Friday, October 11, 2013

Reasonable Assumptions and Algorithm for Simple Actuarial Process

Several individuals have suggested that I provide some guidance with respect to assumptions and the algorithm to be used with the spreadsheets and process described in this website.  The following are my brief thoughts on possible inflation and investment return assumptions to use, reflecting the current economic environment, as well as a possible algorithm to use to adjust future withdrawals for actual experience as it emerges.  Earlier this year (see post of July 12), I recommended that you plan to live until 95 (unless you are already over 85).

Inflation:  In light of an estimated investment return assumption on bonds imbedded in current immediate annuity purchase rates of a little bit more than 4% per annum (as discussed in our post of September 22, 2013) and the long-term relationship between bond returns and inflation, I would assume inflation of something in the neighborhood of 3% per annum.

Investment return:  Given expectations of inflation of 3% and expected bond returns of 4+%, I probably wouldn't use an investment return assumption much higher than 5% per annum (and would use a lower rate if most of my investments were in bonds or other fixed income or I just wanted to be more conservative in my retirement budgeting).  I know that some will argue that equities have historically yielded higher real rates of return, but they also carry higher risk of loss that I would reflect by using a more conservative assumption.

Algorithm for adjusting future withdrawals for actual experience:  I like the approach of increasing last year's withdrawal with actual inflation and then testing the result against a corridor around this year's calculated value.  The example that follows uses a 10% corridor. 
In year 1, Joe determined his withdrawal to be $10,000.  Inflation during year 1 was 3%, so his preliminary year 2 withdrawal is $10,300.  Let's assume actual experience was favorable and his calculated value (using the spreadsheet and revised input items) at the beginning of year 2 is $11,000.  Since the preliminary withdrawal of $10,300 is 94% of the calculated value, Joe would budget a withdrawal of $10,300 in year 2.

Let's assume inflation of 2% in year 2, so Joe's preliminary withdrawal for year 3 would be $10,506 ($10,300 x 1.02).  Let's assume that Joe's calculated value for year 3 is $12,000.  Since the preliminary value of $10,300 is less than 90% of the calculated value, Joe would budget a withdrawal for year 3 of $10,800 (90% of the calculated value of $12,000).  Joe's preliminary withdrawal for year 4 would be $10,800 plus inflation during year 3.