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