Thursday, October 30, 2014

Revisiting the Recommended Smoothing Algorithm

I first proposed a recommended smoothing algorithm for The Actuarial Approach in my post of October 11, 2013.  The purpose of the recommended smoothing algorithm was to balance the desire to have relatively constant real dollar budgets from year to year with the need to keep spending budgets reasonably on track with the "actuarial value" determined using the applicable spreadsheet from this website (generally Excluding Social Security V 2.0), recommended assumptions and the retiree's actual data as of the beginning of each year.

In general terms the recommended smoothing algorithm involves taking the budget amount from the previous year, increasing that amount by inflation (the increase in CPI) for the previous year and making sure that the resulting value is not more than 110% of and not less than 90% of that year's actuarial value.  If the resulting value falls within the corridor, the inflation adjusted value is used to develop the budget for the year.  If the value falls above or below the corridor limit, the applicable corridor value is used in the budget calculation.

Recently, in a conversation with Ian McGugan, reporter for the Globe and Mail in Toronto, Mr. McGugan pointed out that I wasn't terribly specific about what budget amount was being used in this smoothing calculation.  Mr. McGugan (a bright guy) correctly pointed out that in the various examples contained in my website, I had inconsistently used several different amounts for the previous year's budget amount for this calculation.

I will readily admit that there was more art than science involved in developing this smoothing algorithm.  For example, I don't know whether some or all retirees who may use the Actuarial Approach would be better served with a 12% or 8% corridor.  Perhaps someone like Wade Pfau or some other retirement academician can utilize Monte Carlo modeling to develop an optimal corridor.  Similar arguments can be made with respect to the budget (or portion of the budget) that should be subject to the corridor.

If the retiree has an immediate defined benefit pension benefit or life insurance annuity as a retirement income source, she has at least three choices with respect to how the recommended algorithm can be applied:

  1. to the portion of the budget attributable to accumulated savings only
  2. to the portion of the budget attributable to accumulated savings plus the pension/annuity, or
  3. to the total budget, including income from Social Security
If the retiree has no immediate pension or annuity income sources, then items 1 and 2 above will be the same.

Personally, I would prefer that the spending budget stay reasonably close to the actuarial value, so I will recommend that the 90% to 100% corridor be determined using the portion of the budget attributable to accumulated savings plus the pension/annuity rather than using the entire budget including Social Security, as it will produce a somewhat smaller corridor range, all other things being equal.

As a result of Mr. McGuggan's excellent suggestion to try not to confuse readers when possible, I have revised the examples in the June, 2014 article "Using the Actuarial Approach to Determine Your Annual Spending Budget in Retirement" to reflect the more specific recommended smoothing algorithm above.

I thank Mr. McGuggan for his feedback and encourage other readers to submit their suggestions for improvements to this website.