Tuesday, March 31, 2015

Spending More or Less Than Your Spending Budget

This website is all about helping retirees develop a reasonable spending budget in retirement.   Notwithstanding, we understand that there may be many years in retirement where your actual spending may not match your budgeted spending.  This is ok as long as you realize that over-spending now can result in a smaller real dollar spending budgets in the future and vice versa.  We have addressed this concept in many of our previous posts including “You Can Spend it Now or You (or Your Heirs) Can Spend it Later” and “Budgeting Around ‘Lumpy’ Expenses.”

We are revisiting this concept today primarily as a result of a post that appeared in the Huff Post Financial Education blog entitled, “Baby Boomer’s Retirement Strategy:  Binge Spending Or Nothing At All.” In this post, the author refers to a recent study by Hearts and Wallets which showed that “28 percent of older Americans took no retirement income from their personal assets...Another one-quarter took 8 percent or more…”  The author interviewed Laura Varas, a partner and co-founder of Hearts and Wallets, who hypothesized that a significant portion of older Americans may be fasting and binging with their retirement assets on purpose rather than spending these assets in a systematic manner.   The term used in the article for over-spending is spending in “chunks,” and Varas concludes that "Knowing how to spend safely in chunks is something they [retirees] want."

As we said in our post on budgeting around lumpy expenses, there are several ways to use the Actuarial Approach to deal with unusual and unplanned expenses.  One of the suggested approaches is to carve out some of your current assets in anticipation that this portion of your assets will be dedicated to the lumpy expense expected in the future (thereby reducing your current spending budget).  Another approach is to simply treat over-spending the same as unfavorable investment experience or changes in assumptions and apply the smoothing algorithm recommended in this website. 

While the Actuarial Approach can help retirees deal with spending in “chunks”, it is important to note that the over-arching rule for spending in retirement is you can spend it now or you (or your heirs) can spend it later.  This rule also applies to retirees who use the Actuarial Approach.  If you are using our recommended smoothing algorithm to smooth investment experience, changes in assumptions or deviations from spending and the smoothed budget amount is consistently below the actuarial value produced by the spreadsheet, you may be borrowing from future budgets.  If you are spending more than your spending budget in a year, you may be borrowing from future budgets.  If you follow the recommended longevity assumption of planning on living until age 95 or your life expectancy if greater and you live past age 89, you will have borrowed from real dollar budgets after age 90.  Unfortunately, there are no guarantees when you choose to self-insure some or all of your retirement income, not even if you use the Actuarial Approach. 

Monday, March 23, 2015

The Actuarial Approach—A Dominating Dynamic Spending Strategy

Over at The Retirement CafĂ©, Dirk Cotton has provided two informative posts which compare various spending strategies.   The first is dated February 20, 2015 entitled, “Dominated Strategies and Dynamic Spending” and the second (a follow-up to the first) is dated March 17, 2015 entitled “Dominated Strategies, Logically Unsound Strategies, Problematic Strategies and Strategies that Make Me Queasy”

In the first post, Dirk uses game theory (and not the knowledge he may have gained by avidly reading the 50 Shades of Grey trilogy) to determine that Dynamic Spending Strategies (like the Actuarial Approach) “dominate” safe withdrawal rate strategies.  In his March 17 post he continues to eliminate strategies from his “Sound Strategies” list by crossing out strategies that are logically unsound, problematic or that make him feel queasy.   Nice posts, Dirk. 

Sunday, March 22, 2015

The Annually Recalculated Virtual Annuity—Pretty Darn Similar to the Actuarial Approach

Thanks to Wade Pfau for bringing to my attention the article in the January/February 2015 Financial Analysts Journal entitled, “The Only Spending Rule Article You Will Ever Need” by M. Barton Waring and Laurence B. Siegel.  The authors believe that, “constructing a spending rule is itself an annuitization problem at heart but does not require purchasing an actual annuity…”  The name the authors give to their recommended spending rule is the Annually Recalculated Virtual Annuity (ARVA).   
I agree with most of this article, as it is basically the same as the approach I have been advocating for over ten years, the last five of which are documented in this website. 

About the only aspect of the authors’ article with which I am not in complete agreement is the authors’ aversion to smoothing of the spending budget from year to year.  The authors argue that smoothing is “the actuarial mistake that has caused so much difficulty for pension plans” and “It is important to control consumption risk with investment policy, not with accounting tricks like smoothing.”  While I agree that over-smoothing can be a problem, I believe the recommended smoothing algorithm advocated in this website does a pretty good job of balancing retiree needs to have some acceptable degree of spending stability with the need to remain on track with the correct actuarially determined value, and in my opinion is consistent with “the small amount of smoothing” described in footnote 13 of the article.  Further, I find it somewhat hypocritical of the authors to cling so steadfastly to their “no smoothing” mantra at the same time that they play fast and loose with longevity risk by stating, “As with any stream of cash flows, the shape of the cash flow payments to a retiree can be engineered to be anything the retiree wants…”.  After all, as I said in my previous post, any spending rule is designed to give the retiree a budget, and it is ultimately up to the retiree to determine how closely that budget will be followed in the current year. 

I will point out that while this article is entitled “The Only Spending Rule Article You Will Ever Need”, the article itself doesn’t provide much in the way of simple spreadsheets (like we provide in this website) to implement the rule, particularly if a retiree has other sources of retirement income such as immediate or deferred annuities/pensions with which spending from accumulated savings needs to be coordinated.

Thursday, March 19, 2015

Retirement Researcher Confirms Actuarial Methods Spend Down Wealth More Efficiently

In his March 16 paper, “Making Sense Out of Variable Spending Strategies for Retirees”, Dr. Wade Pfau examines ten key variable rate spending strategies (including the Actuarial Method advocated in this website) with the goal of comparing the strategies and evaluating them against certain criteria.  Instead of examining the “failure rate” of the strategies, Dr. Pfau looks at distributions of spending and wealth decumulation outcomes using Monte Carlo simulations assuming hypothetical retirees are comfortable with an X% chance that spending levels fall below a threshold of Y real dollars by year Z of retirement (where X,Y and Z can vary).  

Dr. Pfau separates the ten strategies into two main groups:  decision rule methods and actuarial methods.  He further separates the actuarial methods into four approaches with the Actuarial Approach advocated in this website included in the PMT Formula category (because the formula used in the spending rate determination is mathematically equivalent to the result obtained by using the PMT function in Excel if the retiree has no pension/annuity income with which to coordinate).  Based on his research, Dr. Pfau concludes that the actuarial methods “are all shown to spend down wealth more efficiently” than the decision rule methods. 

I applaud Dr. Pfau’s efforts to examine the various strategies available to retirees and their advisors using the XYZ metric he has developed and Monte Carlo simulations.  It is important to remember, however, that developing a reasonable spending budget in retirement is equal parts art and science, as no one knows what the future holds.  In addition, a spending budget is just that—a budget.  Almost no retiree I know spends exactly her budget each year.

For simplification purposes, Dr. Pfau’s analysis assumes the hypothetical retirees used in his Monte Carlo simulations have no other sources of retirement income other than accumulated wealth.  He does note that the “XYZ” measurement calculation “can incorporate Social Security and other income sources as well…”  If you do have other sources of retirement income (such as annuity income from a pension plan or insurance contract) that are not indexed to inflation or are not currently in payment status these other sources can significantly affect current spending of accumulated savings.  Of course, the simple spreadsheets provided in this website automatically consider these other sources to provide you with a coordinated spending budget, whereas the other “actuarial methods” examined by Dr. Pfau do not

Sunday, March 1, 2015

How Secure is Your Social Security?

This website is all about developing a reasonable spending budget in retirement.  For the last five years, I’ve recommended a spend-down strategy for self-managed assets in order to develop an overall spending budget that is coordinated with all sources of retirement income, including Social Security.  The Actuarial Approach advocated in this website is based on the premise that current law benefits will not be reduced for those retirees who are currently receiving or who are close to receiving Social Security.  In light of Social Security’s financial problem, there are reasons to question this premise. 

For many retirees in the United States, Social Security is the most important retirement income source they have.  It would be nice to know that we can count on the system to continue to provide the same real dollar level of benefits as long as we live.  But we read articles almost every day pointing to Social Security’s financial problems.  As retirees, should we worry about these problems?  Many “experts” tell us that historically, system financial problems have generally been resolved without reducing benefits for those who have already retired or who are close to retirement.  While this provides us with some level of comfort, we also know that there is nothing in the Social Security law that prevents Congress from reducing benefits of those who are already in pay status.  The issue of whether our Social Security benefits will be reduced (and if so, by how much) is an important one for retirees because we will need to make appropriate adjustments in our retirement plans and spending budgets.  Unfortunately, reductions in future Social Security benefits may be yet another risk we need to address when managing our retirement.

This post will briefly discuss Social Security’s financing problem, how likely it is that this financing problem will lead to benefit reductions for retirees in pay status, when reductions may occur, and how large the reductions might be.

The Problem

Under “intermediate assumptions” in the 2014 OASDI Trustees Report and assuming no future changes in the system, Social Security’s actuaries project that in the year 2033, the combined OASDI trust funds (if they were combined) will be exhausted.  The combined trust funds are currently about $2.8 billion.  Under the same assumptions, the actuaries project that the system’s 2034 cost rate will be about 17.03% of taxable payroll and the system’s income rate will only be 13.18% of taxable payroll, a shortfall of 3.85% of taxable payroll.  Absent Congressional action prior to 2034, benefits to those receiving payments at that time would have to be reduced by almost 23% across the board.  Technically, full benefits would still be paid, but they would be delayed so the effect would be the same as a cut in benefits.  Note that this is the “default option” if Congress does not act prior to trust fund exhaustion. 

It is also important to note that these projections are based on lots of assumptions.  If actual experience differs from the assumptions, the size of the shortfall could be larger or smaller and/or the exhaustion date earlier or later than 2033. 

Will Benefits be Reduced for Those in Pay Status?

Well, this is the $64,000 question isn’t it?  Will Congress and the President find some other solution to the problem in the next 18 years that doesn’t involve benefit reductions for those in pay status or for those who are close to being in pay status.   The solution could involve payroll tax increases, general revenue financing, benefit reductions for those not in pay status or combinations of these or other actions.   

For example, if Congress waits until the last minute to address this issue and does not want the default option to go into effect in 2034, it could increase the combined employer/employee tax rate of 12.4% of taxable wages (6.2% for workers and 6.2% for employers) by 3.85% or by approximately 31%.  It is important to note that if no changes are made to the system in the next 19 years and Congress decides in 2034 to limit benefit reductions only to future beneficiaries, the only option would be the 31% tax rate increase (or raise some other form of additional system revenue).   Similarly, if no changes are made to the system in the next 19 years and Congress decides at that time that it can only increase taxes by 1% each on workers and employers, then benefits in pay status will have to be reduced by at least 11% across the board. 

Given recent Congressional actions, there is certainly a non-zero probability that it will not address this problem prior to trust fund exhaustion.  Rather than raise payroll or income taxes or cut benefits, Congress may be willing to follow Thelma and Louise’s example and simply drive the Social Security car over the cliff into the Grand Canyon.

Even if Congress does act prior to trust fund exhaustion, there is a non-zero probability that such action will involve some type of benefit reduction for beneficiaries in pay status.  Congress may feel that a fair solution to the problem should involve a certain amount of shared pain from all the system’s stakeholders.  And while earlier action can reduce the size of the problem somewhat, the magnitude of tax increases/benefit reductions required to solve the problem will still be substantial if they are totally borne by those who are not in pay status.  Don’t be misled by the actuarial deficit of 2.88% in the 2014 OASDI Trustees Report.  Just one look at the graph on page 12 of the report will convince you that the long-range size of the problem is a lot closer to 4% of taxable payroll. 

How Large Might the Reductions Be?

As noted above, if Congress does nothing prior to 2034, the default option is to effectively reduce benefits in pay status by 23% across the board.  If Congress does take action prior to 2034, across the board reductions are likely to be somewhat less.  However, even though the average reduction in benefits might be less than 23%, it is quite possible that certain types of beneficiaries could be hit harder than others.  For example, Congress may reduce some spousal benefits or may reduce benefits for more wealthy retirees.  There is no way of knowing at this time what Congress will do. 

In conclusion, retirees (especially the more wealthy ones) may find it prudent to consider the possibility of future Social Security benefit reductions when developing their retirement spending budgets.