Thursday, May 28, 2015

Another Example of Why You Want to Use the Actuarial Approach

In this post we are going to revisit our hypothetical retiree, Mike, whom we talked about in our posts of April 16, 2015 and February 25, 2015.  As you may recall, Mike is a single 65 year-old male retiree who is eligible to receive a Social Security benefit of $16,800 per annum and he also has accumulated savings of $750,000 but no other sources of retirement income.   As we saw in the previous posts, if Mike uses the Excluding Social Security spreadsheet from this website and the recommended assumptions (and no amount to be left to heirs), he will develop an initial spending budget of $49,427 ($16,800 from Social Security plus a $32,627 withdrawal from his accumulated savings).  If all the recommended assumptions are unchanged and exactly realized each year in the future and Mike spends exactly his spending budget each year, his spending budget would be expected to remain constant in real dollar terms until he reaches about age 90.  If he survives past age 90, his spending budget would be expected to decline somewhat as his age plus his life expectancy starts to exceed 95 (under the mortality assumptions in the 2012 Society of Actuaries Individual Annuitant mortality table with 1% projection). 

Here is Mike’s Actuarial Balance Sheet as of his 65th birthday for this base case.  Present values are determined using the recommended spreadsheet assumptions (4.5% discount rate, 2.5% inflation increases and death at age 95)

(click to enlarge)

As indicated in the previous posts, Mike is not pleased with his spending budget and he has looked at a number of alternatives to increase early year spending.  Mike knows that his life expectancy is 23 years under the Society of Actuaries mortality table.  Therefore, he knows that assuming a 30-year payout period is likely to be conservative and leave money unspent upon his death.   He also knows, however, that if he uses his life expectancy as the expected payout period, his spending budgets will decline in future years as life expectancy does not decrease by one year for each year that a retiree ages (see our post of December 3, 2014 for a graph of this effect).  Mike is also aware of experts who say that many retirees spend less in real dollar terms as they age.  So, Mike feels that there is some conservatism built into the recommended assumptions that he can exploit to increase his near-term spending budgets. 

Mike’s first step is to see how much his essential spending is.  He determines that his essential spending needs are about $40,000 per year.  With respect to his essential spending, however, Mike feels that it is important to be conservative both with respect to the expected payment period of 30 years and with respect to the desire to maintain constant purchasing power.  With a little playing around with the Excluding Social Security spreadsheet and QLAC purchase rates from, Mike sees that if he designates $415,000 of his accumulated savings to essential spending, his entire Social Security benefit and spends $70,000 to purchase a deferred annuity starting at age 85 (with no benefit for death prior to that age), he can generate an initial essential spending budget of $40,074 ($16,800 from Social Security plus $23,274 from accumulated savings) that is expected to remain constant in real dollars over the next 30 years. 

This leaves Mike with $265,000 in accumulated savings ($750,000 - $415,000 dedicated to essential spending - $70,000 for purchase of the QLAC).  With respect to this $265,000 that he has decided to dedicate to non-essential spending, Mike is more willing to front-load this spending.  He decides that he will target his spending over his remaining life expectancy (not 30 years) and he will not build in any increases for future inflation.  Using the Excluding Social Security spreadsheet, he enters 23 for expected payout and 0% for desired increases due to inflation.   This gives him an initial non-essential spending budget of $17,924 and a total initial spending budget of $57,998 ($40,074 essential plus $17,924 non-essential).  This spending budget is approximately 17% higher than his base spending budget 0f $49,427.

Mike knows that his total spending budget will decline in real terms from year to year if all assumptions are realized.  In fact, he estimates that his non-essential spending budget will only be about $5,100 in real dollar terms at age 89.
Here is Mike’s Revised Actuarial Balance Sheet reflecting purchase of the QLAC.  

(click to enlarge)

It is important to note that even though Mike only spent $70,000 for the QLAC, the present value of benefits expected to be received under that contract is about $120,000 as Mike is assuming that he will live until age 95 (not his life expectancy assumed by the insurance company).  Thus, from a pure budget perspective (and not necessarily from an investment perspective), the purchase of the QLAC is a smart move.   He is using the mortality premium from the insurance contract to more cheaply fund future essential expenses than he can with his accumulated savings. 

Could Mike use a conservative approach for his essential spending and a less conservative approach for his non-essential spending and still obtain his desired increased spending budget with the 4% Rule, any safe withdrawal rate rule, or the Guyton decision rules?  Not bloody likely.  That is why smart retirees and their financial advisors should chooose the Actuarial Approach rather than some “simple” rule of thumb.