Friday, February 16, 2018

We Kick the Tires on Fidelity’s “Retirement Score”

We have been playing around with Fidelity’s free retirement planner, “The Fidelity Retirement Score.”  According to Fidelity, the planner will enable you to “Know where you stand for retirement in just 60 seconds. Answer 6 simple questions to get your score and additional steps to consider as you save for retirement.”  In this post, we comment on the pros and cons of Fidelity’s calculator and compare it with the Actuarial Approach using the Actuarial Budget Calculators (ABCs) for pre-retired single individuals and couples available on our website.  

Executive Summary

The Fidelity Retirement Score is not bad, and it may do a reasonably good job of telling you where you stand in your planning for retirement, particularly if you are not highly paid and you don’t have sources of retirement income other than your savings and Social Security.   We think the Fidelity calculator probably under-estimates required savings rates for more highly compensated individuals.  The analysis that we performed and discuss below, may not be all that interesting to you unless you are a real numbers geek like we are.  If you aren’t, feel free to skip the discussion below of how we kicked the tires on Fidelity’s calculator and our analysis of it. 

The Fidelity Retirement Score—What we Like About It

  • Fidelity’s calculator is sexy, quick, easy and, for many people, probably does a reasonably good job of measuring their retirement savings progress.
  • Once you have entered your data, you can see how changes in the data you entered affect your score on the scoreboard screen without having to go back through the original data entering screens.  You can also change your lifetime planning period from the default option of to age 93 on the scoreboard screen, which is helpful.
  • The calculator estimates your Social Security benefit based on the pay you enter and does not require you to calculate your own estimated benefit.  Nor does it require you to estimate your lifetime planning period (but you can change the default option if you want).
  • The calculator projects what you could spend at retirement (including Fidelity’s estimate of your Social Security) and compares that with what Fidelity thinks you’ll need based on what you input for your desired standard of living in retirement.  These amounts are shown in today’s dollars.
  • The calculator uses a fairly conservative estimate of future investment earnings (at least compared with many other calculators) and doesn’t increase your projected income at retirement if you increase your investment risk (from the balanced option) by choosing investment portfolios with higher proportions of stock. See our last post, “Should Increasing Your Investment Risk Increase Your Current Spending Budget” for discussion of why we believe this is a good attribute.
  • The Fidelity calculator is reasonably consistent with their advice to accumulate ten times your annual pay if you want to retire at age 67.  We have found that this is not a bad rule of thumb, particularly for individuals with no sources of retirement income other than Social Security and  savings. 
How We Analyzed Fidelity’s Calculator

As retired actuaries, we still like to crunch numbers.  So, we crunched some numbers for individuals earning $50,000 per year and $200,000 per year using both Fidelity’s calculator and our Actuarial Budget Calculator (ABC) for Single Pre-Retirees.  For the Fidelity calculations, we entered

  • retirement at age 67, 
  • “Spend the Same” standard of living and 
  • “Balanced” investment style,
  • Lifetime planning period ending at age 94 (vs. their default option of 93)  

For the ABC calculations, we entered our recommended assumptions (4% annual investment return, 2% annual inflation and 2% desired increases in spending after assumed retirement).   Consistent with these assumptions, we also assumed 3% annual increases in compensation.  In order to make the ABC calculations somewhat comparable to the Fidelity calculations we also assumed:

  • A lifetime planning period ending at age 94 (our recommended assumption for a 65-year old male),
  • Social Security commencement at age 67
  • No unexpected expenses, no desired estate remaining at death, no long-term care costs, no other non-recurring pre-retirement or post-retirement expenses, no other pre-retirement or post-retirement sources of income (such as annuities, matching employer contributions, income from part-time employment, proceeds from asset sales, pensions, rental income, etc.)
  • No income from spouses and no decrease in desired spending in the event of the first spouse death

For both sets of calculations, we assumed the individuals had accumulated Fidelity’s age-related recommended benchmark amounts of savings for successful retirement at age 67:

  • Age          Target Accumulated Savings as a multiple of pay
  • 35  2X
  • 40  3X
  • 45  4X
  • 50  6X
  • 55  7X
  • 60  8X
  • 66  10X

We also entered 12% of pay annual savings rates for both sets of calculations.  For the Actuarial Approach Social Security benefit amounts, we went to the Social Security Online Quick Calculator and calculated projected benefits commencing at age 67 in future (inflated) dollars using a relative growth factor in future projected earnings of -1% to be consistent with our 3% annual pay increase assumption.  We then calculated real dollar (today’s dollar) equivalent of this benefit using our 2% discount rate assumption. 

We assumed the amount that Fidelity indicates as the amount you’ll need monthly in retirement will remain constant in real dollars throughout your period of retirement.  It is not clear to us, however, how Fidelity incorporates their famous cost of healthcare in retirement estimate ($275,000 for a couple both age 65 retiring in 2017) into this amount you’ll need. 

The table below shows the results of the calculations.  Amounts are shown in today’s dollars.
(click to enlarge)



Our Analysis and Some of the Things We Don’t Like About the Fidelity Calculator

The first thing we noticed was even though the Fidelity calculator indicates that the spending target option they determine is “spend the same,” their idea of what this means is if your pay is relatively low, Fidelity believes your “spend the same” amount will be about 80% of your pay and if your pay is relatively high, your “spend the same amount” will be about 60% of your pay.  By comparison, our ABC estimates your spending before retirement by subtracting what you are saving from your estimated pay.  Thus, under our calculator, the more of your pay you save, the less of it you spend, all things being equal.  However, since your work-related expenses and your taxes will probably less in retirement, our recommended income replacement target is about 85% of your “spend the same” amount.  

The significant difference in how “spend the same” is defined in the two calculators results in significantly different spending targets and savings rates necessary to achieve retirement spending goals.  While the Fidelity calculator appears to imply that an individual earning $50,000 should be saving more than 12%, the individual earning $200,000 appears to be in good shape.   By comparison, our calculator implies that the $50,000 worker is probably ok saving 12% of pay (after adding in recommended levels of expected non-recurring expenses like long-term care costs), but the higher paid worker probably needs to save closer to 20% of pay to “spend the same” in retirement.  Highly compensated individuals using Fidelity’s calculator might find that their “on target” score over 100 may not be as “on target” as they thought. 

While Fidelity assumes that real wages will increase in the future for individuals, their calculator does not assume real Social Security benefits will increase for these individuals.   Ours does.  And while Fidelity’s calculator indicates, “your score is calculated assuming an underperforming market, so it represents a conservative estimate of how much income you could have during your retirement,” the balanced investment style appears to be expected to earn about 5% per annum and therefore would be expected to have more investment risk than the annuity-based pricing investment return assumption of 4% that we recommend.  This extra investment risk is downplayed in the Fidelity calculator.  The difference in expected returns (extra risk) is quantified by comparing the columns labeled “Projected Retirement Income @67 from Accumulated Savings.”

As discussed above, to facilitate comparison of the calculators we had to assume that the hypothetical individuals we looked at only had savings and Social Security benefits and further, they would commence Social Security at the assumed retirement age.  In this respect, the Fidelity calculator has very limited flexibility to consider other sources of retirement income or other commencement dates and does not even attempt to consider couples planning. 

Conclusion

We encourage you to use a calculator to plan for your retirement and to develop a spending/savings budget to help you achieve your retirement goals.   And, when you are planning, it is also very important to remember that whatever calculator you use is only going to provide you with a planning “data point” for you to consider along with many other factors.  For many single individuals, Fidelity’s calculator may provide a reasonably good starting data point.  By comparison, our ABC’s for pre-retired single and couples may not be as sexy as Fidelity’s Retirement Score calculator (or others available on the Internet), and you may not be able to “know where you stand for retirement in 60 seconds.”  However, we believe our calculators are more accurate and flexible in terms of considering all your potential assets and spending liabilities.   We also give you the capability of reflecting the commencement of benefits (such as Social Security) at ages other than your desired retirement age,  having increasing or decreasing patterns of real-dollar spending, and our spreadsheets can be used by individuals and couples outside the U.S.  This is why we advertise our website as “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”

As we have discussed in prior posts, it is also important for you to consider the potential for deviations from expected experience as part of your planning.   For example, your employment may not continue until your desired retirement age, so you will probably want to be even more conservative in your retirement planning than indicated by any retirement calculator, at least until more-favorable-than-assumed experience emerges. 

Sunday, February 4, 2018

Should Increasing Your Investment Risk Increase Your Current Spending Budget?

From time to time, we receive comments from readers who wonder why the recommended assumed investment return/discount rate (currently 4% per annum, or 2% in excess of our recommended annual assumed inflation rate) used to determine one’s Actuarial Budget Benchmark (ABB) is so low.  Given historical returns and the run-up in the equities markets over the past nine years, some feel that equities (or other risky assets) represent a source of consistently higher rates of return that can be expected, over sufficiently long measurement periods, to continue to outperform lower risk investments in the future.  These individuals argue that these expectations justify using higher real assumed rates of return in their budget calculations that can support higher current spending budgets than produced by the ABB, all things being equal.  Other readers wonder why we don’t link our assumed investment return/discount rate to the individual’s assumed investment mix, like most financial advisors and spending calculators do.

In this post, we will:

  • Explain why we recommend assuming a low-investment risk rate of return, irrespective of an individual’s current investment mix, at least for determining one’s ABB 
  • Discuss our concerns with budgeting approaches that imply that you can increase your current spending budget by increasing your investment risk, and 
  • Describe how we use the ABB to develop our own personal spending budgets.
Before proceeding, however, we want to remind you once again that
  1. we don’t advocate any particular investment strategy, 
  2. we don’t insist that you spend a certain amount in any given year, and 
  3. we encourage you to calculate your ABB in addition to whatever other approach you may be using to develop your spending budget, as another “data point” that you may find useful.
Why We Recommend a “Low-Investment Risk” Rate of Return Assumption for Developing Your ABB

To make the ABB a “mark-to-market” calculation, the market value of an individual’s (or couple’s) spending liability is determined using financial economics principles, by using the price of a portfolio of financial assets whose expected distributions match the individual’s anticipated spending in amount, timing and probability of payment.

We recommend using inflation-indexed life annuities as the financial assets for this purpose, and we solve for discount rates and longevity planning periods that produce about the same pricing (inflation-indexed annuity-based pricing assumptions) as for these low-investment risk investments.

While equities and other risky investments may be expected to generate higher returns than low-risk investments over an individual’s (or couple’s) lifetime planning period, such investments carry more risk and are generally not considered to be financial assets “whose expected distributions match the anticipated spending in amount, timing and probability of payment.”
 

It should be noted that the Actuarial Approach is a self-correcting approach.  If future experience is more favorable than assumed in the budget calculations, future spending budgets determined under the Actuarial Approach will increase relative to current spending budgets.  If future experience is less favorable than assumed, future spending budgets will decrease relative to current spending budgets.  Therefore, in this post, we are talking about when such favorable (or unfavorable) future experience is “recognized” for budget calculation purposes.  If you invest in risky assets and expect higher returns as a result, should you recognize those higher expected future returns in your current budget calculation or should you wait and recognize gains in a subsequent year’s budget calculations after they have actually occurred?  See our post of March 20, 2017 “You Can Spend It Now or You (or Your Heirs) Can Spend It Later Part II” for more discussion of this spending balancing act.

Our Concerns with Budgeting Approaches That Imply You Can Increase Your Current Spending Budget by Increasing Your Investment Risk

We are concerned about budgeting strategies (such as those that may be developed using Monte Carlo modeling, safe withdrawal approaches or even our Actuarial Approach with higher than recommended assumed real rates of return) that appear to offer higher levels of current spending at little or no perceived additional risk (of having to reduce your expected spending budget in the future).  For this reason, we recommend that you annually compare your spending budget with the ABB to quantify how much risk you are assuming with your current budget strategy.

We acknowledge that by investing in risky assets, your future investment returns may exceed those expected on low-risk investments, but we are concerned about approaches that recognize expected favorable experience in the spending budget calculation before such favorable experience has actually occurred.  We don’t believe there is a “free-lunch” to be gained by investing in equities or other risky assets.  If there were, insurance companies would want to invest more in equities rather than bonds to cover their liabilities, and it would be a “no-brainer” to leverage your investments (for example, by taking out a mortgage loan at 4% and investing the proceeds in equities expecting a 6% return). 

We are also concerned that some individuals who wish to increase their current spending levels may be persuaded to increase their equity investments beyond their tolerance for risk in order to chase higher expected returns.

How We Develop our Annual Spending Budgets

We don’t know what your future holds and we don’t know your spending goals.  As a result, we can’t tell you what the “correct” amount of your spending should be this year.  We can (and do) provide you with tools to help you perform your own calculations (with or without help from your financial advisor).  We do know that some of you use our Actuarial Budget Calculators with more optimistic investment return assumptions than the annuity-based pricing assumptions we recommend because you believe your investments will earn higher rates of return in the future and you aren’t overly concerned about the extra risk you are assuming.  And, who knows?  Your approach and assumptions may work out better for you than our recommended assumptions.

For what it is worth, we can tell you how we go about our annual budget setting process.  We invest a portion of our retirement savings in equities, and we expect to earn relatively higher rates of return on these risky assets than on our low-risk investments.  We use what we call the “ABB with Rainy-Day Fund” approach.  Under this approach, we calculate our budgets based on our recommended annuity-based pricing assumptions and in the years following years where we experience actuarial gains from more favorable than assumed experience, we park some or all of these gains in a Rainy-Day Fund, which in our spreadsheets is also called “other non-recurring expenses.”  Until we decide to use these Rainy-Day Funds, they do not enter into the calculation of our “annual (recurring) spending budget.”  If (when) we experience a poor investment year, we can dip into this Rainy-Day Fund to mitigate the resulting decrease.  Or, if the Rainy-Day fund becomes too large (which is a pleasant problem to ponder), we can use a portion of it to increase our future spending budgets.

Under this “ABB with Rainy-Day Fund” approach, we don’t recognize more favorable-than-assumed experience in our budget calculations until it actually occurs (or in some instances, not until after it actually occurs).  We feel this is a more prudent approach than one that recognizes higher return expectations before they occur, as would be the case, for example, in the common Monte Carlo model that assumes future higher rates of return when developing (or testing) a spending plan based on a given investment strategy.

Conclusion

We encourage you to be skeptical about spending budget approaches that appear to promise higher levels of spending if you increase your investment in risky assets, or that imply there is little extra risk associated with investment in riskier assets.  Unfortunately, developing a reasonable spending strategy in retirement is a fairly complicated and risky business.  To manage your risks, you might want to consider using the same “ABB with Rainy-Day Fund approach” that we use.  If you don’t use this approach, we encourage you to annually compare the results of the spending strategy you do use with the ABB to quantify your risks and, as discussed in our post of November, 26, 2017, we also encourage you to model potential deviations from assumed experience for the purpose of potentially mitigating your risks.

Sunday, January 21, 2018

Life Expectancy vs. Lifetime Planning Period—Part II

This post is a follow-up to our post of December 6, 2017 regarding lifetime planning period (LPP) assumptions used in financial planning.  As discussed in the December 6 post, for purposes of calculating your Actuarial Budget Benchmark (ABB), we recommend that you use the LPP (or LPPs for couples) based on the 25% chance of survival for a non-smoking male or female (as appropriate) with “excellent health” from the “Planning Horizon” section of the Actuaries Longevity Illustrator.

In this post we will address:

  • the binary nature of the mortality/longevity assumption for individuals 
  • how the LPP assumption is expected to change as one ages, 
  • the spending budget implications of continuing to survive, and 
  • general implications of planning to live longer than your life expectancy
We will also “walk back” a statement we made in the December 6 post that using the 25% chance of survival LPP would enable you to avoid actuarial losses from living too long until you reach your late 80s. 

Binary Nature of Mortality


Some retirement planners and retirement experts advocate the use of probabilities of mortality at each age for personal retirement planning, with the implication that the use of such probabilities makes the resulting spending budget more accurate than approaches that do not use such probabilities.  We are not swayed by this logic, as “pieces” of us do not die each year.  We are either alive for an entire year or we die during that year.   If we die during a particular year, we are generally not alive for any subsequent year.  The law of large numbers that may work well for pension plans with lots of participants doesn’t necessarily apply to individuals or couples.  Therefore, we have no problem developing a spending budget that assumes a specific LPP and a definite age of death at the end of that LPP.

How the LPP is Expected to Change as One Ages


There is a common misperception that your LPP decreases by one year each year that you remain alive.  It would make financial planning easier if this were true, but it isn’t.  The longer we live, the later becomes our anticipated age at death, because we have already reached a certain age.  This is best illustrated by an example.  Based on the mortality assumptions used in the Actuaries Longevity Illustrator, the life expectancy (50% chance of survival) at age 65 for a non-smoker female in excellent health is 25 years, or an expected age of death of 90.  By comparison, the life expectancy (50% chance of survival) at age 85 for a non-smoker female in excellent health is 8 years, or an expected age of death of 93, or 3 years longer.

The graph below shows the expected age at death for non-smoker females aged 65-99 in excellent health under three different lifetime planning alternatives from the Actuaries Longevity Illustrator:

  • 50% chance of survival (or more commonly known as “life expectancy”), 
  • 25% chance of survival, and 
  • 10% chance of survival
Instead of showing three horizontal lines, as would be expected if your LPP decreased by one year each year you remain alive, all three chance-of-survival lines show increasing expected ages at death as the females age, with larger total increases required for the higher percentage chances of survival.
(click to enlarge)
It should be noted that the Actuaries Longevity Illustrator calculates the expected ages at death for someone currently age 65 assuming that this individual was born in 1953, while the expected age at death for someone currently age 85 assumes that such individual was born in 1933, so we are not looking at expected ages at death for the same woman born in 1953 in this graph.  To the extent that current mortality tables anticipate mortality improvement based on year of birth, the expected age at death for a female born in 1953 when she reaches age 85 may be later than implied in this graph.

Budget Implications of Continuing to Survive


Generally, the longer the assumed LPP, the smaller the initial actuarially determined spending budget in retirement.   So, using the 50% chance of survival LPP will give you a larger initial actuarial spending budget than using the 25% chance of survival LPP, all things being equal.  The potential downside, however, of using the 50% chance of survival rather than the 25% chance of survival LPP is that you are also increasing your chances of experiencing future spending budget declines as you age (as conceptually illustrated in the graph in our post of December 6).  

Each one of the increases from the initial expected age at death shown in the three lines in the above graph represents a year when the LPP is not expected to decrease by one year from the previous year. Because the actuarially determined spending budget is calculated assuming that your LPP will decrease by one year each year, each one of these increases is expected to produce an “actuarial loss” in the year of increase.  As with any other actuarial loss recurring from experience that deviates from an assumption, this actuarial loss will decrease that year’s spending budget, all things being equal.

While we continue to recommend using the 25% chance of survival to determine your Actuarial Budget Benchmark (as the combination of the recommended discount rate and this chance of survival is roughly equal to current annuity pricing and the difference between the ABB based on the 25% chance of survival and a lower budget based on a 50% chance of survival strikes us as a reasonable cost of self-insuring one’s retirement), we do want you to be aware of the potential for actuarial losses from this source (and possible spending budget reductions) starting in your early 80s (a little bit later for males) and increasing significantly in your 90s.  Of course, if you survive into your 90s, you may be able to dip into unused funds set aside for bequest motives, long-term care costs, unexpected expenses, home sales, rainy-day funds from favorable investment returns (i.e., actuarial gains from investments), to offset these actuarial losses.  And your recurring spending needs may also be somewhat diminished at these later ages.

Alternatively, you can defer your chances for experiencing these actuarial losses from longevity until your 90s by developing your spending budget based on a 10% chance of survival.  Doing so, will produce a lower initial spending budget than using the 25% chance of survival LPP.   Or, you can scenario test your budget by inputting the higher LPPs associated with the 10% chance of survival and use the result as another “data point” in your budget setting process.

In our post of December 6 of last year, we indicated that if you used the 25% chance of survival LPP, we did not anticipate actuarial losses from longevity until you reached your late 80s.  This was based on the male mortality table we used in 2014, but is not the case with the tables currently used by the Society of Actuaries and American Academy of Actuaries in the Actuaries Longevity Illustrator, as evidenced in the graph above.

General Implications of Planning to Live Longer than Your Life Expectancy

  1. If your spending follows the Actuarial Approach, you are likely to leave money on the table when you die.  Since under this approach you are annually adjusting your LPP based on your age (and not just reducing it by one year each year to live), you are likely to die with some assets left unspent.  The amount of unspent assets should be a little higher with the 25% chance LPP than the 50% chance LPP.  For this reason, you may wish to reduce the amount you plan to leave to your heirs. 
  2. As noted above, by selecting an LPP (or LPPs) longer than your life expectancy, you are generally lowering your current spending budget and reducing the risk of subsequent declines in future spending budgets relative to a budget developed based on your life expectancy.  You will also notice that planning to live longer than your life expectancy will make certain investment strategies appear relatively more favorable.  For example, investments in annuities (either immediate or deferred) or Social Security commencement deferral strategies may appear to be more financially advantageous than if you based your LPP on your life expectancy.  We don’t necessarily have a problem with this result, as we believe that assuming a longer-than-life-expectancy LPP is just part of the cost of self-insuring one’s spending liabilities.