Tuesday, February 2, 2016

The Actuarial Approach—Back to the Budget Basics

It’s been almost six years since I retired and started this blog with a lot of help and encouragement from my buddy, Kin Chan.  Initially I started out with a simple spreadsheet (Excluding Social Security V 1.0) and a description of a recommended process to be used to determine the amount a retiree could afford to withdraw from accumulated savings each year. 

While the calculations have remained the same since 2010, the primary focus of this blog has morphed somewhat away from simply determining the amount to withdraw from savings to developing a reasonable spending budget.  And I have to admit that my skills as a number-crunching actuary have sometimes made it difficult for my readers to figure out what I was talking about.   

While the Excluding Social Security (now version 3.1) spreadsheet can be a good tool for some readers, others may benefit from just the basics.  Therefore, I have put together a one-page explanation of the Actuarial Approach that discusses how to use basic actuarial principles and present values to develop a spending budget (or to check to see that your spending plan is otherwise on track). 

Sunday, January 31, 2016

Which is the Optimal Strategy? Deferring Commencement of Social Security, Buying a QLAC or Neither?

Apologies again to my non-U.S. readers as I’m going to dive back into the “should you delay commencement of your Social Security benefit” debate again.  This post is a follow up to my posts of October 24, 2015, “Does New Math Clearly Demonstrate that People Should Delay Commencement of Social Security Benefits when Possible?”, September 25, 2015, “Another Look at Deferral of Commencement of Social Security Benefits”, and April 16, 2015, “Delaying Social Security Benefits vs. Buying a QLAC—Which is the Better Strategy?

When we last discussed this subject, I took issue with the claim from Dr. Wade Pfau that “the math is clear:  People should delay claiming when possible.”  In this post, I will again take the position that the math is not as clear to me as it is to Dr. Pfau and to most retirement experts who tell retirees what is best for them.

I’m going to do the math for four alternative strategies for a 65-year old single male (with a Social Security Normal Retirement Age of 66) who has quit working and is eligible to commence his age 65 Social Security benefit of $20,000 per year.  He also has investments of $400,000 and no other retirement assets.  To do this math, I’m going to use the very simple Present Value Calculator I posted on the website last month.  Feel free to check my calculations or model different assumption sets.  The simple present value calculator uses annual payments which are assumed to paid at the beginning of each year, so it overstates calculated present values (for all four alternatives) slightly.  For all the calculations, I will be assuming inflation of 2% per annum and an interest discount rate of 4% per annum. 

Here are the four alternative strategies:

  1. Commence the $20,000 per annum benefit immediately at age 65. 
  2. Defer commencement of Social Security benefits until age 70.   The benefit commencing at age 70 under current Social Security law and the 2% inflation assumption would be $31,230.  This amount is equal to his age 65 benefit increased by a factor of 1.414286 for delayed commencement and a factor of 1.104081 for five years of expected 2% per annum cola increases.  
  3. Same as Alternative 1 except take $100,000 of accumulated savings and buy a Qualified Longevity Annuity Contract (QLAC) commencing at age 80 with no pre-commencement or post-commencement benefits.  Based on today’s quote from Immediateannuities.com, a premium of $100,000 would buy a monthly fixed dollar life annuity of $2,627, or $31,524 per annum commencing at age 80 and payable for life thereafter. 
  4. Same as Alternative 1 except take $100,000 of accumulated savings and buy a QLAC commencing at age 85 with no pre-commencement or post-commencement death benefits.  Based on today’s quote from Immediateannuities.com, a premium of $100,000 would buy a monthly fixed dollar life annuity of $4,407, or $52,884 per annum commencing at age 85 and payable for life thereafter.
The table and graph below show the present values at age 65 of the hypothetical retiree’s retirement assets (accumulated savings plus present value, if any, of Social Security benefits plus present value, if any, of expected payments under the QLAC contract) for various assumed ages at death for the four alternative strategies.  Because a retiree’s assets also equal his liabilities, the present values shown below also equal the present value at age 65 of his future spending and amounts to be left to heirs. 
   
(click to enlarge)
      
(click to enlarge)

     
We see from the table and graph above that the present value at age 65 of the retiree’s assets increases with assumed age of death for all four strategies.  Which is the optimal strategy?  Well, that depends on the retiree’s age of death.  If he dies before age 85, he is better off under the commence immediately with no QLAC alternative.  If he dies on or after age 85 and before age 88, he is better off under the defer to age 70 strategy.  If he dies on or after age 88 and before age 95, he is better off under the commence Social Security now and buy a QLAC commencing at age 80 strategy, and if he dies on or after age 95, he is better off under the commence Social Security now and buy a QLAC commencing at age 85 strategy.

Of course, no one knows when they are going to die (a theme from my last post), and even if we did know, age at death would not be the only factor in a decision of which alternative to select.  Readers can revisit some of my prior posts for a discussion of some of these other factors.  My point in this post was to demonstrate once again that the math on this issue is not as clear as we have been led to believe. 

Saturday, January 30, 2016

Live Long and Prosper

As I have said several times in this blog, developing a reasonable spending budget would be a lot easier if we just knew when we were going to die.  In fact, one of my long-time actuary buddies, Bruce O suggested that I would probably get more readers if I simply renamed this site, “How long can I afford to live in retirement?”

So, when I saw the title, “When and how you will most likely die” recently in Business Tech, I knew that this article was going to be must-reading for this mortality nerd.  The article points its readers to an interesting interactive tool developed by Nathan Yau of Flowingdata.  Mr. Yau has mined data maintained by the Centers for Disease and Prevention containing information for people who died in the U.S. between 1999 and 2014 to develop probabilities of death by age and associated probabilities regarding reported cause of death.  Mr. Yau further segregates the data into eight reported categories (four each for males and females):  White, Asian, Black and Native. 

In terms of developing a spending budget, I’m considerably more interested in age at death than I am in  the reported cause of death.  More specifically, I was interested in probabilities of survival from a given retirement age (once I discovered that Mr. Yau didn’t really have a magical crystal ball).  I played with Mr. Yau’s tool to determine probabilities of survival to various ages for males and females currently age 65.  I wasn’t sure why, but Mr. Yau’s tool gave me slightly different probabilities each time I ran the tool.  It also takes a little dexterity to pause the aging process at the right moment.  Here is a summary of the results:


(click to enlarge)

The final column labeled “SoA” shows comparable probabilities of survival from the Society of Actuaries’ 2012 Individual Annuity Mortality table with a 1% per year mortality improvement projection.  This table is available in the “Other Calculators/Tools” section of this website.  I had to estimate probabilities of survival until age 70 for this column.   In general, the SoA table shows much higher probabilities of survival to various ages than the information gleaned from Mr. Yau’s tool.  In my opinion, the primary reasons for this are: 1) the SoA table is based on mortality of individuals who buy annuities where Mr. Yau’s experience is based on all individuals in the U.S., 2) the SoA table includes mortality improvement projections while Mr. Yau’s is based on experience from 1999-2014, and 3) as Mr. Yau’ admits, his data has some deficiencies. 

Mr. Yau’s tool shows that age, gender and race are generally factors in one’s mortality/longevity.  Of course, there are many other factors.  For example, studies have shown factors influencing longevity can include, wealth, general health, smoking, diet, weight, exercise, participating in community activities, marital status, taking part in dangerous hobbies, geographical location, etc.  I wouldn’t be surprised if some researcher has even found a positive correlation between longevity and developing a spending budget for retirement.  Suffice to say that there are a lot of variables at play and caution should be used selecting your period of retirement for budget setting purposes.  

When developing a spending budget, I recommend that retirees and their financial advisors plan on living until age 95 or the retirees’ life expectancy if greater.  Yes, this is a conservative recommendation.  I don’t recommend assuming probabilities of death at every future age even though we all have non-zero probabilities of dying every year in the future.  The fact of the matter is that either 100% of you will be alive in a given year or 100% of you will be dead.  To assume that 2% of you will die next year would just make the calculations more complicated and it wouldn’t add much value to the spending budget you are trying to determine.  Unless you are quite old, I also don’t recommend that you use your life expectancy when determining your spending budget.  The reason for this is that as you age, your expected age at death increases.  Thus, your expected period of retirement will not decrease by one year for each year you age and your spending budget will therefore decrease in the future in each year when your expected age at death increases by that one year, all things being equal. This decrease is illustrated in my post of December 3, 2014.  By assuming death at age 95, the retiree avoids these budget decreases until approximately age 89, when budget decreases may be more acceptable to the retiree.  You can assume a shorter period of retirement, but this will lengthen the potential period when your survival will result in decreases in your spending budget, all things being equal. 

Well, enough time spent on this morbid subject.  I leave you today with a Mr. Spock’s emoji wishing you long life and prosperity in your retirement.