Thursday, May 21, 2015

The Actuarial Approach—Periodic Matching of a Retiree’s Assets and Liabilities

As I said in my previous post, any spending approach that does not periodically match a retiree’s assets with her liabilities runs a significant risk of failing to achieve the retiree’s spending objectives.   What are the retiree’s assets?  They include her accumulated savings and the present value of retirement income from other sources (such as annuities or pensions).  What are the retiree’s liabilities?  These include the present value of future annual spending budgets, the present value of the amount the retiree wishes to leave to heirs and the present value of other expenses such as long-term care.

This post will illustrate, with an example, the matching of assets and liabilities achieved by the Actuarial Approach advocated in this website. 

Let’s assume that we have a hypothetical retiree named Mary who is age 65.  She has $1,000,000 in accumulated savings, a fixed dollar pension of $15,000 per year, a Social Security benefit of $20,000 per year and no other sources of income.  She has determined that her essential expenses in retirement will be about $50,000 per year.   Since believes that these essential expenses will stay reasonably constant in real dollar terms from year to year.   She would also like to leave around $500,000 (in future dollars) to her daughter at her death or have that money available for long-term care or extra medical bills if needed.  She also believes that she will need something like $100,000 for unexpected expenses not included in her essential expense budget, such as purchases of new automobiles or gifts to her daughter. 

Mary goes to the “Excluding Social Security” spreadsheet to see how much of her accumulated savings it will take, together with her pension and her Social Security benefit to cover her $50,000 annual real dollar essential expense budget and still leave her with $500,000 at her expected death.  She enters $600,000 in accumulated savings, $15,000 in annual pension, $500,000 to be left to heirs at death and the recommended assumptions (including a desired annual increase rate applicable to future budgets attributable to savings and pension of 2.5% per annum).  The resulting spending budget when Social Security is added is $51,401.  Since this is close to her estimate of essential expenses she decides she will dedicate $600,000 of her accumulated savings to her “essential expenses” budget along with her pension and her Social Security benefits.  She may even invest these essential expense assets differently than her other accumulated savings. 

To cover unexpected expenses, Mary dedicates $100,000 of her assets to this budget item.  Since she feels that the amount she desires to leave to her daughter at her death can serve several purposes, Mary does not feel it is necessary to dedicate additional assets to cover rising health costs or long-term care expenses.  Finally, Mary wishes to travel early in her retirement and have an active social life.  She dedicates her remaining $300,000 of accumulated savings toward non-essential spending but she wishes to front-load this budget item.  Therefore, she enters $300,000 in the Excluding Social Security spreadsheet with 0% increase in the annual desired increase.  The result for the first year is a non-essential spending budget of $17,624.  Mary knows that this budget item will not increase in nominal terms from year to year and therefore will represent a declining real spending budget as she ages.

Mary’s first year spending budget is $69,025 (a total of $51,401 from Social Security, her pension and her essential assets) plus $17,624 from her non-essential assets.   The exhibit below shows Mary’s Actuarial Balance Sheet as of her date of retirement.  The present values are based on the recommended assumptions and results from the Excluding Social Security spreadsheet. 

Click to enlarge

Mary will revisit her spending budget thought process at the beginning of each new year.  She will use the Excluding Social Security spreadsheet and enter new data and new assumptions.  Investment experience may deviate from the assumptions she used.  Her spending may deviate from her budget.  Assumptions may be changed.  Her objectives and liabilities may change (or she may refine what is essential and what is not essential).  If she continues to use the Actuarial Approach, she has the flexibility to make informed adjustments in her budgets.  Each year, she will balance her assets and her liabilities.  If she uses the recommended smoothing algorithm, assets and liabilities may not be perfectly matched, but she knows that the match will be close enough. 

Mary knows that she has to crunch a few more numbers under the Actuarial Approach than she would have to under the 4% withdrawal rule or some other variation of this rule, but Mary feels much more comfortable with the control she has over her spending budget using this much more sophisticated (and not that much more complicated) approach.  Mary also finds comfort in the fact that the approach she is using is consistent with basic actuarial principles and is not just some simple rule of thumb approach.