Sunday, November 16, 2014

Does Your Financial Advisor Develop Your Annual Spending Budget Based on How Much Assets You Have and How Long You Might Live?

Lets assume that you and your Financial Advisor meet approximately annually to determine your spending budget for the year.  If you don't actually have a Financial Advisor, then you and/or your spouse are acting as your own Financial Advisor.  In a recent survey of Financial Advisors by Russell Investments, 234 Financial Advisors were asked how they develop spending budgets for their clients near or in retirement.  25% responded that they based their approach on levels of pre-retirement spending, 22% indicated that they used a rule of thumb like the 4% Rule, 19% indicated that they used some variation of the Bucket Strategy, 16% indicated that they compared assets with future liabilities and 18% indicated some other approach. 

The Russell Investments survey concluded that not enough Financial Advisors were using "math and science" to develop spending budgets for their clients and should be periodically comparing the client's assets with the client's liability (the present value of the future withdrawals from the accumulated assets) similar to how actuaries measure the funded status of pension plans (which coincidentally is the basis for the approach recommended in this website).

Along the same line, in an interview for Advisor Perspectives, Nobel Laureate Bill Sharpe provided his views on developing spending budgets and the 4% Rule (and other Safe Withdrawal Rate Rules):

"What you spend should depend upon (1) how much you’ve got and (2) how long you think you might live, or the range of possible lengths of life. The 4% rule is fine on both fronts on day one. For example – you’ve got $1 million and you’re 65. Spend $40,000. This may be just fine.

After the initial year, however, what you spend with this rule has nothing to do with how much you have, or for that matter, how long you expect to live. Most importantly, it doesn’t depend how much you have at the moment. Any rational person would say, “What you spend ought to depend upon how much money you have.” Isn’t that self evident?  A rule that doesn’t do that after year one doesn’t make any sense. And this should be the end of the discussion. But we see such an approach advocated in many places."

Finally, Dirk Cotton provided similar views in his entertaining blog of October 27,2014 entitled "Spherical Cows."  Commenting on the use of Safe Withdrawal Rate approaches, Dirk said,

"One of my favorite Spherical Cows is the one used to calculate sustainable withdrawal rates. SWR models assume that a mythical investor will continue to spend the same amount of money each year from savings, even after it becomes obvious that he or she is about to deplete their retirement savings. The models take a percentage, say 4%, of initial portfolio value and subtract that fixed dollar amount ($4,000 from a $100,000 portfolio in this case) from the portfolio balance every year, counting the number of years before the portfolio is depleted.

Many financial writers argue that no one really "does it that way", meaning everyone adjusts spending based on their remaining portfolio balance instead of spending a flat amount, but I have two responses to that. If no one does it that way, then everyone in the financial press should stop saying that you can do it that way.  And second, the SWR models predict outcomes for you only if you do "do it that way". (Operations Research guys say that a model is predictive only to the extent that its policies are followed.) The SWR results aren't predictive if you do something else, like adjust spending to portfolio value changes – which apparently is what everyone is actually doing."

Bottom Line:  If you act as your own Financial Advisor, you should spend the time to learn the pros and cons of alternative withdrawal strategies.  The Actuarial Approach recommended in this website uses established actuarial principles that consider how much assets you have each year and the expected payout period.  If you do work with a Financial Advisor, you should compare the budget recommended by your Financial Advisor with the budget developed using the Actuarial Approach and discuss any significant differences with your Financial Advisor.  If you are a Financial Advisor for others, you may wish to consider employing the math in the Actuarial Approach for your clients to see how it compares with whatever method you are currently using.