Monday, March 23, 2015

The Actuarial Approach—A Dominating Dynamic Spending Strategy

Over at The Retirement CafĂ©, Dirk Cotton has provided two informative posts which compare various spending strategies.   The first is dated February 20, 2015 entitled, “Dominated Strategies and Dynamic Spending” and the second (a follow-up to the first) is dated March 17, 2015 entitled “Dominated Strategies, Logically Unsound Strategies, Problematic Strategies and Strategies that Make Me Queasy”

In the first post, Dirk uses game theory (and not the knowledge he may have gained by avidly reading the 50 Shades of Grey trilogy) to determine that Dynamic Spending Strategies (like the Actuarial Approach) “dominate” safe withdrawal rate strategies.  In his March 17 post he continues to eliminate strategies from his “Sound Strategies” list by crossing out strategies that are logically unsound, problematic or that make him feel queasy.   Nice posts, Dirk. 

Sunday, March 22, 2015

The Annually Recalculated Virtual Annuity—Pretty Darn Similar to the Actuarial Approach

Thanks to Wade Pfau for bringing to my attention the article in the January/February 2015 Financial Analysts Journal entitled, “The Only Spending Rule Article You Will Ever Need” by M. Barton Waring and Laurence B. Siegel.  The authors believe that, “constructing a spending rule is itself an annuitization problem at heart but does not require purchasing an actual annuity…”  The name the authors give to their recommended spending rule is the Annually Recalculated Virtual Annuity (ARVA).   
 
I agree with most of this article, as it is basically the same as the approach I have been advocating for over ten years, the last five of which are documented in this website. 

About the only aspect of the authors’ article with which I am not in complete agreement is the authors’ aversion to smoothing of the spending budget from year to year.  The authors argue that smoothing is “the actuarial mistake that has caused so much difficulty for pension plans” and “It is important to control consumption risk with investment policy, not with accounting tricks like smoothing.”  While I agree that over-smoothing can be a problem, I believe the recommended smoothing algorithm advocated in this website does a pretty good job of balancing retiree needs to have some acceptable degree of spending stability with the need to remain on track with the correct actuarially determined value, and in my opinion is consistent with “the small amount of smoothing” described in footnote 13 of the article.  Further, I find it somewhat hypocritical of the authors to cling so steadfastly to their “no smoothing” mantra at the same time that they play fast and loose with longevity risk by stating, “As with any stream of cash flows, the shape of the cash flow payments to a retiree can be engineered to be anything the retiree wants…”.  After all, as I said in my previous post, any spending rule is designed to give the retiree a budget, and it is ultimately up to the retiree to determine how closely that budget will be followed in the current year. 

I will point out that while this article is entitled “The Only Spending Rule Article You Will Ever Need”, the article itself doesn’t provide much in the way of simple spreadsheets (like we provide in this website) to implement the rule, particularly if a retiree has other sources of retirement income such as immediate or deferred annuities/pensions with which spending from accumulated savings needs to be coordinated.

Thursday, March 19, 2015

Retirement Researcher Confirms Actuarial Methods Spend Down Wealth More Efficiently

In his March 16 paper, “Making Sense Out of Variable Spending Strategies for Retirees”, Dr. Wade Pfau examines ten key variable rate spending strategies (including the Actuarial Method advocated in this website) with the goal of comparing the strategies and evaluating them against certain criteria.  Instead of examining the “failure rate” of the strategies, Dr. Pfau looks at distributions of spending and wealth decumulation outcomes using Monte Carlo simulations assuming hypothetical retirees are comfortable with an X% chance that spending levels fall below a threshold of Y real dollars by year Z of retirement (where X,Y and Z can vary).  

Dr. Pfau separates the ten strategies into two main groups:  decision rule methods and actuarial methods.  He further separates the actuarial methods into four approaches with the Actuarial Approach advocated in this website included in the PMT Formula category (because the formula used in the spending rate determination is mathematically equivalent to the result obtained by using the PMT function in Excel if the retiree has no pension/annuity income with which to coordinate).  Based on his research, Dr. Pfau concludes that the actuarial methods “are all shown to spend down wealth more efficiently” than the decision rule methods. 

I applaud Dr. Pfau’s efforts to examine the various strategies available to retirees and their advisors using the XYZ metric he has developed and Monte Carlo simulations.  It is important to remember, however, that developing a reasonable spending budget in retirement is equal parts art and science, as no one knows what the future holds.  In addition, a spending budget is just that—a budget.  Almost no retiree I know spends exactly her budget each year.

For simplification purposes, Dr. Pfau’s analysis assumes the hypothetical retirees used in his Monte Carlo simulations have no other sources of retirement income other than accumulated wealth.  He does note that the “XYZ” measurement calculation “can incorporate Social Security and other income sources as well…”  If you do have other sources of retirement income (such as annuity income from a pension plan or insurance contract) that are not indexed to inflation or are not currently in payment status these other sources can significantly affect current spending of accumulated savings.  Of course, the simple spreadsheets provided in this website automatically consider these other sources to provide you with a coordinated spending budget, whereas the other “actuarial methods” examined by Dr. Pfau do not