Tuesday, September 22, 2015

Retirement Planning in an Uncertain World--Part 2

This is a follow-up to our post of August 11, 2013.  In that post, I included what I considered to be one of the most helpful (and most succinct) pieces of advice I have ever read regarding managing the risks involved in financial planning for retirement in today’s world.  In his MoneyWatch article of August 7, 2013, my friend and fellow actuary, Steve Vernon said,

"Step 1: Plan to support the life you want, using your best estimate of the future regarding the economy, capital markets, your life expectancy and so on.

Step 2: Be prepared in the event that your forecasts are wrong."

While the simple spending budget calculation spreadsheets (Excluding Social Security and Social Security Bridge) included in this website include a Runout tab (and an inflation adjusted Runout tab) that shows future year’s expected results based on exact realization of all the input assumptions, no changes in assumptions and spending each year exactly equal to the total spendable amount, retirees who use these spreadsheets should have absolutely no expectation that these projected future year’s results will actually occur.  They are primarily provided to show the user that the math works, and that under these totally unrealistic conditions, the amount left to heirs at the end of the expected payout period will equal the amount the user inputted on the input page. 

The fact that the future numbers in the Runout tabs will be wrong, however, does not invalidate the approach recommended in this website to determine a retiree’s spending budget.  The Actuarial Approach anticipates that a retiree’s assets and liabilities will be re-measured at least once a year to adjust the retiree’s budget for differences between actual and assumed experience, for differences between actual and assumed spending and for changes in assumptions.  This re-measurement process is essential for keeping the retiree on track.  I view this as part of Step 2 in the process Steve Vernon outlined above. 

There are lots of possible reasons why forecasts made today will be wrong (deviate from expected results) in the future.  These reasons include:

  • Differences between actual and assumed investment returns 
  • Changes in assumed future investment returns
  • Differences in actual or assumed spending
  • Differences in desired amounts to be left to heirs
  • Differences in actual or assumed rates of inflation/desired increases in budgets to keep up with inflation
  • Differences in actual or assumed longevity
  • Differences in sources of income
Each of these differences can increase or decrease the retiree’s spending budget under the Actuarial Approach.  It is important for a retiree to realize that their spending budget can and will go up and down in future years depending on these changes.  As indicated in previous posts, the spending budget determined under the Actuarial Approach (with or without applying the recommended smoothing algorithm) is simply one of several decision factors that a retiree can use in the process of determining his or her actual spending for the year. 

Depending on the proportion of a retiree’s spending budget that is derived from accumulated savings invested in risky assets, differences between actual and assumed investment returns can have a significant effect on the retiree’s spending budget.  In order to give retiree’s a sense of how such deviations from the assumed investment return can affect accumulated savings and spending budgets, we have added a new tab to the “Excluding Social Security” spreadsheet (now called “Excluding Social Security V 3.0”).  The new tab is called “5-year forecast” and the only difference between the results shown in this tab and the results shown in the Runout tab are attributable to different investment returns inputted by the user for years 1-5 at the top of this tab.  If the same assumed investment return is input for each of the 5 years as is input for the assumed investment return in the input tab, the results shown in the 5-year projection will be the same as those shown in the Runout tab.  We have also provided two graphs which highlight the differences in beginning of year account balances and total spendable amounts (excluding Social Security and other inflation indexed annuities) resulting from investment experience different from assumed.  No smoothing algorithm was applied to the results in the 5-year projection. 

We encourage you play with the “actual” investment inputs in the 5-year projection to provide yourself a better sense of the investment risk you are assuming with your current investment strategy (or strategies).  As discussed in recent posts, if you have separate budgets for essential expenses, non-essential expenses, emergency expenses, etc. and different investment strategies for these different categories of expenses, you can “kick the tires” on these separate investment strategies to see if you are comfortable with the risk you are assuming for each expense category.  

Inspiration for this post and the resulting modification of the “Excluding Social Security” spreadsheet came from discussions with John D. Craig and from work by the Pension Committee of the Actuarial Standards Board on exposure drafts of a standard of actuarial practice regarding assessment and measurement of risk associated with measuring pension obligations.  Thanks to both John and the ASB Pension Committee.  Readers who are interested in John’s thoughts on Retirement Planning may find this website to be of interest.