Monday, November 6, 2017

Five Common Misperceptions About Using the Actuarial Approach for Personal Financial Planning

When you propose something different, you can expect that not everyone is going to fully appreciate or understand your position.   We at How Much Can I Afford to Spend advocate using basic actuarial and financial economic principles to help individuals (and their financial advisors) develop reasonable spending budgets and make better personal financial decisions.  Because we are actuaries and not financial advisors or academics and because what we advocate differs somewhat from approaches advocated by industry “experts” or described in articles contained in well-established personal financial planning literature, we experience a fair amount of misunderstanding of what we propose.   Most of this misunderstanding comes in the form of individuals erroneously describing what we are advocating and the associated deficiencies of what they think we are advocating.   We have found that the majority of these misperceptions have come from individuals who:
  • Have never read the explanations of the Actuarial Approach provided in our website, 
  • Have never tried to apply the basic principles endorsed, 
  • Have different agendas to pursue or 
  • Some combination of the above items.
In this post, we will respond to some of the more common misperceptions we hear about the Actuarial Approach, and we will encourage individuals and their financial advisors to try to ignore these misperceptions, try to be a little more open-minded about this new approach and actually try to apply the basic actuarial principles endorsed by us as a supplement to what they are currently doing.  To repeat the tagline from Alka Seltzer commercials from the early 1970s; we believe you should, “Try it, you’ll like it.”

Misperception #1—We advocate conservative investments. 

Not true.  We don’t advocate any specific investment strategy.  Yes, we do recommend using assumptions consistent with annuity-based pricing to develop your Actuarial Budget Benchmark (ABB), but we believe determining the cost of your spending liabilities for this purpose is a separate issue from the issue of how best to invest your assets to accomplish your financial goals.  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).

There are plenty of good reasons why you may or may not want to invest all or part of your assets in liability-driven investments (like annuities) or in more risky assets (like equities).  We aren’t going to list those reasons here.  We leave the decision of how best to invest your assets to meet your financial goals up to you with possible assistance from your financial advisor. 

We acknowledge that the basic financial economics principle that the cost of future spending liabilities may be determined independently of the client’s investment mix is almost heretical within the financial advisor community.  This community frequently concludes that client spending may be increased, within limits, by increasing the client’s investment risk; a result generally obtained by assuming historical real rates of return and variances will continue in the future.   We counter this general conclusion by pointing to the problems created by public pension plan actuaries who similarly assumed plan contributions could be reduced simply by increasing investment risk, and to recent Actuarial Standards Board considerations requiring actuaries to disclose a low-investment risk liability in actuarial reports for public pension plans as a way to quantify the extra risk assumed by the plan sponsor (and taxpayers) resulting from the plan’s investment policy (similar in concept to what we advocate with our ABB calculation).

Misperception #2—We advocate conservative spending.

Not true.  We don’t tell you how much you should spend each year.  The amount you spend each year is your business (or your and your spouse’s business).  We tell you how much you can afford to spend this year to meet your financial goals based on your financial situation and the assumptions you make about the future.   If you use our recommended assumptions to calculate your ABB, you are calculating a current year spending budget based on a relatively low investment-risk strategy.  Yes, this approach should produce a reasonably conservative spending budget.  But, you don’t have to spend your ABB.  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.

In our posts, we have discussed many ways that you can spend more aggressively by front-loading your spending.  Several ways to do this without increasing your investment risk include:

  • Assuming declining future real dollar future spending budgets, 
  • Assuming decreases in the spending budget upon the first death within a couple, or 
  • Treating some expenses (such as travel expenses) as non-recurring and thus not spreading them over your entire expected longevity planning period.
Misperception #3—We advocate using a deterministic assumption model rather than a stochastic model

Partly untrue.  While the simple Excel workbooks that we make available on our website to facilitate the present value calculations required under the general asset/liability matching model we advocate use deterministic assumptions, this doesn’t mean that our general individual model (the Basic Actuarial Equation) can’t accommodate stochastic modeling.  Since we provide you with an ABB based on basic financial economics principles and don’t claim to provide you with the maximum amount of income that can be provided at a specified probability of success based on assumptions with respect to expected returns and variances associated with various types of investments, we don’t feel a need to complicate our simple models with unnecessary stochastic modeling.   Unlike black-box stochastic models, our models are relatively transparent when deterministic assumptions are used, and unlike stochastic models, our process anticipates periodic future valuations to adjust for future experience that will inevitably differ from assumed experience.

Misperception #4—We advocate using only the Actuarial Approach to determine a reasonable spending budget

Not true.  As discussed in our post of April 20, 2017 and as discussed above, we recommend that you consider your ABB as another “data point” to be used in making your spending decisions.   Thus, we recommend that you use this calculation in combination with, and not in lieu of, other budgeting approaches you may be using that you find to be helpful.

Misperception #5—The Actuarial Approach is either too simple, not as sophisticated as Monte Carlo modeling and therefore inferior or it is too complicated for average individuals to use. 

Partly untrue.  As discussed above, quite a few people tend to conflate the Excel workbooks that we provide to facilitate the present value calculations required under the Basic Actuarial Equation with the more general process we refer to as The Actuarial Approach.  The Actuarial Approach involves using three basic actuarial principles:

  1. Use of a generalized individual model that compares assets with liabilities (The Basic Actuarial Equation), 
  2. Annual valuations to keep spending on track to meet financial goals, and 
  3. Modeling of deviations in assumed experience to assess risk and assist financial planning
When taken together, these principles are much more powerful personal financial budgeting tools and concepts than our simple Excel spreadsheets. 

We will admit that the calculations required by the Actuarial Approach may unfortunately be beyond the comprehension of many individuals today.  That is why we have targeted Intelligent Numbers People (INP) in our communications.


No one (not even actuaries or financial advisors) knows what your investments will earn in the future and no one knows how long you (or your spouse) will live.   In fact, what we do know is that whatever assumptions we make about the future will be wrong, and future adjustments to spending plans will likely be required.  These unknowns make spending budgeting a difficult task.  Many stochastic models use historical experience to forecast future investment performance, and many clients rely on these models (and their questionably precise probability of success calculations) to make complex financial decisions regarding investments and spending.  We have concerns about stochastic models that promise higher levels of spending without properly quantifying the additional risk.  We also have concerns about blindly relying on the results of these models, particularly over extended periods of time without adjustment.   And while no one knows what future investments will earn, we do know how much insurance companies are currently charging to provide income for life based on life annuity quotes.  We believe that this “known” market pricing information can be useful in developing a low-investment-risk Actuarial Budget Benchmark that you can use in combination with the other approaches you are using to make better financial decisions.

Unlike others who may encourage you to use a specific budgeting approach, we have no financial stake in the decision you make.  We won’t benefit financially if you decide to buy annuities or invest in equities or use the Actuarial Approach.  We receive no direct or indirect income from advertising or hits to our site.   Despite having to occasionally address these misperceptions and live with the baffling lack of support from our own profession, we remain passionate about recommending the same basic actuarial principles that we applied in our work as actuaries to help INPs make better financial decisions.

We encourage you to try to keep an open mind with respect to using the Actuarial Approach and give it a try rather than rejecting it out of hand simply because of misperceptions you may have heard or read about it.

Sunday, October 29, 2017

We Have Two New Actuarial Budget Calculator (ABC) Workbooks for Couples

Our website is all about using basic actuarial principles to help you (or your financial advisor) develop a reasonable spending budget designed to meet your personal financial objectives.  The first actuarial principle of personal financial planning (and budget development) involves balancing your assets with your spending liabilities.  Our readers are quite familiar with the Basic Actuarial Equation shown below, where assets are the items on the left-hand side of the equation and spending liabilities are the items on the right-hand side of the equation.

Accumulated Savings
PV Income from Other Sources
PV Future Non-Recurring Expenses
PV Future Recurring Annual Spending Budgets

Note that if you are comfortable performing the present value calculations and math required by the Basic Actuarial Equation, you may not need to use our Excel workbooks at all.  The ABC workbooks that we make available on our website have been designed to simplify these present value and math calculations, but may not be as robust in all situations as the results that can be obtained from directly applying the basic principle to your specific fact situation.   

Our previous ABCs for Retirees and Pre-Retirees involved using a single Lifetime Planning Period (LPP) to estimate the present values of income from other sources and the present value of certain future non-recurring expenses and recurring annual spending budgets.  This single LPP assumption made the calculations easier, but not as accurate, as the calculations required for a couple.  We discussed the complications involved in couple’s budgeting in our post of July 4, 2017.  After that post, we decided to create separate workbooks for retired couples and pre-retired couples.  The new workbooks are the result of that decision. 

Instead of using one LPP for a couple, the new ABC couple’s workbooks use four LPPs:  one for each person in the couple, one for the LPP while either person is expected to be alive and one for the LPP while both persons are expected to be alive.  These four LPPs may be obtained from the “Planning Horizon” section of the Actuaries Longevity Illustrator.  In addition to these additional LPPs, the new Couple’s workbooks require entry of the percentage decrease in the couple’s desired recurring spending budget upon the first death within the couple.

The new workbooks are titled, “ABC for Retiree Couples” and “ABC for Pre-Retiree Couples.” The original single LPP workbooks still reside in our website (with the new workbooks) in our “Spreadsheets” section and have been relabeled as “ABC for Single Retirees” and “ABC for Single Pre-Retirees.”

As part of the process of developing the new couple’s workbooks and renaming the old workbooks, we have updated the overview tab material describing each workbook.   We encourage you to read this material to obtain a better understanding of the workbooks.

We wanted to make these new workbooks available to you in time for your 2018 calendar year budgeting, and we encourage you to “kick the tires” on them.  We hope you will like the changes.  If you like the workbooks, please recommend them to other “intelligent numbers people.”  If you think they can be improved, please pass along your recommended changes to us as we are always interested in your feedback.

Happy Budgeting from all of us at How Much Can I Afford to Spend.

Monday, October 23, 2017

In Search of the Optimal Retirement Planning Strategy

In his October 18 post What Is The Optimal Shape of Retirement Planning—Curve, Triangle or Rectangle? Michael Kitces did an excellent job of summarizing the evolution of retirement planning strategies and discussing the benefits and limitations of the three different strategies identified in his post.  The inspiration for Mr. Kitces’ post is a fine article by Patrick Collins and Francois Gadenne entitled The Shapes of Retirement Planning—Are You a Curve, a Triangle, or a Rectangle?  In our post today, we will briefly highlight some of the discussion in these articles and encourage you to read these thought-provoking pieces.

Collins/Gadenne Article

In their article, Messrs. Collins and Gadenne employ three very clever geometric metaphors to describe the three general types of retirement planning strategies currently used by financial advisors.  They encourage advisors to consider employing the more holistic household balance sheet approach, the rectangle shape, that considers all of a household’s present and future assets and spending liabilities to determine a funded status or a current spending budget.  According to these gentlemen, “This article is a call to advisors to expand beyond asset allocation pie charts and Sharpe ratio values to diagnose feasibility of goal funding and monitor the plan’s performance by helping clients ask and answer the following questions:

  • Do I have enough to do what I’d like?
  • How likely is it that my plan will remain sustainable under future economic environments?
  • What is my capacity to meet the unknown or unexpected?”

While we have not developed a full understanding of the planning strategy they proposed, it is clear to us that it has a lot in common with our rectangularly-shaped Actuarial Approach, as both approaches employ balance sheet comparisons of an individual’s or household’s assets and spending liabilities.

Michael Kitces Post

In his post, Mr. Kitces deftly summarizes the three Collins/Gadenne geometric metaphors and his understanding of the benefits and limitations of employing each type of retirement planning strategy.  In response to his question “What is the optimal shape of retirement planning?” Mr. Kitces concludes that the best approach for retirement planning may involve incorporating elements from all three shapes.

Our Take

We support the Collins/Gadenne endorsement of what we consider to be the use of basic actuarial principles in the personal financial planning process.  We believe employing these principles will not only better meet the needs of clients of financial advisors, but also reduce financial advisor fiduciary liability.  At the same time, however, we also support Mr. Kitces’ conclusion that an optimal consulting approach may very well involve elements from different approaches.  It is exactly for this reason that we suggested in our Advisor Perspective article (originally entitled “Give Your Clients Another Data Point Each Year to Help Them Make Better Financial Decisions”) that financial advisors supplement their client consulting (i.e., not necessarily replace what they are doing) with calculation and explanation of the client’s Actuarial Budget Benchmark (ABB).

Mr. Kitces is critical of the sensitivity of the rectangle approach to the use of different discount rate assumptions to determine present values of assets and spending liabilities.  He indicates:

  • that there is little agreement on the appropriate discount rate to use,
  • “nothing on the household balance sheet directly conveys the greater risk that is inherent in assuming a higher discount rate”, and
  • “two advisors using the same rectangle approach may still come up with substantively different conclusions and recommendations about whether the prospective retiree is on track!”
It is exactly for these reasons that we advocate using basic financial economic principles and annuity based pricing assumptions to develop the client’s ABB.  Use of these assumptions provides a mark-to-market comparison of the client’s assets and liabilities under the Actuarial Approach and significantly mitigates the concerns raised by Mr. Kitces.