Saturday, October 31, 2015

Actuaries Release Five New Issue Briefs on Retiree Lifetime Income

As a follow-up to their 2013 Public Policy Discussion Paper, “Risky Business—Living Longer Without Income for Life” (discussed in our post of June 20, 2013), the American Academy of Actuaries’ Lifetime Income Risk Joint Task Force recently released a flurry of Issue Briefs on Retiree Lifetime Income.  The five issue briefs are titled,
  1. Retiree Lifetime Income:  Choices and Considerations 
  2. Retiree Lifetime Income:  Product Comparisons
  3. Risky Business:  Living Longer Without Income for Life—Legislative and Regulatory Issues
  4. Risky Business:  Living Longer Without Income for Life—Actuarial Considerations for Financial Advisers, and
  5. Risky Business:  Living Longer Without Income for Life—Information for Current and Future Retirees
The Issue briefs can be found on the Task Force’s webpage.  There is a lot of good material contained in the issue briefs, and I encourage you to read some or all of them.  
The stated goal of the Academy’s Task Force is to educate the public, financial advisors, employers, the media, lawmakers and regulators on the risk of inadequate guaranteed lifetime income.  As may be expected from a group of actuaries with this goal, the issue briefs tend to stress the advantages of risk sharing (or risk pooling) arrangements (annuities and defined benefit pension benefits).  However, this most recent batch of issue briefs does not focus exclusively on the advantages of annuity products and the disadvantages of structured withdrawal programs.   They do acknowledge that there can be advantages of combining the two approaches.  For example the following guidance is contained in the Actuarial Considerations for Financial Advisers brief:

“A judicious use of pooling-based solutions, integrated with appropriate investment strategies, can often yield a more favorable financial result than one that fails to take pooling into appropriate consideration.”

I was also pleased to see that the Financial Advisers brief included the following recommended task, which is a common theme expressed in my website

“Assuring that recommended systematic withdrawal strategies meet client objectives and also appropriately reflect the existence or absence of pension benefits or insurance-based solutions that incorporate risk-pooling features.”

Sharp-eyed readers who go to the Task Force website may see my name included as a Task Force member.  Yes I did recently join this group, but for the most part, most of these Issue Briefs were drafted prior to my arrival. 

Saturday, October 24, 2015

Does New Math Clearly Demonstrate that People Should Delay Commencement of Social Security Benefits When Possible?

Apologies to my non-US readers as I will once again take on the subject of when to commence US Social Security benefits.  This post is in response to the October 23 article in The Wall Street Journal entitled, "The New Math of Delaying Social Security Benefits”, in which Dr. Pfau concludes, “the math is clear:  People should delay claiming when possible.”

As I have discussed in several prior posts (most recently in posts of September 25, 2015, April 16, 2015 and August 9, 2014) and based on the “old math” built into the simple Social Security Bridge spreadsheet on this website, deferring commencement of Social Security benefits can be a reasonably good strategy for many individuals, but it may not be all that it is cracked up to be by the media experts. 

I’m going to use the same example person in this post as Dr. Pfau used in his article (which I suggest that you read because I’m not going to repeat the entire example here).  His example person sets aside assets of $316,800 in a non-interest bearing account to pay herself $39,600 per year (the age 70 Social Security benefit without CPI increases) during the eight year bridge period (from age 62 to age 69) during which no Social Security benefits are paid.  He then determines that the initial withdrawal rate at age 62 from remaining assets necessary plus the withdrawals from this artificial Social Security replacement account to meet a $60,000 annual real dollar total income level is only 4.22% vs. a 4.69% initial withdrawal rate necessary to meet the $60,000 total income level if she commences her Social Security benefits at age 62.  From this comparison of initial age 62 withdrawal rates, Dr. Pfau concludes that it is financially advantages for everyone to defer commencement of Social Security from age 62  until age 70.

If we assume inflation of 2.5% per year and we assume that the example retiree wishes to pay herself the expected age 70 Social Security benefit in real dollars each year during the bridge period, she will need to set aside assets of $345,951.  Under these assumptions, the initial age 62 withdrawal percentage to achieve the $60,000 income target will be 4.49% ($60,000 – $39,600)/ ($800,000 - $345,951) vs. the 4.69% withdrawal rate if she commenced Social Security at age 62.  This example still favors the deferral strategy, but not by quite as much.

If we also assume investment return of 4.5% per annum on the example retiree’s assets not set aside for bridge purposes, at age 70, she will have remaining assets of $428,583 to go with her Social Security benefit of $48,249 ($39,600 plus eight years of CPI increases of 2.5% per annum).  By comparison, if she commenced benefits at age 62, she would have $738,560 of remaining assets at age 70 and a Social Security benefit of $27,414.  Thus, under these assumptions, she effectively spends $309,977 ($738,560 - $428,583) of her expected assets at age 70 ($35,974 less than the $345,951 she set aside) to obtain an additional $20,835 ($48,249 - $27,414) of fully CPI-indexed Social Security benefits commencing at age 70. 

As noted in prior posts on this subject, deferring commencement of Social Security can increase total retirement income under most reasonable assumptions.  This strategy also adds inflation protection and can provide larger benefits to your spouse.  If you want to retire and adopt the commencement deferral strategy, you have to be willing to dip into your accumulated savings to make it work (and therefore this strategy may involve loss of some spending flexibility).  The degree of success of the commencement deferral strategy will depend on the investment return you could have earned on the "bridge payments" you withdraw from your accumulated savings, the rate of future inflation, how long you live and how much of your accumulated savings you spend during the bridge period.  Assuming Social Security law remains unchanged, it can be an effective way to mitigate inflation risk, investment risk, and longevity risk.  In a very real sense, the decision to defer is analogous to using your savings to purchase additional longevity insurance/real annuity income.  However, under most reasonable assumption scenarios, you aren’t likely to see the increases in total retirement income that you might have expected from reading articles on this subject by the retirement experts. 

I recommend that retirees who are reasonably comfortable spending a significant portion of their accumulated savings up front during the bridge period consider the commencement deferral strategy.  On the other hand, I am also sensitive to retirees who could have made this decision but didn’t or who are just not comfortable with this strategy.  To them I say, Don’t listen to those experts who say that not deferring until age 70 is one of the biggest mistakes you can make in retirement.  Move on with your life based on the decision you made (or will make).  If it is indeed a mistake not to defer, it is probably not the biggest mistake you will make in retirement. 

As with all my prior posts on this subject, I (and Dr. Pfau in his article) looked at non-married individuals.  The factors involved in a decision to defer can be different for a married individual under current law. 

Saturday, October 17, 2015

All About that Budget

If I had to pick a theme song for this website, I guess I would have to consider Meghan Trainor’s popular song with a small modification.  While Meghan sings, “Because you know I’m all about that bass”, this website is all about a different “B” word—“Budget.”   Yes, the primary purpose of this website is to help retirees develop a reasonable spending budget.    Pretty much this entire website is devoted to this task; a task that a lot of retirees don’t even bother with, or if they do bother with it, they frequently ignore it when it comes to making spending decisions.   Does the fact that a lot of retirees don’t develop a budget or ignore their budget bother me?  Not particularly.  Unlike many experts who think that most retirees aren’t smart enough or motivated enough to manage their own money, I believe that most retirees possess the necessary skills to successfully manage their finances in retirement, much like they successfully managed their finances when they were employed.  Of course, for those retirees who can afford one, a financial advisor can be very helpful in this process.   However, when push comes to shove, it is you, Mr. or Ms. Retiree, who are ultimately responsible for making the investment and spending decisions that affect your financial situation during your retirement.  If you are reading this post, I hope it is because you are interested in learning about and taking advantage of the benefits of having a reasonable spending budget. 

You won’t find anything in this website that suggests how much of your accumulated savings or other sources of retirement income you should spend each year.  As noted above, that decision is yours based on your own personal situation.  I’m not going to chastise you for spending more (or less) that the budget amount you may develop using the Actuarial Approach.  In fact, it would be unusual if you did spend exactly the amount that you budgeted each year.  However, one of the primary benefits of developing a spending budget is to help you make your spending decisions. 

You also won’t find anything in this website that suggests that you should develop a spending budget any more frequently than annually.  There may be reasons why you may wish to develop a monthly spending budget (for example if you are trying to reduce your spending), but again, I will leave that decision up to you.

While I think it is worthwhile to track actual spending for the year to compare it with the spending budget, doing so is a fair amount of work that may not provide a lot of value to you.  There are software programs that can help you with this task, but again, tracking actual spending can be time-consuming and it is not necessary to keep your budgeting on track.  Under the Actuarial Approach, simply comparing your actual end of year assets with your expected end of year assets will give you an indication of the total gain or loss for the year resulting from the combination of spending deviations and investment deviations.  As indicated in my September 4, 2015 post, it may make sense during the middle of a year to compare actual assets with expected end-of-year assets to see how you are doing during the year for the purpose of helping you make spending decisions for the rest of the year. 

I also think it can be worthwhile to develop separate budgets for different types of expenses.  In prior posts, I have encouraged you to develop separate budgets for such different types of expenses as essential non-medical expenses, essential medical expenses, bequest motive/end-of-life expenses, other unexpected expenses and non-essential expenses.  The reason for doing this is that you may have different goals and investment strategies for these different types of expenses that may require different approaches.

Prior posts have also indicated why I think it is important to develop a spending budget that reflects the existence of other sources of retirement income that you may have.  Most other withdrawal strategies simply provide a suggested way to “tap your savings” and fail to suggest how to develop a reasonable spending budget (or budgets). 

While not every financial expert believes that budgets are essential (especially monthly budgets), many experts do.  Here are a couple of recent articles touting some of the benefits of developing a budget. 

5 Ways to Save Money During Retirement (US News)

8 Things Not to Do in Retirement (GoBankingRates)

Thursday, October 15, 2015

Making Sense Out of Variable Spending Strategies for Retirees?

In his October 2, 2015 blog post, Dr. Wade Pfau, Professor of Retirement Income at The American College, reprinted his article from the Journal of Financial Planning, Making Sense Out of Variable Spending Strategies for Retirees. The stated purpose of this article was to “assist financial planners and their clients in figuring out which sort of variable spending strategy will be most appropriate for their situation [by using] simple metrics to evaluate and compare strategies.” See my post of March 19th of this year for my initial thoughts on this paper.  Today’s post will supplement my earlier post with additional thoughts on this article.

Perhaps the most interesting part of Dr. Pfau’s article is his suggestion that financial advisors use his “XYZ Formula” approach to help clients select a combination budget setting strategy (variable spending strategy) and investment strategy.  Under this approach, the financial advisor uses Monte Carlo modeling and the client’s specific information to help the client select the combination budget setting and investment strategy that has an “X% probability that spending falls below a threshold of $Y (in inflation-adjusted terms) by year Z of retirement”, where the client (with the advisor’s help) chooses the values of X, Y and Z, presumably in accordance with the client’s risk preferences.  The XYZ formula approach assumes that the client’s spending will exactly equal the client’s spending budget so determined each year.  

Even though it is based on the unrealistic assumption that retiree spending will actually equal the spending budget resulting from application of variable spending strategy,  I believe that Dr. Pfau’s approach can provide some value to retirees.  However, rather than providing a broad analysis of various combinations of budget setting strategies and investment strategies for hypothetical clients with different situations, Dr. Pfau instead holds investment allocations constant, fixes values of X,Y and Z and looks at a client that (with one notable exception) has no pension/annuity income.  The purpose of fixing these items was presumably to isolate differences attributable to differences inherent in the variable spending strategies. 

I was pleased to see the Actuarial Approach advocated in this website included in Dr. Pfau’s list of examined variable rate strategies (albeit grouped with other so-called actuarial strategies).  I was also pleased that Dr. Pfau concluded, “The actuarial methods were found to spend down wealth more efficiently.”  However,  I feel compelled in this post to (i) respond to a specific comment made in the article about application of smoothing to my approach and (ii) point out why my approach is superior to the “PMT approach” with which my approach was grouped. 


In his article, Dr. Pfau says, “Steiner (2014) suggested that users may smooth spending adjustments relative to the changes implied by this formula. Not all would agree, as Waring and Siegel (2015) noted that a less volatile asset allocation is a safer way to smooth spending fluctuations.”  While I certainly don’t have a problem with the position that a less volatile asset allocation is a reasonable way to manage volatility in spending budgets,  I believe Waring and Siegel’s suggestion that spending budgets not be smoothed is ridiculous.  For most retirees, a spending budget is simply a suggestion as to how much the retiree may want to spend for the year.  Only retirement academics and other Monte Carlo modelling advocates assume that retirees will actually spend their spending budget each year (and only as a calculation expediency).  It therefore makes no sense to me to require a spending budget to be based on strict (non-smoothed) application of a formula if the retiree can then choose to spend whatever he or she wants.  

Actuarial Approach vs. PMT Approach

Waring and Siegel’s ARVA (PMT) approach is essentially mathematically equivalent to the simple spreadsheet included in my website if the retiree has no fixed dollar pension or annuity income.  If the retiree has a fixed dollar pension benefit, a fixed dollar immediate annuity or a fixed dollar deferred annuity, the PMT approach can’t properly handle it.

It is ironic to me that the approach that appears to produce the most favorable results in Dr. Pfau’s article (at least in terms of initial spending rates under the given XYZ specifications) is the “Annuitize Floor and Aggressive Discretionary Spending” approach.  This isn’t really a different variable rate spending approach, but rather a combination of a different investment strategy (partial annuitization) with the Guyton decision rules.  As noted in previous posts (most recently my post of April 26, 2015), I’m not a big fan of the Guyton decision rules, but inclusion of this final option does illustrate the potential benefits of partial annuitization for risk averse clients.  It also indirectly points out the importance of using a variable spending strategy that properly coordinates with fixed dollar pension and annuity benefits.  And once again, I will end a post by noting that the Actuarial Approach is the only one of the variable spending strategies listed in Dr. Pfau’s article that does this. 

Monday, October 12, 2015

Fear of Outliving Your Savings vs. Fear of Not Spending Enough—Finding an Appropriate Balance

In his September 29 article for US News, Why You Won’t Run Out of Money in Retirement, David Ning outlines several safeguards that he believes “will prevent you from spending your savings too quickly.”  He indicates that you “aren’t likely to completely run out of money in retirement,” and therefore you shouldn’t “let the fear of outliving your savings prevent you from enjoying retirement.” One of the safeguards recommended by Mr. Ning is to withdraw only 3% or 4% of accumulated savings each year. 

I agree with Mr. Ning that retirees shouldn’t let the fear of outliving their savings prevent them from enjoying retirement.  On the other hand, simply taking steps to make sure that you don’t spend your savings too quickly (by using a conservative 3% or 4% withdrawal rate) is only part of the equation for enjoying retirement.  Another critical part of this equation is spending enough each year to maintain a certain standard of living, including spending on non-essential items.  Therefore, what retirees really need is a Goldilocks-type solution that involves not only not spending too much but also not spending too little.  Unfortunately, since no one knows, for certain, things like how long you will live, what your investments will earn, what future inflation will be, etc., there can be no such Goldilocks solution. 

The Actuarial Approach discussed in this website attempts to help retirees find the appropriate balance between spending too much and spending too little.   If you use our recommended assumptions to develop some or all of your annual spending budget and invest your accumulated savings reasonably well, you will likely end up with more assets than you desire upon your death (even though withdrawal rates for retirees with no pension/annuity income and no amounts to be left to heirs under the Actuarial Approach will exceed 6% at ages above 75, compared with the 3% or 4% withdrawal rate suggested by Mr. Ning.)

More effective safeguards to balancing not spending too much and not spending too little (as well as achieving ancillary goals such as: (i) having relatively predictable and stable inflation adjusted income from year to year, (ii) having spending flexibility to meet unforeseen expenses, (iii) maximizing the general level of spendable income and (iv) not leaving too much unspent upon death) include using the Actuarial Approach to develop separate spending budgets for essential expenses, non-essential expenses, long-term care/other end of life expenses, and unexpected expenses with appropriate investment strategies for the funds dedicated to these separate spending budgets as discussed in recent posts.