Thursday, January 12, 2017

Another Call for a Paradigm Shift in Retiree Spending Budget Thinking

In our post of October 27 of last year, we called for a paradigm shift in thinking about the use of a strategic withdrawal plan (SWP) in the development of a reasonable spending budget in retirement.  This post was followed by an article in Advisor Perspectives and our post of December 21, where we somewhat facetiously called for attachment of an “Actuaries’ Warning Label” to SWPs.  In these communications, we warned that the Old Paradigm of simply adding the amount determined under an SWP to income from other sources (IFOS) for the current year may not produce a spending budget that is consistent with the retiree’s spending goals.

Old Paradigm:  Take x% of invested assets per SWP and add to IFOS, to get this year’s spending budget.

We apologize to our readers who have already grasped the importance of changing their thinking about SWPs.  Unfortunately, there are still quite a few financial advisors and retirement experts out there who still don’t get it.  Why?  We can only imagine that it is due to a combination of several factors, including:

  • Poor communication skills on our part 
  • Lack of awareness of our call for change 
  • The Old Paradigm is strongly ingrained and some just don’t want to deal with a New Paradigm
Because we feel strongly about this subject, we are going to take another shot in this post at explaining the problems with the Old Paradigm and the benefits of using the New Paradigm.  We are going to do this by manipulating the basic actuarial equation, discussed in this website, to try to make our points clearer to those who are still having trouble grasping the issue.  It is our hope that after reading this post you will come away with two main take-aways:


  1. You shouldn’t just start developing your budget by spreading your current investments over your remaining lifetime using an SWP formula, as suggested by many retirement experts.  Before you develop a spending budget for recurring annual expenses, you need to set aside assets for future expected non-recurring expenses, such as long-term care expenses, unexpected expenses and amounts desired to be left to heirs.  This may involve determining the present values of at least some of these future expenses, and subtracting the results from your current investments.
  2. If you want to develop a recurring spending budget that is consistent with your retirement goals, you should spread the present value of your IFOS over your expected retirement period, and add the result to your SWP amount for the year (or you can simply use the actuarial approach set forth in this website rather than using an SWP approach).
Manipulating the Basic Actuarial Equation to Develop the New Paradigm

The basic equation for personal financial planning in retirement that is the foundation for this website is Equation (1):

where PV IFOS is the present value of your (and your spouse’s) future retirement income from all other sources and includes Social Security income, pension income, annuity income, income from part-time or full-time employment, proceeds from future asset sales, rental income, etc.

We now want to solve this Equation (1) for this year’s spending budget.

Step 1: Subtract PV Future Non-Recurring Expenses from both sides of Equation (1) and re-arrange terms, to get Equation (2):

Step 2: After deciding on the desired rate of increases in future recurring spending budgets (x%), divide both sides of Equation (2) by the present value of $1 payable per year for the expected lifetime planning period and increasing by x% per year (PV future years increasing by x%).  The result can be expressed as Equation (3):

Equation (3) supports the two take-aways discussed above.  The first item on the right-hand side of Equation (3) tells us that we must first reduce the current value of assets by the PV Future Non-Recurring expenses before we spread the net value over the retiree’s expected lifetime.  This is what you want your SWP to do (if you insist on using one).  The second item on the right-hand side of Equation (3) supports the second take-away discussed above.  It tells us that instead of adding the SWP amount to IFOS for the year to develop your spending budget, you should add the SWP amount to the present value of IFOS spread over the future expected lifetime.

When is the Old Paradigm Ok?

Under certain limited circumstances, the Old Paradigm will produce the same answer as the New Paradigm.  To accomplish this, advocates of SWPs will typically assume that:

  1. non-recurring expenses are separately funded elsewhere 
  2. IFOS consists only of immediate Social Security benefits or perhaps of immediate life annuity benefits indexed to inflation, and the retiree desires future spending budgets to be constant in real dollars.
Under these convenient assumptions, the present value of IFOS spread over the retiree’s future lifetime will be equal to the IFOS for the year, and the Old Paradigm will work.

In many instances, however, the two assumptions above necessary to make the SWP approach work will not be consistent with reality.  We can probably work around the first assumption relative to non-recurring expenses, but it isn’t all that easy to work around the second assumption relative to constant IFOS.  For example, my wife is younger than I.  I have started receiving my Social Security benefits and my company-provided pension.  She, however, wants to commence her company-provided pension in 6 years and wants to commence her Social Security benefit in 11 years.  In addition, I have a QLAC (deferred life annuity) scheduled to commence in 18 years.  We clearly don’t have the constant IFOS needed to make the Old Paradigm work well (and even if we did, we might not be happy with the Old Paradigm requirement that future spending budgets to be constant from year to year in real dollars).

But don’t just take our word for it.  Go to the Actuarial Budget Calculator (ABC) for Retirees in this website and develop a spending budget by entering different sources of income and different starting dates for this income.  Then go to either of the runout tabs and look at the expected pattern of future withdrawals from accumulated savings.  You aren’t going to find a “systematic” pattern of withdrawals.

The simple answer for most individuals or couples, who don’t live in a retirement researcher’s artificial bubble, is to avoid SWPs.  Just because the researchers may use Monte Carlo modeling with 10,000 (or more) simulations, to project the future to compare various esoteric SWPs, doesn’t make these SWPs any more relevant to individuals or couples who have several sources of income.  Yes, to get a more reasonable spending budget, we might have to calculate a present value or two.  But, we make that task easier for you (and your financial advisor) with our Actuarial Budget Calculator and Present Value Calculator on this website.

Those individuals and financial advisors who insist on staying with their SWPs, and who set aside sufficient assets for non-recurring expenses, will also need to appropriately adjust IFOS to develop a reasonable spending budget in instances where IFOS is not expected to be constant from year to year.  To add confusion to this issue, it is our understanding that many financial advisors who claim to use SWPs do, in fact, do these adjustments.   It is important to note, however, that if these financial advisors perform these adjustments correctly, withdrawals from current investments (increased or decreased as necessary for the difference between actual IFOS and adjusted IFOS) will not necessarily be equal to the amount determined under the SWP algorithm, so these financial advisors aren’t technically using SWPs and the Old Paradigm.

Sunday, January 8, 2017

4 Keys to Winning the Financial Security Game

Depending on many factors that are usually somewhat out of one’s control, winning the Financial Security Game can either be a relatively easy process, or it can involve a significant amount of hard work, sacrifice and patience.   You can be lucky and marry someone with lots of money, inherit lots of money, discover a rich gold-mine in your back yard or win a Megabucks lottery.  Or, you can take the more traditional approach:  you can work for many years and prudently spend and save until you think you have accumulated enough assets to feel financially secure.

Generally, there are four keys to winning the financial security game:

  1. Accumulate your assets 
  2. Grow your assets 
  3. Protect your assets 
  4. Find the right balance between Trade-offs
This post will discuss, in general terms, how you can go about trying to win the Financial Security Game.  Unfortunately, since we don’t have the phone numbers of attractive and wealthy potential mates, locations of gold-mines or future winning lottery numbers, we will focus mostly on the more traditional approach to achieving financial security.

Accumulate Your Assets

The first step toward achieving financial security is to begin to accumulate assets.  Note that these should legally be your assets.  So, if you have married someone with lots of money or you expect to receive a large inheritance (or you expect to win the lottery), you should exercise some caution in your financial planning with respect to those assets until you actually have a legal right to them. 

As frequently noted in this website, the basic actuarial equation for determining how much you can afford to spend (a key determinant of financial security) depends on how much assets you accumulate. 

This equation can be stated as follows:

Where the items on the left-hand side of the equation are your assets and the items on the right-hand side are your spending liabilities. 

Generally, the traditional way to accumulate assets is to become gainfully employed and spend less than one’s employment income (save).  For younger individuals interested in becoming financially secure, this should be a high priority as the current value of their investments is likely to be fairly small and therefore their only significant asset to be tapped for future spending is going to be their future savings.

Grow and Protect Your Assets

Once you have accumulated some assets, your financial life becomes more complicated as you will now need to grow and protect those assets.  These two objectives can often be conflicting.   The following tables show financial priorities for growing and protecting assets for younger pre-retirees and for older retirees/near retirees. 

click to enlarge

click to enlarge

In developing these priority tables, we have assumed that younger pre-retirees will continue to grow and protect their assets until they decide that they have enough to retire.  Therefore, their top “asset growing” financial priorities will generally continue to be saving a significant portion of their employment income (inside employer sponsored plans or outside), earning Social Security benefits, earning pension benefits (if available) and investing accumulated assets.  While their focus is primarily on growing their assets, they must also be concerned with protecting the assets they have already accumulated and expected future income.  This is accomplished mostly through various types of insurance.  For example, life insurance or disability insurance can be very important for replacing future expected income for affected young families with children. 

As individuals get close to retirement or reach retirement, their financial priorities generally shift somewhat.  While they still must grow their assets (generally by investing them), they must also protect their (now presumably much more significant) assets to make sure that they last for the rest of their lives.  Therefore, they may choose to consult with an investment manager/Financial Advisor.   A good Financial Advisor will help them develop an investment plan (to continue growing assets) as well as a spending plan that meets their financial goals in retirement (which presumably includes not outliving assets).   In addition to possibly investing their assets more conservatively than younger individuals, retirees and near-retirees will generally select different forms of insurance than younger individuals to protect against relevant risks.

Of course, pre-retirees, retirees and their financial advisors can use our Actuarial Budget Calculators (ABC) to help develop savings strategies (generally for pre-retirees), spending strategies (generally for retirees) and for determining when they may have enough assets to afford to retire.  If you develop a spending/savings budget as an individual or as a couple, you might also want to develop separate “contingency” budget strategies based on alternative assumptions about the future, including assumptions that:

  • your current employment ceases,  
  • your significant other dies, 
  • you get divorced or 
  • one of you becomes disabled or requires long-term care,
You can also use the 5-year projection tabs to model the impact of variations in investment returns and spending.  This “contingency” modeling may be helpful in selecting types of insurance to protect your assets, deciding on an appropriate investment strategy or simply developing “what if” strategies for planning purposes.

Finding the Right Balance Between Trade-offs

Unless you are one of the extremely lucky few who suddenly comes across a big pile of money, it is not necessarily an easy task to win the Financial Security Game these days.  There are a lot of trade-offs involved and opportunities to make mistakes.  In addition to the trade-off whether to grow assets or to purchase insurance to protect your assets, you must choose how much you can afford to spend today vs. how much you will be able to spend in the future.  These decisions would be much easier to make if you could only predict your (and/or your significant other’s) future employment, lifetime, health, investment returns on your assets, inflation, inheritances, etc.  Unfortunately, we just don’t know what the future holds.  Therefore, we must make our best-estimate (or conservative) assumptions about what the future holds and be prepared when our assumptions inevitably turn out to be wrong.

Tuesday, January 3, 2017

How Did You Do Last Year?

We encourage retirees to maintain a record of prior years’ spending budget calculations and prior years’ expenses.  This historical information can serve as additional data points to help with future spending decisions.  The information can also be useful in selecting assumptions about the future, particularly about future assumed increases in various types of expenses.  So, every year around this time, in addition to encouraging you to develop your new year’s spending budget (and saving this information), we also encourage you to take reasonable steps to compile and save useful information regarding your actual spending for the previous year.

In addition to comparing your actual spending with your spending budget for the previous year, it may be helpful to determine how much of your spending was for the following expense types:

  • essential non-health related expenses, 
  • essential health related expenses, 
  • non-essential expenses and 
  • unexpected expenses
If your history shows that you have constantly overspent your spending budget (in total or by expense type), you may be understating your spending needs when developing your budget.  Or, if your history shows that your overspending relative to your budget is increasing from year to year, this can be a signal of financial problems on the horizon.  On the other hand, a history of ever widening under-spending relative to your spending budget provides evidence that you may be too conservative with your spending.

If you don’t use the Actuarial Budget Calculator (ABC) workbook with recommended assumptions to develop your spending budget, you may want to track the difference over time between your spending budget and the budget developed under the ABC with recommended assumptions.  If your history shows a widening of the gap between your calculated spending budget and the ABC amount, you may wish to revisit how you develop your spending budget.

Do you need to track your spending exactly?  While it may be helpful to do so, particularly if you develop your spending budget as the sum of several different categories, it probably isn't necessary.  If you know all of the items in the equation below other than your spending, you can solve for the amount you spent during the year.

Regarding the other important assumptions used in developing your spending budget, you can also track how well you did on your investments vs. your assumed rate of return, and actual inflation vs. assumed inflation.  Of course, every year that you and your significant other (if you have one) survive to work on a new year's spending budget should be considered a good year.

Happy budgeting and wishing you all the best in 2017.