Friday, April 6, 2018

Do Stochastic Models Necessarily Do A Better Job of Helping You Determine How Much You Can Safely Spend This Year?

The impetus for this post was another thought-provoking post from our friend Dirk Cotton over at The Retirement Cafe entitled, “The ‘Future’ of Retirement Planning” in which he states, “Determining how much you can safely spend this year requires a good model of the future.”  Since we are “How Much Can I Afford to Spend in Retirement,” several of our readers wanted to know what we thought about Dirk’s post.   In particular, they wanted to know whether we agreed with his implication that models that use Monte Carlo stochastic assumptions (simulations) are “much better” than models (like our simple Actuarial Budget Calculators) that use deterministic assumptions (or what Dirk calls spreadsheet models).   In this post, we will discuss where we agree with Dirk and where we agree to disagree.  

Where We Agree

We totally agree with Dirk that: 

  • “determining how much you can safely spend this year [and making other personal financial decisions] requires a good model of the future”, 
  • A model is not a plan.  A plan is an intention or decision about what to do based on the results from a model, 
  • “Of course, you can plan when outcomes are uncertain…”, 
  • A good model should not ignore sequence of return risk, and
  • A stochastic model that uses expected rates of investment return for various asset classes but adjusts for investment risk is a better model for determining safe spending levels than a deterministic model that simply utilizes expected rates of return without adjusting for investment risk, all other things being equal.
Where We Agree to Disagree

While we agree that it is important to employ a “good model” of the future when developing a retirement plan, we are not convinced that it is absolutely necessary to use a model that employs simulations.  Therefore, we will push back in this post on Dirk’s recommendation that “If you're using an online calculator, make sure it incorporates simulation”.

In our opinion, a “good model” for determining how much you can safely spend in the current year, or for making other personal financial decisions, is one that:

  • Does a reasonably good job of forecasting future experience,
  • Adequately addresses your retirement risks, and
  • Helps you to make informed financial decisions with some degree of confidence.  

We believe that such a model should:

  • Consider your personal financial situation and goals,
  • Be relatively transparent,
  • Allow you to do “what-if” scenario testing,
  • Reflect all current assets and expected amounts and timing of future assets Reflect all expected amounts and timing of current and future expected expenses,
  • Employ reasonable, or relatively conservative, assumptions with respect to:
    o   Future investment returns
    o   Future increases in expected expenses (including before and after the first death within a couple)
    o   Your (and your spouse’s) future lifetime, and
    o   Other relevant future experience
  • Develop a total spending budget for the current year, not just an amount to be withdrawn from invested assets/accumulated savings
Our point in describing the criteria for a good personal financial model is that there are quite a few conditions to satisfy to be considered “good.”  So, even if a model uses stochastic assumptions that are reasonable, this will not guarantee that such a model is necessarily a “good model” if it fails to satisfy some of the other criteria above.

Actuarial Approach with Recommended Assumptions (Actuarial Budget Benchmark)

We believe that the generalized individual actuarial model (The Actuarial Balance Equation) used in our Actuarial Budget Calculators combined with our recommended assumptions (to develop what we call the Actuarial Budget Benchmark (ABB)) will satisfy most of the above criteria to be considered a “good model” for developing retirement plans and spending budgets.

Just like most pension plan actuarial valuations, our simple Actuarial Budget Calculators (ABCs) use deterministic, not stochastic investment return assumptions.  When using these Excel workbooks, we recommend using assumptions consistent with assumptions used by insurance companies to price inflation-adjusted annuities to develop a market value (or market-priced) valuation of future spending liabilities.  While equities and other risky investments may be expected to generate higher returns than such low-risk investments over an individual’s (or couple’s) lifetime planning period, such investments carry more investment risk.  Following basic financial economics principles, the “risk-adjusted” expected returns on these more-risky investments should be approximately the same as expected returns on low-risk investments available in the market.   Thus, in applying these principles, we believe that using these low-investment risk assumptions are reasonable for the purpose of determining how much you can safely spend, and the use of stochastic modeling is not an absolute requirement for a “good model”.  

For a more detailed defense of our simple spreadsheet model, see our post of October 8, 2017, and for more discussion of the implications of using basic financial economic principles to determine the cost of retirement and thoughts from Dr. Moshe Milevsky on this subject, see our post of July 10, 2017.

Our Concerns with Monte Carlo (Stochastic) Modeling

Our concerns with Monte Carlo (stochastic) modeling may be summarized as follows:

  • Stochastic Model results are highly dependent on assumptions made for expected returns and variances for various asset classes (which are frequently built into the model, based on historical experience)
  • Stochastic Models are generally not transparent
  • Stochastic Models may not reflect all assets and spending liabilities, and
  • Stochastic Model results may not facilitate the making of good financial decisions (the primary purpose of using a model)

We discuss these concerns in more detail below. 

Model Assumptions.  Even if you are (or your financial advisor is) using a stochastic model that meets most of the above criteria to be considered to be a “good model,” you are pretty much forced into accepting the model designer’s “built-in” assumptions for expected future real investment returns and standard deviations for various classes of assets.  Therefore, the reasonableness of the results of such a model will be very dependent on the reasonableness of these built-in assumptions about the future.  You can accept these assumptions on faith, or you can question whether they are reasonable.   And unlike assumptions that can be relatively easily gleaned from current annuity market pricings, it may not be so easy to tell how reasonable these assumptions are.  You can, of course, compare them with historical results, but everyone knows that historical results don’t necessarily reflect current economic conditions and therefore are not necessarily great predictors of the future.  Alternatively, you can compare the model results of using such assumptions with the model results of using annuity-based (low-investment risk) pricing assumptions.   As discussed in our post of February 4, 2018, “Should Increasing Your Investment Risk Increase Your Current Spending Budget?,” we become concerned when we see models that suggest that you can increase current spending with little or no perceived additional risk by investing in riskier assets.  This is an indication to us that the investment return assumptions for equity investments (or other risky investments) built into a model may be too aggressive in the current market environment.

We understand that Monte Carlo modeling is fairly standard practice among financial advisors.  We also understand that most financial advisors make their living by increasing AUM (assets under management).  And while most financial advisors undoubtedly believe they are using reasonable assumptions for future investment returns and variances for various classes of assets in their models, it may be prudent for you to try to independently assess how reasonable these assumptions might be.  For example, you might want to ask your financial advisor how he or she has adjusted these assumptions for variations in the Shiller Cape 10 index (which at over 30 today would suggest lower than historical real expected rates of return in the future, all things being equal.)

Transparency and Reflection of All Assets and Spending Liabilities.  In general, stochastic models tend to be somewhat “black boxy” in nature.  Model results tend to be something like, “if you invest as follows, you will have a X% probability of being able to spend $Y per year in real dollars as long as you or your spouse is expected to live.  When using such a model, you will need to determine if all future expected expenses (such as medical expenses that are expected to increase faster than inflation, unexpected expenses, long-term care expenses, other non-recurring expenses, etc.) have been adequately reflected in the model.  

Using the Model to Make Decisions.  We like Dirk’s weather forecast analogy in his argument for using a model that develops probabilities.  If there is a 5% chance of rain today, you may decide not to bring an umbrella.  A good model is supposed to help you make more informed decisions.   Unfortunately, results of stochastic modeling tend to provide probabilities of success applicable to  long periods of time and may not facilitate good short-term decision making.  For example, a couple may become complacent after they are told that they have a 95% probability of being able to spend $X per year irrespective of actual future investment experience.  Unlike the Actuarial Approach, which encourages annual valuations, periodic scenario testing and annual thinking about the safe amount to spend (and Rainy- Day Funds to establish or use to mitigate fluctuations in spending), the results of a Monte Carlo model can encourage more of a “set-it-and-forget-it” type of behavior that could result in either significant over-spending or under-spending as time goes by. 

We are also concerned with Monte Carlo models that may lead users to invest too aggressively.   For example, if overly aggressive future real rates of investment return (or overly conservative standard deviations) are assumed for equities, some individuals who wish to increase their current spending levels may be persuaded to increase their equity holdings beyond their tolerance for risk.   

You Aren’t Required to Use Just One Model/Conclusion

There is no law that says that you have to use just one model in your retirement planning.  You should feel free to look at the results produced by several models.  We don’t think you should reject models just because they use deterministic assumptions if these models adequately address retirement risks.  We also think it is perfectly reasonable to be somewhat skeptical of models developed by model designers who have a financial stake in the decisions you may make as a result of using their model.  If you want to use a stochastic model, or your financial advisor uses a stochastic model, we encourage you to compare the results of that model with the results of our ABC model (developed by retired actuaries who have absolutely no financial stake in the decisions you make as a result of using our models) or other models.  If the different models produce significantly different results, you should try to figure out why.  This exercise will provide you with  more “data points” to help you make better informed financial/spending decisions, which is, after all, the primary purpose of modeling the future. 

Saturday, March 3, 2018

Developing a Sustainable Spending Plan (SSP) vs. Using a Systematic Withdrawal Plan (SWP)

We still see quite a bit of literature in the popular press encouraging retirees to use specific Systematic Withdrawal Plans (SWPs) to determine withdrawals from their accumulated savings.  For example, the recent article, “No Pension? You Can ‘Pensionize’ Your Savings” discusses the “Spend Safely in Retirement” strategy developed by Steve Vernon, Joe Tomlinson and Dr. Wade Pfau in collaboration with the Society of Actuaries.  The SWP advocated in their report is the IRS Required Minimum Distribution approach we discussed in our post of December 21, 2017.  In addition, we are aware that many researchers and financial advisors still advocate the use of SWPs, and some even confusingly refer to these “withdrawal plans” as “spending plans.”  Therefore, we will once again
  • attempt to draw the distinction between spending plans (and in particular Sustainable Spending Plans (SSPs)) and SWPs, and 
  • Indicate why we believe SSPs are superior to SWPs
SWPs

SWPs provide a retiree with an algorithm for withdrawing funds from their investment portfolio.  Sometimes this is also referred to as “tapping” one’s savings.   Common examples are the 4% Rule and the IRS RMD approach.  SWPs can be very simple or very complicated (with floor and ceiling adjustments, etc.) but all involve systematic withdrawals from accumulated savings.  It is generally assumed that the amount withdrawn for the particular year under the SWP plus income from other sources (IFOS) for that year will be spent by the retiree (or couple). 

A SWP isn’t coordinated with the amount or timing of income the retiree (or retired couple) may have from other sources (IFOS).  Assuming a retiree’s IFOS is reasonably constant from year to year, it is possible that adding the SWP withdrawal to the IFOS for the year may be consistent with the individual’s spending goals.  However, even assuming that this is the case, the SWP only focuses on recurring spending needs and does not consider non-recurring spending needs the retiree may have, such as unexpected expenses, long-term care costs or specific bequest motives.  As noted in the Society of Actuaries’ recent report, Shocks and the Unexpected: An Important Factor in Retirement, “Successful provision for the unexpected is critical to success in financial management during retirement.”  So, any SWP will be deficient in this regard.

SSPs

A Sustainable Spending Plan develops a spending budget that is consistent with the individual’s (or couple’s) spending goals.  Typically, these goals will include:

  • Maximizing current levels of spending without jeopardizing ability to meet future anticipated expense needs 
  • Not spending too much and not spending too little 
  • Avoiding year to year spending volatility 
  • Having spending flexibility 
  • Leaving approximately desired amounts to heirs at death
The reader will note that none of the above goals necessarily involves how much should be withdrawn from savings (or how systematic such withdrawals should be).  The focus of the SSP is on spending, not withdrawals from savings.  For example, if one member of the couple’s Social Security benefit is expected to commence at a later date than the other member, it may be very reasonable (and consistent with the couple’s spending goals) for the couple’s withdrawals from savings to be larger before the second commencement than after.  In fact, in situations where IFOS doesn’t commence at the same time or expenses are non-recurring in nature, an SSP will work much better than an SWP in meeting typical spending goals.

The Actuarial Approach advocated in this website will help you develop a SSP, not an SWP.  Under the Actuarial Approach:

  • All of your assets are considered, not just your accumulated savings 
  • All of your spending liabilities are considered, not just your recurring spending 
  • Since the amount withdrawn from savings is equal to the sustainable spending amount minus IFOS, it will automatically mitigate potential spending volatility associated with amount and timing differences that may be inherent in IFOS 
  • You can maximize current spending without jeopardizing your ability to meet expected future expenses.  For example, you can increase current real dollar spending by
o  treating travel expenses or home mortgage expense as a non-recurring expense, or
o  planning on future expenses that decrease in real dollars
  • Spending is flexible and is automatically adjusted, as a result of annual valuations, to be consistent with your goals (even if those goals change), and 
  • Periodic scenario testing will enable you to better plan for deviations from assumed future experience
Conclusion

Depending on personal situations and goals, SWPs may be OK for some individuals and couples, and may be just fine as a distribution option in a defined contribution plan or IRA, but generally you (or your financial advisor) can do better.  The Actuarial Approach will help you develop a much more robust spending budget (SSP) than can be obtained by simply adding an SWP amount to IFOS.  Will it take a little more work and number crunching?  Yes.  But, we believe it will be worth your while, and that is why we refer to 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.”

Wednesday, February 28, 2018

Save More for Retirement? Nah, I’ll Just Work Longer

This post is a follow-up to our post of December 11, 2017 titled, When Can I Afford to Retire and When Should I Commence my Social Security Benefits (which was a follow-up to our posts of November 14, 2016 and April 28, 2014 touting the clear financial benefits of working longer).  In that post we included an example and concluded that:

“John’s calculations [using our Actuarial Budget Calculators] will show that if he retires and defers commencement of his Social Security benefit, he can expect his real dollar spending budget to increase by about 1% for each year of deferral (or slightly less if John is not in “excellent” health), whereas it increases by about 8% for each year that he continues to work.  Therefore, while we agree that the deferral of Social Security commencement strategy is probably “better than a poke in the eye with a sharp stick”, your decision of when to stop working is generally going to be a more significant driver of the amount of your spending budget in retirement than your decision of when to commence your Social Security benefit.’


In their recent research paper, “The Power of Working Longer,” the authors reach the same conclusion, stating, “Roughly speaking, deferring retirement by one year allows for an 8 percent higher standard of living for a couple and the subsequent survivor.”  And while it is nice to have esteemed academic scholars support the same annuity-based pricing of spending liabilities that we recommend and confirm our calculations, we have some concerns about the authors’ assumptions and methodology, which cause them to conclude that working longer may be a more attractive option for individuals and couples than increasing their savings.  While we agree that working longer is a powerful tool for increasing an individual’s or couple’s spending budget in retirement, we think it is probably a financial planning mistake to believe that you don’t have to save for retirement because you will simply work longer and rely on increased Social Security benefits, especially if you are relatively highly paid. 

Authors’ Assumptions and Calculations for Stylized Household

The authors look at a “stylized household” which consists of a 36-year-old primary earner and his or her same age spouse.  It is not clear from the example whether the spouse has the same earnings or has no earnings.  The following assumptions are made by the authors:

  • Whatever wage is being received by the household (either approximately the economy-wide average wage index by the primary earner and nothing for the spouse or two times that amount assuming they are both paid the same amount), it is assumed to remain constant until the assumed retirement age of 66 
  • Contributions of 6% of annual wage are made to their respective 401(k) plans and these contributions receive a 50% match (assuming here that the spouse actually has earnings) for a total of 9% of wage annual contributions. 
  • The assumed rate of return on accumulated savings in the 401(k) plans is 0%.  This assumption is inconsistent with the assumptions used by the authors to convert accumulated savings to lifetime income and significantly inconsistent with the approximate 6% return assumption used in Social Security law to develop actuarially equivalent adjustment factors for early and deferred retirements. 
  • Social Security benefits for the husband and wife at age 66 are assumed to be 42% of their assumed to be constant wage at age 65.  Note that the authors state that this is an average benefit payable at Social Security’s full normal retirement age, but under current law, age 66 would not be the full normal retirement age for these individuals.  No Social Security spousal or survivor benefits are considered. 
  • Social Security law is assumed to remain unchanged in the future.  This assumption includes continuation of actuarial increases of 8% per annum for each year of deferred commencement (even though increases in wages and real investment returns are assumed to be nil, and no changes in program benefits in light of significant future expected deficits. 
  • Accumulated savings are converted to an annuity at assumed retirement using fairly conservative assumptions and also assuming payment in the form of a joint and survivor annuity with 100% to be paid to the last survivor (even though the effect of survivor benefits in Social Security is to pay in the form of a joint and survivor annuity with 66.67% paid to the surviving spouse.
Using these assumptions, the authors conclude that the 9% of pay rate of savings (6% plus the 3% match) for the next thirty years will generate only about 19.4% of total expected retirement income at expected retirement at age 66 with the remainder (80.6%) coming from Social Security. 

Comparison with Our Calculations

Somewhat surprising to us, given the assumptions made by the authors, the authors’ approximate 80%/20% distribution of expected real retirement income between Social Security and accumulated savings for this stylized couple is not terribly different from the distribution obtained by using the Actuarial Budget Calculator (Pre-Retired Couple) for a 36-year-old couple currently both earning $50,000 per year and contributing 9% of pay.  For our calculations, we assumed:

  • 3% future pay increases, 
  • Economic and longevity assumptions we recommend for determining the Actuarial Budget Benchmark, 
  • a 33 1/3% reduction in desired retirement income upon the first death within the couple. 
  • Social Security benefits from The Social Security Online Quick Estimator (with adjusted future pays to be consistent with our 3% pay increase assumption) of about 47% of final year’s pay (about $55,092 per annum in future dollars). 
  • Consistent with the author’s calculations, we assumed no other non-recurring expenses or other sources of income. 
  • We also ignored the present value of expected spousal benefits from Social Security upon the first death within the couple.

Using these assumptions, we developed projected total real first year retirement (age 66) spending of $74,957 of which $60,829 was expected to come from Social Security and $14,128 from accumulated savings.  Thus, our calculations produced a 77% Social Security/ 23% accumulated savings lifetime income split for the authors’ stylized couple. 

This total first year of retirement projected spending of $74,957 represented 62.07% of projected real dollar spending for the final year of working (age 65).  Since it is less than the 85% rate that we recommend as a benchmark target, and further, since no reserves are contemplated for long-term care, unexpected expenses, rainy-day reserves, etc., we would encourage this stylized couple to consider alternatives such as increasing savings, continuing to work, taking on part-time employment, investing more aggressively, cutting back current expenses and/or not committing to funding education costs, tapping home equity, finding a rich person who will leave them an inheritance, etc.

Should You Give Up on Increasing Your Savings?

If you haven’t saved enough to date, we don’t think you should give up in your efforts to save for retirement and assume that you will just keep working and rely on Social Security.  Here are some reasons why we believe you should increase your savings if our ABC tells you that you are falling behind:

  • One very nice aspect of increasing your savings, from our point of view, is that it lowers your current spending budget and gives you a smaller spending target to replace in retirement.  If you are saving 25% of your pay and you spend 15% of your pay on work-related expenses, your replacement spending target in retirement is only going to be 64% of your pay (.75 X .85).  By comparison, if you don’t save, your replacement target will be 85% of your pay. 
  • The years just prior to your desired retirement will, in many cases, be your best opportunity to save.  You may be eligible to make “catch-up” contributions and expenses such as education costs may be reduced, 
  • Given Social Security’s financial condition, there is a non-zero probability that Social Security benefits will be reduced in the future.  These reductions may take many forms, including the possibility that Social Security’s actuarial increase factors for delayed commencement will be reduced to be more consistent with today’s low interest rates.  We call this “Social Security Reduction Risk” 
  • You (or your spouse) may not be able (or want) to continue to work at a job that will pay you the same level of earnings (or more) as you age.   Poor health, the need to take care of a family member, corporate downsizing initiatives/mergers, etc. may reduce employment opportunities.  We call this “Continued Employment Risk” 
  • If you are highly compensated, Social Security represents a smaller percentage of your overall total retirement income, so you need to save more, all things being equal. 

Conclusion

Working longer is a great solution to solving the problem of not having enough income in retirement, if you can make it work.  As the old saying goes, “Nice work if you can get it” (pun intended).  Therefore, unless you:

  • really love your job, 
  • you are quite happy with the idea of working until age 70 or longer, 
  • you believe your boss thinks you are absolutely irreplaceable and/or there is almost no chance you (or your spouse) will lose your jobs (e.g., you are a tenured college professor),
we strongly encourage you to use our calculators annually to help you develop a financial plan that considers and, if possible, reduces your Continued Employment and Social Security Reduction risks.    Sorry folks, but for many individuals, this will require increased savings.