Sunday, August 31, 2014

Managing Your Spending in Retirement--It's Not Rocket Science

This post once again takes on the so-called experts who say that most retirees aren't smart enough or motivated enough to properly manage their spending.  For some reason, they believe that individuals who have managed to live within their means prior to retirement (and even save money) will no longer be able to do so during retirement.  I believe that with a little bit of effort and the tools provided in this website most retirees can do a reasonably good job of managing their spending in retirement.  It is really as simple as following these four steps:

Step 1:  Develop a Reasonable Budget--Using one of the spending spreadsheets and the recommended assumptions set forth in this website, determine how much total income you can spend for the upcoming year (from Social Security, pensions, annuities, withdrawals from accumulated assets and income from employment).  To determine your "income" from withdrawals, you may need to adjust your current accumulated assets for events expected to occur in the future.  For example you may add the present value of amounts you expect to receive, such as gains from downsizing your home, expected inheritances, re-payments of loans owed you, etc.  Conversely you may subtract the present value of such items as future loan repayments you owe or amounts you wish to set aside for unusual future expenses (as discussed in the previous post).  The June, 2014 article in the articles and spreadsheets section of this website provides a brief description of how to use the Actuarial Approach to determine a spending budget and includes several posts that provides examples of these adjustments.

Step 2:  Determine Your Spending Needs/Living Expenses For the Upcoming Year--Most retirees keep track of their expenses, so they have a pretty good idea of normal living expenses.  To this amount add an estimate for other expenses you expect to incur.  Don't forget to include taxes that you may need to pay.

Step 3:  Compare the Results of Step 2 with Results of Step 1 and Make Necessary Adjustments--If the results of Step 2 are higher than the results of Step 1, you may need to reduce some of your expenses for the year or you may need to increase your income.  You can increase your income by working more or you can revisit the assumptions used to develop your budget.  For example, you may be comfortable developing a budget that is not expected to remain constant in real dollar terms from year to year, so this adjustment may increase your spending budget for the current year (at the expense of reducing it for future years, all things being equal).  Alternatively, you may simply decide that it is not important to have your expenses match your budget for the upcoming year.

Step 4:  Repeat Steps 1-3 at Least Once Per Year--This is not a "set-and-forget" process.   You need to periodically (I recommend doing this once each year at the beginning of each calendar year) revisit the three step process described above to reflect investment gains and losses, changes in assumptions, deviations of actual spending from the budget or other changes.  I recommend using the recommended smoothing algorithm in this website for this purpose.  Under this smoothing algorithm, you generally increase your budget by the increase in inflation over the previous year unless your budget falls outside a 10% corridor around the "actuarial value" produced by the spreadsheet.  Depending on actual results, your budget may increase or decrease from year to year.

That's it!  Yes, it takes some work and some discipline but after the first time it will probably take you less time than you take to plan your next trip, fill out your NCAA tournament brackets or make your fantasy league picks. 

Wednesday, August 27, 2014

Budgeting Around "Lumpy" Expenses

There may come a time during your retirement where you are looking at an expense that may blow your annual budget.  Examples of such expenses include the purchase of a new car or vacation home, helping your children purchase a new home, paying for a wedding, etc.  This post will take a look at several different ways you can handle these "lumpy" expenses under the Actuarial Approach. 

In summary, there are quite a few reasonable ways to adjust your budget for unanticipated expenses under the Actuarial Approach. In many ways, developing a budget for retirement is more of an art than a science. Irrespective of what your budget is, you are the one who decides how much of your available assets you will spend each year. After all, it is only a budget, and no one is going to force you to live within it. On the other hand, if you believe you will have unanticipated expenses in the future, it may be prudent to reserve for such expenses by reducing the accumulated assets you have available for normal retirement expenses and establishing a separate unanticipated expense fund.

Before discussing the different ways to adjust your budget for unexpected expenses, lets provide some facts for a hypothetical retiree so that we can illustrate the impact of using the different approaches:

Raymond retired at age 65.  At that time, he had accumulated assets of $500,000, a fixed dollar pension of $10,000 per year and Social Security of $24,000 per year.   He used the Excluding Social Security V 2.0 spreadsheet in this website with the recommended assumptions.  Because he wanted to leave some of his assets to his daughter, he developed his initial spending budget by inputting $100,000 in the amount to be left to his heirs. 

His resulting first year budget is $51,733 ($24,000 from Social Security, $10,000 from his pension and $17,733 from withdrawals).  In the first year of retirement, his accumulated assets earn 10%.  In the second year of his retirement, his accumulated assets earn 3%.  Let's assume that CPI increases were 2% in each of his first two years of retirement and further assume that Raymond spends exactly his total budget each year.  To determine his budget in subsequent years, Raymond applies the smoothing approach recommended in this website to the sum of his pension and withdrawals and then adds his Social Security benefit for that year.

Since the budget amount (prior to adding Social Security) increased by inflation in each of his first two years of retirement remains inside the 10% corridor around the actuarial value, Raymond determines his budget for his second year of retirement by increasing the first year pension and withdrawals of $27,733 by 2%.  This equals $28,288 so he withdraws $18,288 from his accumulated savings and his total budget for his second year is $52,768 ($24,480 from Social Security, $10,000 from the pension and $18,288 from withdrawals).

Late in his second year, Ray determines a preliminary budget for his third year.  He increases the pension and withdrawal from the previous year of $28,288 by 2% to get a sum of $28,854 for a total budget of $53,824 ($24,970 from Social Security, $10,000 from the pension and $18,854 from withdrawals.  At the beginning of his third year of retirement, he has $527,572 in accumulated assets.  By comparison, the actuarial budget for his third year (based on the spreadsheet without smoothing) would be $55,094 ($24,970 from Social Security, $10,000 from the pension and $20,124 from withdrawals).

But, let's assume that at the beginning of his third year of retirement, Ray discovers that he has an upcoming expense of $40,000 at some time in the near future.  How should he adjust his third year budget in light of this new expense?

Approach #1--Restart the Actuarial Approach

Under Approach #1, Ray redetermines his budget for year 3 reducing his assets at the beginning of year 3 by $40,000 (even though all of this expense may not occur in year 3).  So, instead of inputting $527,572 in assets to determine the actuarial budget, he enters $487,572 and a 28 year remaining period.  The resulting total budget is $53,265 ($24,970 from Social Security, $10,000 from the pension and $18,295 from withdrawals). 

Approach #2--Treat the Unexpected Expense as Any Other Gain/Loss (Including Deviations of Withdrawals from Budget)

Under Approach #2, Ray inputs $487,572 into the spreadsheet as his accumulated assets (the same as in Approach #1).  Using the smoothing method, he compares the result of the spreadsheet calculation ($28,295 = $10,000 from the pension and $18,295) with the previous years total increased by 2% inflation ($28,854).  Since the amount from the previous year increased by inflation falls within a 10% corridor around the actuarial value, Ray adds $28,854 to his Social Security benefit of $24,970 to get the same budget for his third year that he had prior to recognition of the unexpected expense. 

Approach #3--Recognize the Expense in Budget Over a limited Period

Ray doesn't feel comfortable with the negligible or no decreases in budget resulting under the first two approaches and feels that spending an extra $40,000 in accumulated saving should be recognized in his spending budget over a shorter time-frame.  Therefore, under Approach #3, Ray decides that he will reduce his spending budget for each of the next four years by $10,000 per year.  To accomplish this, Ray will add $40,000 to his reduced assets of $487,572 in year three and will determine the same budget (without recognition of the extra expense) of $53,824.  From this amount, he will subtract $10,000 to get a third year expense budget of $43,824.
To determine the budget in year 4, Ray will follow the regular actuarial process, but instead of adding $40,000 to his beginning of year assets, he will only add $30,000.  He will then subtract $10,000 from the resulting budget.  He will continue this process for two more years until there are no more adjustments to the inputted assets and no more $10,000 subtractions from the budget.  Depending on whether Ray actually pays attention to his spending budget, this approach is more conservative than the first two, but results in approximately a $10,000 increase in his annual budget when the expense is fully recognized. 

Approach #4--Reduce Amount Desired to be Left to Heirs

Yet another approach is to use either Approach #1 or Approach #2 and reduce the amount previously input for the bequest motive.  This approach may be perceived to me more reasonable if in fact the unanticipated expense is in reality a pre-payment of one's bequest motive (such as a gift to assist a child purchase a home).

Thursday, August 21, 2014

The Actuarial Approach vs. the "Bucket System"

This post welcomes yet another challenger to my claim that the Actuarial Approach is a better withdrawal strategy for you to use to develop a reasonable annual spending budget in retirement.  The challenger in this post is called the "Bucket System" and an example of its use is set forth in this Bankrate article.

Under the Bucket System, Jason Flurry proposes to establish three separate investment buckets (with increasing levels of investment risk) and a strategy for draining those buckets over time to provide retirement income to a hypothetical 55-year old couple with $2 million in accumulated assets.  His proposal would be expected to provide the couple with income of $60,000 per year for the first ten years of retirement.  In order to facilitate a comparison of the approaches, I am going to assume the following additional facts:  

  1. the couple has earned combined Social Security benefits of $4,000 per month payable at age 65 (before any increases in inflation),
  2. investment return per annum for the Bucket System equal to the percentages specified in the example (0% for Bucket 1, 4% for Bucket 2 and 6% for Bucket 3
  3. 5% per annum investment return for the Actuarial Approach
  4. 3% per annum inflation
  5. no other sources of retirement income, no desire to leave significant amounts to heirs, expected payout period under the Actuarial Approach of 40 years at initial retirement, and
  6. the couple expects to commence their Social Security benefits at age 65.  They expect the total annual amount of their Social Security benefits at that time (with 10 years of inflation at 3% per annum) will be $64,508 ($4,000 X 12 X 1.3439).
Under the Actuarial Approach, the couple uses the Social Security Bridge spreadsheet from this website, enters $2,000,000 in assets, expected Social Security of $64,508, number of years until commencement of Social Security: 10, zero to be left to heirs and the other recommended assumptions for the spreadsheet.  The resulting withdrawal for the first year is $103,340.  And, if the assumptions are exactly realized each year (and the couple spends exactly the total budget amount each year), each future year's total budget (Social Security plus withdrawals) until the couple reaches approximately age 91 is expected to remain at $103,340 per year in real (inflation-adjusted) dollars. 

By comparison, if all assumptions are realized under the "Bucket System" set forth in the article (and the couple spends the total budget amount each year--withdrawal plus Social Security), the total budget (in real dollar terms) is expected to increase significantly when the couple starts commencement of Social Security and again after 15 years when income from the third bucket kicks in.  The figure below shows a comparison of the expected total budget amounts under the two approaches from the couple's age 55 until they reach age 90.  I calculate that there will be in excess of $3.2 million in assets (including about 871,000 in Bucket 2) remaining at age 91 under the Bucket System vs. $749,489 at age 91 under the Actuarial Approach.  Note that this amount ($749,489) is shown in the run-out tab of the Social Security Bridge spreadsheet.  If you can't see the run-out tab, you need to maximize the spreadsheet window. 

Of course, actual future experience will not exactly follow assumed experience.  That is why it is important for a systematic withdrawal approach to automatically adjust for actual experience.  Under the Actuarial Approach this is easily accomplished:  As long as the previous year's budget amount increased by the increase in inflation for the previous year falls inside of a 10% corridor around the actuarial value, you stay with the previous year's value increased by actual inflation.  Automatic adjustment occurs under the Bucket System after the 15 year when the couple uses the IRS Required Minimum Distribution (RMD) rules to determine distributions.  As mentioned in previous posts, budget amounts can vary significantly from year to year under RMD approach as there is no smoothing of the actual experience.

The three major problems with the Bucket System (based on the facts of this example) from my perspective are: 1) it does not coordinate well with expected commencement of Social Security benefits, 2) it does not anticipate future inflation and 3) it uses the RMD rules to determine distributions from Bucket 3.  As a result of the first two problems, the matching of retirement income to the energy level of the hypothetical couple may not be optimal.  During the first ten years of their retirement, when they may wish to enjoy a more active life style including travel and adventure, their retirement income is significantly restricted relative to expected income in later years.  In addition, RMD is more likely to leave more money to heirs than desired.

Note that the Actuarial Approach produces an expected budget pattern under these assumptions that is constant in real dollar terms.  Some argue that retirees don't need constant real dollar income in retirement, but can accept some degree of decrease as they age, perhaps followed by an increased need much later in life.  This "smile" pattern can also be accomplished under the Actuarial Approach by inputting a lower percentage for desired increase in payments than the percentage anticipated for inflation and by inputting the expected increase in cost (for assisted living, etc.) as amounts desired to be left to heirs.  I believe it is better to factor these needs directly into the calculation than it is to use a method (such as RMD) that can simply result in unintended and undesirable deferral of spending. Of course, different spending patterns can also be achieved by consciously spending more or less than the spending budget produced under whatever approach is used.


 (click to enlarge)

Wednesday, August 20, 2014

Can Retirees Successfully Survive in a World of 401(k) Plans? - Part 2

I ran across three articles concerning living in a 401(k) world that might be of interest to the readers of this blog.

To get a different viewpoint from the one expressed by Professor Frolik in the last post, here is an article in Fiduciary News in which Phil Chiricotti claims, "lobbying to replace 401(k) is "lunacy" and "Not only are they not broken, but 401k plans are the most successful savings vehicle in history".

The second article comes from Brookings and argues that we don't just have a savings problem; we also have a spending problem.  "Upon retirement, households are faced with another daunting challenge--turning their accumulated wealth into security...Ultimately, a sound retirement means adept choices about both savings and spending."   Since this website is devoted to helping retirees with the "spending problem", I will have to agree with Brookings on this one.

Perhaps the most interesting of the three articles is actually a press release and a survey of retirees and near-retirees completed by T. Rowe Price.  It shows that the survey retiree group is living on significantly less income than they had prior to retirement, but 89% of respondents report being "somewhat or very happy with retirement so far."

The actual survey results contain a wealth of information, including the following:

Average sources of income in retirement:

Social Security: 43%,
401(k)/IRA: 18%,
Pension: 19%,
Earnings from employment: 8%,
Annuity income: 2%

48% of retirees have a withdrawal plan with an average withdrawal of 4.9% of accumulated assets (median of 4%). 

60% of retirees prefer to adjust spending up and down depending on the market to maintain the value of their portfolio

80% of retirees track expenses carefully and 63% stick to a spending budget

89% of retirees believe that they can adjust their lifestyle according to income

59% of retirees expect to spend their assets rather than leave significant amounts to heirs 

Of special interest to me is the fact that 63% of surveyed retirees stick to a spending budget.  Since the purpose of this website is to help retirees develop a reasonable spending budget (and one that smoothes variations due to investment performance but also adjusts the budget up and down when necessary), these survey results are encouraging to me.

Wednesday, August 13, 2014

Can Retirees Successfully Survive in a World of 401(k) Plans?

In his latest paper, Rethinking ERISA's Promise of Income Security in a World of 401(k) Plans, Professor Lawrence Frolik of the University of Pittsburgh School of Law, paints a reasonably depressing picture of retirement in the future.  Professor Frolik correctly points out that as employers and other plan sponsors transition out of defined benefit plans and into defined contribution plans, "retirees face formidable planning hurdles."  Not only must they be responsible for investing their retirement assets in this world, but they "must spend their retirement fund at a rate that will not exhaust it before they die, yet take a sufficient amount out, that when added to their other sources of income...will enable them to live at the level that they deem adequate." 

Professor Frolik presents an impressive argument that because of diminished physical and mental capacity, many retirees will not be up to the task.  He concludes that the use of annuities must be encouraged by our government.  He says, "unless the government does something to encourage the use of annuities by IRA owners, the financial security of many retirees will be severely compromised in the years to come.  We can expect rates of elderly poverty and increasing financial exploitation and abuse."

He pulls no punches by concluding, "The assumption that retirees can successfully manage their IRAs during their declining years is a folly.  Why any society would willfully create a retirement system that relies on the financial acumen of millions of aging individuals can only be explained as the triumph of hope over common sense and reality."

Whether you agree or not with Professor's assessment of the implications of living in the "World of 401(k)s", he does make a good argument for diversification of risks in retirement through purchase of life annuities (immediate and/or deferred) with some or all accumulated retirement assets, and he makes a good indirect argument for using a relatively simple approach like the one proposed in this website, for determining a spending budget in retirement. Under any circumstance, however, there should be a plan in place for transfer of financial responsibilities to a competent party when an individual becomes physically or mentally incompetent. 

Saturday, August 9, 2014

Deferral of Social Security Commencement is a Reasonably Good Strategy, But it May Not be All That it's Cracked Up to Be.

This post is a follow-up to my posts of April 28, 2014, April 4, 2014, December 8, 2013 and July 23, 2013 on the benefits of deferring commencement of Social Security benefits. 

It is difficult today to read advice from retirement experts without running across statements such as, "it is a huge mistake to commence your Social Security benefit prior to your Normal Retirement Age", "You can significantly enhance your retirement security by deferring commencement", and "for many retirees, the increases in retirement income from the delayed retirement credits may mean the difference between poverty and comfort."  Most of these articles also mention the fact that the Social Security benefit commencing at age 70 for an individual with a Social Security Normal Retirement Age of 66 is 76% higher than the benefit commencing at age 62.

As I have said in previous posts, deferring commencement of Social Security benefits is a reasonably good strategy, but if you want to achieve significant increases in your total retirement income, you probably are going to have to keep working and deferring not only the commencement of your Social Security benefit, but also your actual retirement.  Most articles don't mention that if all you do is defer commencement of the benefit and dip into your accumulated savings to "bridge" the period of deferral (assuming you have such savings), the expected increase in your total retirement income will not be as near as much as you might have expected. 

The motto of the Society of Actuaries is, "The work of science is to substitute facts for appearances and demonstrations for impressions."  So the purpose of this post is to crunch some numbers and substitute some demonstrations for impressions.  Before I dive into the numbers, I'll say up front that I have only considered benefits of commencement deferral to the individual and have not considered additional benefits that may inure to the individual's spouse as part of the deferral strategy.  Also, Social Security benefits are fully indexed to inflation and that feature may not be fully captured by looking at deterministic projections of future experience.  On the other hand, I've assumed that the Social Security program will remain unchanged in future years despite its problematic financial condition. 

The tables below compare total annual retirement income (Social Security + Structured Withdrawals from Savings) produced under various Social Security deferral strategies vs. commencing Social Security immediately.  The success of any Social Security deferral strategy vs. immediate commencement generally depends on investment return on accumulated savings, inflation and age at death of the individual.  So I'll examine different assumptions for these items. 

Table 1 looks at deferring Social Security benefits from age 62 to age 66 (the assumed Normal Retirement Age).  Table 2 looks at deferring Social Security benefits from age 66 to age 70 and Table 3 looks at deferring Social Security benefits from age 62 to age 70.

In Tables 1 and 3, the individual is assumed to retire at age 62.  For the commencement deferral strategy the individual is assumed to dip into accumulated savings so that total retirement income (from Social Security and withdrawals from savings) is expected to remain constant from year to year (in real dollars) over the payment period based on the indicated assumptions.    Amounts shown in each Table, therefore, represent the initial total retirement income which is expected to increase by inflation each year over the expected payment period.  These calculations are performed using the Social Security Bridge spreadsheet on this website.

In Table 1, the individual is assumed to have $100,000 of accumulated assets and a Social Security benefit payable at age 66 (before any cost-of-living-adjustment increases) of $1,000 per month.  At age 62, she can commence her benefit of $750 per month, or she can defer commencement until age 66 and receive $1,125 per month ($1,000 plus four years of CPI increases of 3% per year under the 3% inflation assumption scenarios).  If she chooses to defer, she needs to dip into her accumulated savings.  It isn't cheap to do this.  Under the 5% investment return / 3% inflation assumptions, the present value at age 62 of these "bridge payments" is $46,646.  She is effectively purchasing a much larger deferred annuity payable from Social Security (fully indexed to inflation) with these bridge payments. 

How much more annual retirement income will she receive by deferring commencement of Social Security from age 62 to age 66?  It depends.  Under assumption scenario #1 (5% investment return, 3% inflation and expected payments until age 95), she will have total income under the commencement deferral strategy of $14,163 (such income to increase by 3% per year until her death at age 95) vs. total retirement income assuming immediate commencement of $13,054 (also increasing by 3% per year). The difference of $1,109 per annum equates to about an 8.5% increase resulting from the commencement deferral strategy under these assumptions.   

The other numbers on Table 1 and the numbers in the other two figures make the same comparison but use different assumptions and different deferral periods.  It should be noted that for Table 3, the individual was assumed to have $125,000 in accumulated assets because $100,000 would have been insufficient to bridge the period of deferral. 

Bottom Line:  Deferring commencement of Social Security can increase total retirement income under most reasonable assumptions.  This strategy also adds inflation protection and can provide larger benefits to your spouse.  If you want to quit working and adopt the commencement deferral strategy, you have to be willing to dip into your accumulated savings to make it work.  The degree of success of the commencement deferral strategy will depend on the investment return you could have earned on the "bridge payments" you withdraw from your accumulated savings, the rate of future inflation and how long you live.  Under most reasonable assumption scenarios, you don't see the increases in total retirement income that you might have expected from reading articles on this subject by the retirement experts.  Nor do you see the magnitude of increases necessary to lift retirees out of poverty and into a life of comfort.  

Readers are encouraged to do their own modeling of the commencement deferral strategy by using the Social Security Bridge spreadsheet.

 (Table 1 - click to enlarge)

  (Table 2 - click to enlarge)

  (Table 3 - click to enlarge)

Saturday, August 2, 2014

Are You "Most People"?

If you are visiting this site, you are presumably interested in developing a reasonable spending budget for retirement and how much of your accumulated savings you can afford to spend each year.  Thanks for visiting.  If you are looking for a super simple answer, I'm afraid you won't find it here (or anywhere).  The right answer for you depends on your personal situation and your objectives, and, yes, I'm afraid it involves a little number crunching. 

My friend, fellow actuary and former colleague, Steve Vernon, who is now a research scholar for the Stanford Center on Longevity, has told me that his research shows that most people aren't comfortable doing these types of calculations on their own, and they want someone else to do them for them.  If you are "most people" and are not comfortable with doing these calculations, you should probably consult a financial planner.  However, if you are not "most people", I suggest that you familiarize yourself with the Actuarial Approach set forth in this website.  We have put together a brief explanation of the process which includes an example and a screen shot of the Excel spreadsheet used for the calculations here.  Many of the entries in the spreadsheet have recommendations.  I assure you that it is not rocket science.  Our last few posts have illustrated that spending the little extra effort to do these calculations can pay large dividends.