "Excluding Social Security" spreadsheet on this website inputs the recommended assumptions and sets the desired increase in payments equal to the inflation assumption, annual future budgets (including Social Security) are expected to remain constant in real dollar terms from year to year until the retiree reaches almost age 90 (when age plus life expectancy starts to exceed 95) if all assumptions are realized, assumptions are not changed and actual spending exactly equals budgeted spending. As discussed in our previous post, unlike under many other withdrawal strategies, this is true under the Actuarial Approach even if the retiree has other fixed dollar sources of retirement income such as pension income or immediate or deferred annuity income.

There is a school of thought that says that spending generally declines in real terms as we age. See our post of July 19, 2014 for a discussion of David Blanchett's research on this subject. In that post we indicated that developing a declining real dollar budget (on an expected basis) can be accomplished using the Actuarial Approach by inputting a smaller percentage for desired increases in payments than the expected annual inflation assumption. In addition, the figures in the tab labeled "Inflation-Adjusted Runout" will show the expected future budgets if such an approach is used. Note that these declining spending budget components are not coordinated with the Social Security component of the budget (which is inflation-indexed under current law), so the retiree/financial advisor would have to make appropriate adjustments if the retiree's total spending budget is desired to be declining from year to year at a desired rate.

A couple of days ago, I received a request from a reader named Greg asking if there were some way to modify the Excluding Social Security spreadsheet so that his expected spending could remain constant in real dollar terms for the first 10 years of his retirement and then decline in real terms by 1% per year thereafter. While the spreadsheet cannot perform this task as easily as it can for a constant percentage decrease, with some extra calculations, it can accomplish this objective on an approximate basis. Since Greg didn't tell me his age or financial situation, I am going to make up some numbers for him for purposes of illustrating how one can go about solving this problem.

I am going to use the current recommended assumptions of 4.5% investment return, 2.5% inflation and an expected payment period of 95-age or life expectancy if greater. I'm going to assume that Greg is age 65 with $500,000 of accumulated savings, no fixed dollar pension or annuity benefits and no bequest motive. For the first 10 years of his retirement, Greg is going to have to calculate an average desired rate of payment increase. In the first year, this will be equal to 10 X 2.5% (the inflation assumption) plus 20 X 1.5% (the inflation assumption minus 1%), the result divided by 30 (or 1.83%). He uses this percentage to determine the actuarial value in the spreadsheet and his first year spending budget. In the second year, this average desired rate of payment increase will be 9 X 2.5% plus 20 X 1.5%, the result divided by 29 (or 1.81%). After 10 years, he will just use 1.5% (assumed inflation minus 1%). In determining his spending budget for years 2-10 (Excluding Social Security), he will increase his prior year budget by 2.5% and compare that result with the 10% corridor around the actuarial value he determined as described above. For years, 11 through 30, he will increase his prior year budget by 1.5% and compare that result with the 10% corridor around the actuarial value he determines in those years.

The graph below shows the shapes of the expected real dollar future budgets for Greg under 1) the constant real dollar approach, 2) the constant inflation minus 1% approach and 3) the hybrid approach Greg wanted (constant for 10 years and inflation minus 1% thereafter). The graph assumes future experience exactly follows the recommended assumptions (4.5% investment return, 2.5% inflation, no changes in current assumptions and exactly the budget amount is spent each year). While these assumptions for future experience will certainly not occur, the purpose of this exercise is to illustrate how the Actuarial Approach can be used to shape expected future budgets (excluding Social Security).

As I have said in many of my prior posts, you can spend your assets now or you (or your heirs) can spend them later. If you want to "front-load" your spending, you can do this in several ways. You can either decide to spend more than your constant real dollar budget in your younger years or you can develop a budget that you expect to decline in real dollar terms at some point during your retirement. The bottom line is that this decision to front load should be a conscious one and not the result of using a particular withdrawal strategy that either starts out with too high of a withdrawal rate or, as discussed in my previous post, doesn't properly coordinate with fixed dollar pension/annuity income. You should also have a sense of what the out-year implications may be of a decision to front-load your spending. I believe the Excluding Social Security spreadsheet (and its inflation-adjusted Runout tab) does a good job of giving you the information you need in this regard. If you aren't using the Actuarial Approach and you/your financial advisor aren't adequately addressing these issues, you may wish to consider switching to the Actuarial Approach. At a minimum, you may wish to compare the spending budget produced under your current approach with the budget produced under the Actuarial Approach and reconcile any significant disparities.

There is a school of thought that says that spending generally declines in real terms as we age. See our post of July 19, 2014 for a discussion of David Blanchett's research on this subject. In that post we indicated that developing a declining real dollar budget (on an expected basis) can be accomplished using the Actuarial Approach by inputting a smaller percentage for desired increases in payments than the expected annual inflation assumption. In addition, the figures in the tab labeled "Inflation-Adjusted Runout" will show the expected future budgets if such an approach is used. Note that these declining spending budget components are not coordinated with the Social Security component of the budget (which is inflation-indexed under current law), so the retiree/financial advisor would have to make appropriate adjustments if the retiree's total spending budget is desired to be declining from year to year at a desired rate.

A couple of days ago, I received a request from a reader named Greg asking if there were some way to modify the Excluding Social Security spreadsheet so that his expected spending could remain constant in real dollar terms for the first 10 years of his retirement and then decline in real terms by 1% per year thereafter. While the spreadsheet cannot perform this task as easily as it can for a constant percentage decrease, with some extra calculations, it can accomplish this objective on an approximate basis. Since Greg didn't tell me his age or financial situation, I am going to make up some numbers for him for purposes of illustrating how one can go about solving this problem.

I am going to use the current recommended assumptions of 4.5% investment return, 2.5% inflation and an expected payment period of 95-age or life expectancy if greater. I'm going to assume that Greg is age 65 with $500,000 of accumulated savings, no fixed dollar pension or annuity benefits and no bequest motive. For the first 10 years of his retirement, Greg is going to have to calculate an average desired rate of payment increase. In the first year, this will be equal to 10 X 2.5% (the inflation assumption) plus 20 X 1.5% (the inflation assumption minus 1%), the result divided by 30 (or 1.83%). He uses this percentage to determine the actuarial value in the spreadsheet and his first year spending budget. In the second year, this average desired rate of payment increase will be 9 X 2.5% plus 20 X 1.5%, the result divided by 29 (or 1.81%). After 10 years, he will just use 1.5% (assumed inflation minus 1%). In determining his spending budget for years 2-10 (Excluding Social Security), he will increase his prior year budget by 2.5% and compare that result with the 10% corridor around the actuarial value he determined as described above. For years, 11 through 30, he will increase his prior year budget by 1.5% and compare that result with the 10% corridor around the actuarial value he determines in those years.

The graph below shows the shapes of the expected real dollar future budgets for Greg under 1) the constant real dollar approach, 2) the constant inflation minus 1% approach and 3) the hybrid approach Greg wanted (constant for 10 years and inflation minus 1% thereafter). The graph assumes future experience exactly follows the recommended assumptions (4.5% investment return, 2.5% inflation, no changes in current assumptions and exactly the budget amount is spent each year). While these assumptions for future experience will certainly not occur, the purpose of this exercise is to illustrate how the Actuarial Approach can be used to shape expected future budgets (excluding Social Security).

(click to enlarge) |

As I have said in many of my prior posts, you can spend your assets now or you (or your heirs) can spend them later. If you want to "front-load" your spending, you can do this in several ways. You can either decide to spend more than your constant real dollar budget in your younger years or you can develop a budget that you expect to decline in real dollar terms at some point during your retirement. The bottom line is that this decision to front load should be a conscious one and not the result of using a particular withdrawal strategy that either starts out with too high of a withdrawal rate or, as discussed in my previous post, doesn't properly coordinate with fixed dollar pension/annuity income. You should also have a sense of what the out-year implications may be of a decision to front-load your spending. I believe the Excluding Social Security spreadsheet (and its inflation-adjusted Runout tab) does a good job of giving you the information you need in this regard. If you aren't using the Actuarial Approach and you/your financial advisor aren't adequately addressing these issues, you may wish to consider switching to the Actuarial Approach. At a minimum, you may wish to compare the spending budget produced under your current approach with the budget produced under the Actuarial Approach and reconcile any significant disparities.

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