Sunday, January 14, 2018

Maintaining Your Principal—Another Spending Budget “Data Point”

Recently published research from BlackRock confirmed earlier research from the Society of Actuaries that retirees tend, on average, to spend just about their income each year, where income is defined as income streams from sources such as Social Security and employer provided pensions plus interest, dividends and capital appreciation on their investment portfolios.   According to the research, “The vast majority haven't been spending their retirement savings—leaving nest eggs mostly untouched and living on ready sources of income instead.”  This post will discuss this “maintain your principal” (MYP) strategy as another “data point” to be used in determining your spending budget setting strategy.

The MYP strategy has been around ever since people started to retire and wondered how they should deploy their accumulated savings.  The strategy can work reasonably well if you don’t need to rely too heavily on portfolio income for essential expenses and/or if interest and dividend payments generated by your portfolio are reasonably adequate and stable.  In the recent low-interest rate environment, it has been difficult for some retirees to make this strategy work well.  The Blackrock research appears to find, however, that many retirees have adjusted their spending to implement this strategy, even during the recent low-interest rate environment.

We at How Much Can I Afford to Spend don’t tell you how much you should spend each year.  That is your decision to make.  We do give you tools to use to provide you with additional “data points” that can supplement other data points available to you to help you make your spending decisions.  Further, even if you use our recommended Actuarial Budget Benchmark (ABB) to develop your annual spending budget, there is no requirement to actually spend that amount each year.   For example, you may feel more comfortable spending less than your ABB.

We are strong advocates of retirement planning that meets your specific financial goals.  If one of your primary goals is to maintain or grow your accumulated savings, then the MYP strategy may be more appealing to you than a spending strategy that reduces your accumulated savings over time to fund your goals for higher levels of spending.

As we have said many times in this website, we encourage you to annually calculate your ABB and compare it with whatever you are currently doing to develop your spending budget.  If the MYP strategy isn’t consistent with your long-term spending goals, you owe it to yourself to examine alternative strategies that may be.

Wednesday, December 27, 2017

It’s Time to Perform Your Annual Actuarial Valuation

As part of our ongoing effort to encourage you to think more like an actuary when it comes to your personal finances, this post will recommend that you to perform an Actuarial Valuation based on your personal data as of January 1, 2018, and prepare an “Actuarial Report” to document your thought process and your planning decisions.  The purposes of this exercise are to:
  • Review how well you did in 2017 
  • Develop 2018 spending budget “data points” 
  • Finalize your 2018 calendar year spending budget (or spending/savings budget for pre-retirees) 
  • Document the assumptions, data and adjustments used to determine your final 2018 spending budget, and 
  • Collect and save information that may be useful for your future actuarial valuations
The first step in the actuarial valuation process is to gather all your relevant personal financial data as of January 1, 2018.

Measuring How You Did in 2017

We hope that you saved your data as of January 1, 2017 and documentation of your 2017 spending budget calculations.  With this data you should be able to determine how you did in 2017, by approximating the items in the following equation:

2018 Accumulated Savings
2017 Accumulated Savings
2017 Investment Income
2017 Income from Other Sources
2017 Amount Spent

Solving for these amounts and comparing them with amounts expected, based on your 2017 calculations, will enable you to determine your total actuarial gain/(loss), by subtracting Expected 2018 Accumulated Savings from Actual 2018 Accumulated Savings.  If your actual 2018 BOY Accumulated Savings exceeds your Expected 2018 Accumulated Savings, you experienced an “actuarial gain.”

Similarly, you can determine your gain/(loss) by source by comparing actual amounts experienced in 2017 with expected values (based on the 2017 actuarial valuation) for the following items:
  • investment income 
  • income from other sources 
  • spending
Since it looks like equities will have earned about 20% during 2017 (based on the S&P 500 index at the time of writing), those of you who invested a significant portion of your Accumulated Savings in equities probably experienced actuarial gains on investment income during 2017.  All things being equal, these investment gains will translate into a larger Actuarial Budget Benchmark (ABB) for 2018.  We will discuss below, however, whether you might want to save some of these gains in a Rainy-Day Fund rather to use them to increase your 2018 spending budget.

Developing 2018 Spending Budget “Data Points”

As discussed in our post of April 20, 2017, the process of deciding on your 2018 spending budget involves considering a number of “data points.”  The data points may include, but are certainly not limited to, the following:
  • Your 2017 Spending Budget or actual 2017 spending increased with inflation or some other percentage increase 
  • Your 2018 Spending Budget recommended by your financial advisor or someone else, 
  • Your 2018 Actuarial Budget Benchmark (ABB) 
  • Your desire to avoid significant fluctuations in spending 
  • Your desire to be conservative 
  • Your scenario testing (discussed in our post of November 26, 2017) 
  • Recurring and non-recurring spending plans for 2018, etc.
For the first item above, we recommend using the same increase announced for Social Security cost of living increases for 2018: 2%.  If you develop your spending budget based on desired future increases of inflation minus 1%, however, your preliminary 2018 Spending Budget “data point” would be your 2017 spending budget increased by 1% (2% ‒ 1%).

As previously discussed in many of our previous posts (most recently in our post of November 6, 2017), we encourage you to develop your ABB as another data point in your budget setting process.  The ABB is a budget developed using basic financial economic principles by comparing the market value of your assets with the approximate market value of your spending liabilities (i.e., the theoretical cost of purchasing currently available insurance annuity contracts to cover your future spending).  The purpose of the ABB is to gauge how conservative or aggressive your current spending strategy is.  Armed with this benchmark, you can choose the level of spending with which you are comfortable and, just as important, you can monitor how aggressive your spending is each year by annually comparing it with your annually revised ABB. Recommended assumptions to develop your ABB as of January 1, 2018 are summarized in the overview tab of our Actuarial Budget Calculator (ABC) workbooks and, with the possible exception of using different Lifetime Planning Periods (LPPs) for couples, are unchanged from last year.  

As noted above, if you invested significantly in equities in 2017, it is likely that you enjoyed some investment gains.  In order to avoid significant fluctuations in spending and to be more conservative, you may wish to put some or all of your unexpected 2017 investment gains in a Rainy-Day Fund.  One way you can do this is to increase the amount entered in our Actuarial Budget Calculators (ABCs) for the present value of unexpected expenses and non-recurring expenses.  We have no idea when the equity market will see its next “correction,” but it does seem prudent to us to plan on one.  You may wish to use our 5-year forecast tabs (in the ABCs for single retirees and pre-retirees) to see how a significant correction in 2018 could affect your 2019 ABB.

Finalizing Your 2018 Spending Budget

Based on the data points discussed above (and possibly others), you can finalize your 2018 Spending Budget.  And while we use the terms “final” and “finalize,” you can always revise your final 2018 spending budget during the year if economic conditions or your personal situation changes.

Documenting Your 2018 Actuarial Valuation

Actuaries generally document their work in what is called an “Actuarial Report.”  We encourage you to document your work in sufficient detail that you can figure out next year what you did to develop your final 2017 Spending Budget.  This process can be as simple as printing out the “Input and Results” tab of the ABC workbook you used and writing notes on it.  Or you may save the workbook with your notes in a file on your computer.

Maintaining an Historical Record

In addition to documenting your work in developing your 2018 Spending Budget, we encourage you to maintain an historical record of your spending budget calculations.  This historical information will provide you with additional “data points” that you can use to refine future spending budget determinations.  We have provided a sample spreadsheet for this purpose that will reside in our “spreadsheets” section.  We aren’t trying to make you do a bunch of unnecessary busywork, so feel free ignore items in this spreadsheet you don’t feel like maintaining.  This is just a spreadsheet that we use ourselves to maintain historical information.  We have started the spreadsheet with 2017 information, but if you have information for earlier years, feel free to add that earlier information to your personal spreadsheet. 
(click to enlarge)


Instead of watching some of those college football games this year, we recommend that you take some time to think about your personal financial situation and do some planning.  We recommend that you perform an actuarial valuation of your assets and spending liabilities, and document your thought process in an Actuarial Report that you can revisit next year during college bowl season.  We also recommend that you maintain this information each year so that you can use the historical information to make better assumptions and spending decisions.

Happy New Year and Happy Budgeting from Ken and Bobbie.

Thursday, December 21, 2017

Better Budgeting with the IRS/RMD Table? — Part II

Several of our readers have asked us to comment on the recently released 145-page report entitled Optimizing Retirement Income by Integrating Retirement Plans, IRAs and Home Equity, authored by Dr. Wade Pfau, Joe Tomlinson, FSA and Steve Vernon, FSA.  The report is a collaboration between the Stanford Center on Longevity and the Society of Actuaries.  Since the report was authored by two actuaries and reviewed by many actuaries (including me), our readers wondered how the recommended strategy contained in this report compares with the Actuarial Approach we advocate here at How Much Can I Afford to Spend in Retirement.  Unfortunately, the two strategies contain some significant differences that may or may not be successfully explained by desires to appeal to different target audiences.  

The authors advocate what they call the “SS/RMD Spend Safely in Retirement Strategy.”  For those who do not want to wade through all 145 pages in the full report, the strategy is summarized in Steve Vernon’s shorter 19-page marketing piece entitled, “How to ‘Pensionize’ Any IRA or 401(k) Plan.”  Briefly, the approach anticipates deferring commencement of Social Security until age 70 and using a Systematic Withdrawal Plan (SWP) known as the IRS/Required Minimum Distribution (RMD) rule to determine annual withdrawals from the individual’s (or couple’s) account balances.   

We discussed the potential downsides of using the IRS/RMD approach recommended by the authors in our post of October 3, 2017.  The reasons we are not big fans of using this approach include:

  • The IRS/RMD SWP is quite conservative 
  • SWPs frequently do not coordinate well with other sources of retirement income 
  • SWPs generally do not adequately recognize non-recurring expenses in retirement and do not anticipate different rates of increase in future recurring expenses 
  • SWPs generally don’t permit “budget shaping” to meet individual retirement goals, and 
  • SWPs generally don’t do a particularly good job of helping you with pre-retirement planning
Feel free to read our October 3 post if you want more explanation of these reasons for not liking the IRS/RMD approach, as we will not be repeating them in this post.

We will, however, take another shot at explaining why we believe the IRS/RMD SWP is generally pretty conservative, more so even than the Actuarial Approach with recommended assumptions.

Contrary to the author’s statement that “the account balance in taxable retirement accounts (such as traditional IRAs and 401(k) accounts) is divided by the participant’s life expectancy to determine the minimum required withdrawal amount for the coming year,” the denominator in this calculation is generally the joint life expectancy of the participant and a hypothetical beneficiary ten years younger than the participant.  In addition to the participant’s account balance being divided by this conservative joint life expectancy, the withdrawal rate is developed utilizing a 0% discount rate.  Thus it produces a significantly smaller annual withdrawal than anticipated under the Actuarial Approach, all things being equal.  We recommend annuity based pricing to determine a person’s (or couple’s) spending budget, and our approach is frequently criticized as being too conservative.  The table below, however, clearly shows that the IRS/RMD approach is even more conservative than the Actuarial Approach.
(click to enlarge)

This conservatism does, of course, make it a “safer” approach, but potentially at the cost of not spending enough, not providing adequate income in retirement, and leaving a larger-than-desired estate.  Note that for comparison purposes, the table assumes that the individual’s account balance is the individual’s only asset.  Also note that the table compares withdrawal rates for individuals, and the comparisons could be closer for couples, particularly for couples with significant differences in ages.


The authors argue that their Spend Safely strategy is a straight-forward solution for “ordinary workers” who lack the skills necessary to understand the math that may be involved with retirement planning.  This may be true.  However, we don’t believe that the Spend Safely strategy is truly an “optimal solution”, particularly for Intelligent Numbers People (INPs) who aren’t afraid to do a little number crunching to get a better answer.  The Actuarial Approach is a flexible process that provides “data points” that can be used to help individuals and couples make better financial decisions and help them achieve their financial goals in retirement.  Its basic principles can be applied globally.  The Spend Safely strategy, on the other hand, is an inflexible rule of thumb approach, appropriated from Internal Revenue Service regulations that were designed to force retirees with pre-tax accumulations in U.S. qualified defined contribution plans and IRAs to take distributions from these plans so that the U.S. government could collect its taxes.

As we indicated in our post of October 3, even though we are not big fans of the IRS/RMD approach to help individuals make spending decisions in retirement, we have no problem if defined contribution plan sponsors wish to offer something like this approach as a distribution option in their plans.