Monday, November 30, 2015

5 Ways to Increase Your Near-Term Retirement Spending Budget

In our post of August 31, 2014, Managing Your Spending in Retirement—it’s Not Rocket Science, we set forth a simple four-step process for managing spending:

Step 1:  Develop a reasonable spending budget

Step 2:  Determine your spending needs/living expenses for the upcoming year

Step 3:  Compare results of Steps 1 and 2 and make necessary adjustments to bring them into balance (i.e., reducing expenses, increasing the budget or some combination of these two actions), and

Step 4:  Rinse and repeat at least once a year.

For purposes of this post, we will assume that you have crunched your numbers, the result of Step 2 is larger than the result of Step 1 and you would prefer to increase your near-term spending budget rather than decrease your current living expenses.  We will look at some of your options.  Remember, however, that since you can either spend more in the near-term or you (or your heirs) can spend more later, you may not be all that comfortable increasing your risk of possible real dollar spending reductions as you get older under some of the more aggressive approaches below.  You can use the spending spreadsheets in this website to quantify the possible effects on your current spending budget of adopting these approaches.

  1. Find part-time work or other sources of income.  Perhaps the best way to increase your current spending budget is to go out and find additional sources of income.   This can involve a part-time job such as becoming an Uber driver or additional income from renting out one of your rooms through an organization like Airbnb.  If you are lucky, it may involve an inheritance from one of your relatives or friends.  It can also involve reverse mortgages or funds you expect to receive in the future from the sale of your home or from other assets. 
  2. Defer commencement of Social Security and/or purchase immediate or deferred annuities.  As discussed in previous posts, implementing these approaches (which involve mortality pooling credits) can enable you to increase your near-term spending budgets because some or all of the future expenses you previously needed plan for will be covered by these lifetime guarantees.
  3. Use more aggressive assumptions.  The recommended assumptions for determining a spending budget for 2015 under the Actuarial Approach were:  4.5% investment return, 2.5% inflation and an expected age at death of 95 (or life expectancy if greater).   The rationale for selecting these assumptions was discussed in more detail in our post of February 14, 2015, but suffice to say that many investment advisers would find a 4.5% annual rate of investment return (2% real) to be relatively conservative for most investment portfolios.  Also, until you reach your late 80s, the recommended expected lifetime assumption is longer than life expectancy, which could also be perceived as a conservative assumption.  I stand by my recommended assumptions (for the reasons noted in the February 14 post), but if you are willing to increase your risk of future real dollar spending decreases, you can develop your budget by running the spreadsheets in this website with higher assumed real rates of investment return and/or lower expected payment periods.
  4. Use more aggressive assumptions only for non-essential expenses.  This is a variant of item 3  for individuals who aren’t comfortable taking the risk of being too aggressive for all expenses, particularly essential expenses, but are more comfortable assuming an increased risk of declining future real dollar non-essential expense budgets.  Some experts believe that such expenses generally decline with age.
  5. Increase your budget by X%.  This final option is equivalent to making a conscious decision that you are going to spend what you want as long as it is within x% of your calculated budget.  Clearly if you do this on a consistent basis, you are more likely to experience decreases in future real dollar spending budgets, but this may not be a significant issue for you.  

Of course it is also important to remember that in addition to increasing the risk of declining real dollar spending later in retirement as a result of too much spending early in retirement, spending budgets can also go up or down temporarily as a result of investment performance.  If you want to stress test your spending budget for variations in investment performance, you can model future experience with the 5-year projection tab in the “Excluding Social Security V 3.0” spreadsheet. 

Tuesday, November 24, 2015

Retirement Researcher Endorses Qualified Longevity Annuity Contracts

In his recent article in Advisors Perspectives, Why Advisors Should Use Deferred Income Annuities, Dr. Michael Finke touts the benefits of including Qualified Longevity Annuity Contracts (QLACs) in a retirement portfolio.  Dr. Finke is a Professor and Director, Retirement Planning and Living at Texas Tech University. 

I agree with the points made by Dr. Finke, as his article is very similar to my post on the pluses and minuses of QLACs on July 12, 2015.  Readers who want to dive deeper into QLACs can also revisit my posts of May 28, 2015, April 26, 2015, February 25, 2015, July 31, 2014 and July 26, 2014 for further discussion. 

As I have indicated many times in this blog, The Actuarial Approach is probably one of the only strategic withdrawal approaches that easily and properly coordinates withdrawals from investments with benefits payable from a QLAC. 

Year end is coming soon.  Next month I will be re-visiting my recommended assumptions for developing 2016 spending budgets. 

Let me take this opportunity to wish all my readers a happy and safe Thanksgiving.

Wednesday, November 18, 2015

Actuary Discovers Chinks in Monte Carlo Modeling Armor

In his recent article in Advisor Perspectives, fellow actuary Joe Tomlinson raises serious credibility concerns about Monte Carlo simulations that use historical data to calculate the expected equity premium for stocks when such simulations are used to determine how much wealth to spend down during retirement.    Mr. Tomlinson points out that out limited statistical evidence regarding equity premiums produces levels of uncertainty that are unacceptable to most clients. 

As I have indicated in prior posts (see for example my posts of July 15 of last year and January 24th and 25th of this year), I am not a buyer of the supposed superiority of Monte Carlo modeling as a tool for developing reasonable spending budgets for retirees.  These Monte Carlo models are also frequently used to develop static withdrawal strategies (see my last post for discussion of the superiority of dynamic over static approaches).  Mr. Tomlinson article confirms some of my major concerns about using Monte Carlo simulations and static approaches.

While the simple spreadsheets provided in this website can accommodate higher equity premium investment return assumptions, I recommend (at least for determining essential expense budgets) that retirees use an investment return assumption that is approximately equivalent to interest rates baked into single premium immediate life annuities at the time of determination.  For example, an immediate monthly life annuity of $582 ( yesterday from Income for a 65-year old male with a life expectancy of 274 months under the Society of Actuaries’ 2012 Individual Annuitant Mortality Table with 1% mortality projection translates into approximately a 4.5% annual interest rate.  As I have previously indicated, including riskier assets in your portfolio (such as equities) can increase your expected rate of return, but it will also generally increase variability and therefore may not increase your annual spending budget over the long-run. 

The Actuarial Approach is a dynamic approach that involves periodic (usually annually) remeasurement of the retiree’s assets and liabilities and possible periodic adjustments to the spending budget, not a one-and-done static approach developed using Monte Carlo modelling.  I caution you to question the data used in Monte Carlo simulations producing a spending budget for you that significantly differs from the budget you (or your financial advisor) develop using the Actuarial Approach.  

Budget Pun of the Day (My first and probably my last one):  You’ll feel Stuck with your debt if you don’t properly Budge it.

Tuesday, November 17, 2015

Retirement Researcher Quantifies Benefits of Dynamic Withdrawal Strategies

Thanks to Nelson Murphy for drawing my attention to an article in the Summer, 2015 edition of The Journal of Retirement Research, by David Blanchett, Head of Retirement Research for Morningstar Investment Management.  The article is entitled, “Dynamic Choice and Optimal Annuitization.”  This article is fairly technical, but I found the investment of time and energy required to wade through it to be generally worthwhile.

As a result of his analysis, Mr. Blanchett concludes that “there is a significant potential benefit to retirees who implement dynamic strategies.”  He defines  static strategies as those where the retiree makes decisions only at retirement (such as the 4% withdrawal rule or other types of safe withdrawal rule approaches) and dynamic strategies as those that involve intelligent changes during retirement (such as the approach advocated in this website).  He also looked at dynamic vs. static annuitization strategies, but the differences in these two types of strategies was not as significant.

The dynamic withdrawal strategy used by Mr. Blanchett is approximately mathematically equivalent to the approach advocated in this website (assuming the retiree has no fixed dollar immediate or deferred annuities, no fixed dollar pension benefits and no specific bequest motive) and the same assumptions are used for investment return, inflation and mortality.  If, instead of using the recommended assumptions in this website, you use Mr. Blanchett’s assumptions of 3% investment return, 2.5% inflation and life expectancy based on the Society of Actuaries 2012 Individual Annuity Mortality Table (without mortality improvement), you will develop roughly the same withdrawal rates shown in Exhibit 1 of Mr. Blanchett’s article.

Through his simulations, Mr. Blanchett also develops optimal levels of annuitization for retirees with different shortfall preferences, different bequest motives and different expected life expectancies.  Of course the results of any analysis like this are dependent on the assumptions used and the assumed portfolio investment mix over the life of the retiree.  The future economic assumptions employed by Mr. Blanchett include a 2.5% inflation rate, 3% bond yields, 9% per annum equity returns (with a standard deviation of 9.4%) and 50 basis point annual fee.   The retiree is assumed to maintain a 40% equity/60% fixed income portfolio throughout retirement.  While the optimal level of annuitization developed by Mr. Blanchett using these assumptions was lower with the dynamic withdrawal strategy than with the static withdrawal strategy, there were still some scenarios where annuitization was still optimal.  Even though he assumed a 6.5% annual real rate of return on equities, on average annuitization was optimal for at least 25% of the retiree’s portfolio (in addition to Social Security) under these modeling assumptions as shown in his Exhibit 2.

Mr. Blanchett concludes that “implementing a dynamic withdrawal strategy alone (without annuities) resulted in higher levels of utility-adjusted wealth than a static withdrawal strategy that included both optimal immediate annuitization as well as dynamic annuitization.”  He also concludes that delaying purchase of annuities for a while does not significantly affect outcomes for retirees compared with immediate purchase of annuities at retirement.

Bottom line:  There were two things I liked about Mr. Blanchett’s research:  1) He favored a dynamic withdrawal approach very similar to the approach advocated in this website and 2) depending on their preferences and circumstances, retirees should consider investment of some percentage of their retirement portfolio in annuities.

Thursday, November 5, 2015

Social Security Reform—Some Solutions are More Sustainable than Others

As discussed in my posts of March 1 and May 3 of this year, I occasionally get drawn into commenting on US Social Security System financing issues. While these issues are somewhat technical, I believe they are important and, in the long run, can affect many of the individuals who visit my site looking for advice regarding budgeting in retirement.  Therefore this post will be another Social Security financing article with the purpose  of warning my U.S. readers  about frequently made claims regarding the long-term sustainability of specific reform proposals.  As we get closer to 2034 (the trust fund exhaustion date expected for Social Security under the intermediate assumption set selected by Social Security actuaries and the System’s Trustees in the most recent Trustees’ report), we are seeing a rash of proposals to solve the System’s financial problems.  Many of these proposals quantify just how much of the System’s “funding problem” will be solved by a specific reform proposal.  For example, in the American Academy of Actuaries recently released “Social Security Game,” the Academy states that raising the payroll tax from 6.2% to 7.4% (for both employees and employers) “will solve 85% of the problem".  Further, if you combine that change with a 1% decrease in the cost of living increase, the Social Security Game will tell you, “Congratulations, You have won the game by fixing Social Security.” 

While I understand the Academy’s desire to engage the public in a discussion about Social Security’s reform options, I am concerned that statements such as these can mislead the public and our policymakers.  I was frankly surprised (and more than a little disappointed) that my profession (a profession that claims to serve the public, one that stresses sustainability in our financial systems and one that has stated it “believes that any modification to the Social Security system should include “sustainable solvency” as a primary goal) is ignoring the concept of “sustainable solvency” and is claiming in this “Game” that eliminating Social Security’s current 75-year actuarial deficit will solve Social Security’s financial problems.  It should be noted that the Academy is not the only organization to utilize the 75-year actuarial deficit in this manner.  

While reducing the 75-year actuarial deficit is a reasonable first step, there are two problems with any proposed reform
options that simply reduce Social Security’s 75-year actuarial deficit to zero: 

  1. Given the projected costs of the program, limiting the actuarial balance calculation to 75 years ignores projected annual deficits expected to occur after the end of the 75-year projection period.  Over time, these deficits will emerge in the actuary’s annual calculations.
  2. There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities.  Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits mentioned in Problem #1 above, or because of changes in assumptions, experience losses or gains, or from other sources. 

We need look no further than the 1983 Amendments to Social Security (which eliminated the 75-year actuarial deficit in existence at that time) for an example of how these two problems interacted to put us in the financial position in which we presently find ourselves.   Social Security Administration Actuarial Note Number 2015.8 tells us that of the total increase in the 75-year actuarial deficit of 2.69% of taxable payroll since 1983, 70% of the increase (or 1.90% of taxable payroll) was attributable to changes in the valuation date (problem #1 above), leaving 30% (or .79% of payroll) attributable to all other causes.  Since no action was taken in response to these emerging deficits over the past 31 years (problem #2 above), we are now looking at projected trust fund exhaustion in 2034 under the best estimate assumptions. 

As a result of these two problems, Social Security is now looking at a shortfall of projected revenues compared with projected expenditures.  And we have unlimited supply of possible actions that Congress can adopt to address this shortfall, generally involving some combination of revenue increases and expenditure decreases.  Because it was discussed on page 25 of this year’s annual Trustees’ Report, I’m going to focus on two alternative reforms involving only tax increases.  I’m doing this to illustrate reform option concepts, not to recommend that reform options should only involve tax increases.   The same concepts generally apply if expenditure reductions or combinations of revenue increases and expenditure decreases are adopted. 

The graph below shows two alternative tax rate scenarios that would be expected, if all the intermediate assumptions made in the 2015 Trustees’ report were exactly realized over the next 75 years, to cover projected System benefits over the next 75 years, leaving almost no trust fund at the end of 2089.  Under the “wait for trust fund exhaustion” alternative, we would keep the tax rate at its current combined employer-employee level of 12.4% until 2034 at which time it would increase to 16.1% and then gradually increase thereafter (I have assumed straight-line increases) to 17.4% in 2089.  I have also assumed that the necessary tax rate for years thereafter would remain at the 17.4% level.   The second option shown in this graph is the “75-year solution (2015)” which reduces the 2015 75-year actuarial deficit to zero by increasing the current tax rate from 12.4% to 15.02% in 2015.  Since this solution only lasts for 75 years, the graph shows that the tax rate would also need to be increased in the year 2090 to 17.4% when the trust fund accumulated under this option would be expected to be depleted.  This graph illustrates a very important financial principle:  the magic of compound interest.  Even for a program that many experts claim is a pay-as-you-go system, you can pre-fund your liabilities.  By contributing 15.02% for 75 years, you can avoid higher tax rates for the period 2035 to 2089.  The concepts illustrated in this graph are also used by individuals who argue that fixing the system now can avoid higher tax rates or lower benefit levels later on.  Of course this same argument can be employed by those who would like to see smaller periodic adjustments to the program rather than infrequent large increases (to address Problem #2).


(click to enlarge)

In an effort to deal with Problem #1 above, the Office of the Actuary of the Social Security Administration developed the concept of “sustainable solvency.”  Under this concept, “the projected trust fund ratio is positive throughout the 75-year projection period and is either stable or rising at the end of the period (emphasis added).”  As with other ways to solve system problems, there are a number of ways that sustainable solvency can be achieved.  For example, in addition to a 75-year solution, you could adopt additional tax rate increases that take effect 65 or 70 years from now so that the relatively low trust fund ratios at the end of the period remain stable at the end of the 75-year period.  Because there exist many different ways to achieve sustainable solvency, the Trustees’ Reports do not quantify changes necessary to achieve it.  Also, for this reason, organizations like the American Academy of Actuaries focus only on communicating the presumably more quantifiable 75-year solutions.  It should be noted, however, that even though adoption of a reform package that achieves sustainable solvency will address Problem #1 above, it does not address Problem #2 above.  
The graph below modifies the graph above by inserting a third line, labeled “sustainable solvency solution (2015)”.  This line is estimated by me.  As discussed above, there are many different approaches that could achieve sustainable solvency, but I have selected one (a level tax rate similar to the approach used for The Canada Pension Plan) that I would expect to meet the criteria for sustainable solvency under the assumptions described above.  This approach would involve an immediate 3.6% of taxable payroll increase in the current tax rate of 12.4% to about 16%.  By comparison, the 2015 Trustees’ report indicates that the shortfall over the infinite projection period is 3.9% of taxable payroll.  Note also that this graph could have a fourth line representing a combination of the 75-year solution and periodic increases after 2015 to address the expected deficits that would occur as a result of Problem #1.  This line would be expected to start at about the 15% of pay level and slowly increase as deficits are recognized.  This fourth line would be expected to end above the sustainable solvency (2015) line and below the 75-year solution line. 


(click to enlarge)

Conclusion—Some Solutions are More Sustainable than Others

In its Public Policy White Paper, Sustainability in American Financial Security Programs, the Academy’s Public Interest Committee said, “Sustainability is enhanced when the funding source and the benefits promised remain balanced over the lifetime of the program.”  I agree and further believe that Social Security solutions that anticipate significant tax increases in the future (other than perhaps ones to phase in tax increases over a relatively short time period) to support promised benefit levels are less sustainable than approaches that don’t.  For this reason, I caution readers to question 75 (or lower)-year solutions, and, as part of the next round of system reform, I encourage policymakers to adopt an automatic approach designed to maintain the balance between system assets and liabilities in the future.  As suggested in my May/June, 2015 Contingencies article, we can learn a lot about sustainable solutions in the U.S. from the actions taken almost 20 years ago to reform The Canada Pension Plan.  In furtherance of its mission, I also encourage the Academy to advocate these more sustainable solutions rather than appearing to endorse problematic 75-year “solutions” in their “Game.”