Thursday, December 10, 2015

Use Our Revised Spreadsheet to Keep Your (or Your Client’s) Safe Withdrawal Rate (SWR) Approach on Track

After our post of December 7 entitled “Is the Actuarial Approach Really the Only Financial Planning Software Capable of Helping You Formulate an Actual Financial Plan?” Michael Kitces graciously responded by indicating that, based on a quick review our spreadsheet, it did not appear to him to represent the “financial planning” he had in mind in his post. He said,

“To say ‘just recalculate your spending based on your account balance annually’ is not what I consider a viable real-world solution for most people, because it translates 100% of market volatility into an identical amount of spending volatility on a 1:1 basis, and most people can’t handle that much spending volatility. Nor do they need to. In a world where retirees only spend 3%-4% of the portfolio, there’s no reason to cut your core spending by 20% because the OTHER 97% of the portfolio has a temporary/short-term downdraft. That’s the whole point (indirectly) of the safe withdrawal rate research – when your spending is sufficiently low, you don’t have to cut spending in down markets, because you’ve left enough available to ride out the volatility.”

While I do advocate a dynamic approach that periodically adjusts a retirees’ spending budget (or budget components) for actual experience, I do see Michael’s point (and there is no question in my mind that the man is extremely bright, an excellent writer and tremendously productive) . That is why I also recommend using a budget smoothing algorithm, and I take great pains to talk about spending budgets rather than the amount to be spent in a year (which is up to the retiree and may or may not be equal to the retiree’s spending budget). In other words, the retiree can always smooth her spending either by smoothing the spending budget or by spending more or less than the spending budget determined using the Actuarial Approach without smoothing. The key advantage of the Actuarial Approach over an approach such as the Safe Withdrawal Approach is that you always know how much you can spend to keep your current assets in balance with your current liabilities (the present value of future spending budgets based on reasonable assumptions and desired spending goals). With an SWR approach (which I feel is kind of a “head-in-the sand” approach that relies on past results which may or may not be repeated), the retiree doesn’t really know when spending can (or should) be increased (or decreased) or if it should be changed, by how much, which I felt was the primary concern expressed in Michael’s post.

In response to Michael’s feedback (which is always appreciated), I have modified the 5-year projection tab in the “Excluding Social Security” spreadsheet available in this website (updated with this post to version 3.1) to allow users to input different “actual” spending amounts (such as spending under an SWR approach) to see how future “actual” investment returns and actual spending amounts affect the spending budget determined under the Actuarial Approach. Financial advisors and/or their clients can then compare their desired smoothed spending with the actuarial spending budget under various investment/spending scenarios to see if (and when) changes in the SWR spending should take place.

I will illustrate with an example. Let’s assume that Bill is a 65-year old male with accumulated savings of $800,000, an annual fixed dollar pension of $12,000 per year and Social Security of $20,000 per year. Let’s further assume that Bill wants to leave $100,000 to heirs at his demise and he wants his spending to remain constant in real dollar terms until he dies (and, for illustration purposes, he doesn’t determine a separate spending budget for essential expenses, non-essential expenses, etc. as I generally recommend). Bill goes to the input tab of the spreadsheet, where he inputs the recommended assumptions, $800,000 in accumulated savings, $12,000 in immediate life annuity amount and $100,000 as desired amount remaining at death. He also inputs 2.5% as the expected rate of inflation (which is also equal under the recommended assumptions to the desired annual rate of increase in spending budget). The input tab shows that his actuarially determined spending budget for the first year (under these assumptions and input items, excluding Social Security, income from employment and other miscellaneous income) is $42,526 ($32,526 from accumulated savings and $12,000 from the pension). He then goes to the Runout and Inflation-adjusted Runout tabs and sees that if all input assumptions are realized in the future (and the expected payment period is reduced by one each year), his annual real dollar spending budget attributable to withdrawals from savings and his fixed dollar annuity will remain at $42,526 for thirty years and he will have $47,674 in real dollar assets ($100,000 in nominal assets) to pass along to his heirs.

Bill then goes to the 5-year projection tab. If he inputs 4.5% for annual investment returns for each future year and inputs the amounts shown in column L of the Runout tab for actual amounts spent, then the actuarially determined spendable amount will equal the amounts Bill has input for actual spending. But like Micheal Kitces, Bill is not interested in using the Actuarial Approach to determine the amount he wants to spend each year. He wants to use the 4% rule and he even wants to cheat a little and have his total non-Social Security spending budget (the sum of his withdrawal from savings and his fixed dollar pension in his first year of retirement) increase with inflation each year. So he inputs the following amounts for “actual” amount spent: $44,000 (.04 X $800,000 plus $12,000), $45,100 ($44,000 X 1.025), $46,228, $47,383, and $48,568. He also wants to stress test his investments to some degree, so he inputs -15% for year 3 (keeping actual returns at 4.5% for the other years). He sees that under this scenario in year 4, the actuarially balanced spending budget (excluding Social Security) decreases to $38,489, and the ratio of amount Bill wants to spend in year 4 to the actuarial spending budget is 123%. When Bill factors in his expected Social Security benefit into both amounts, however, this ratio is only about 115%. Is this ratio high enough to get Bill to change his spending in year 4 if this scenario were to occur? Who knows? However, Bill, with the possible assistance of his financial advisor, can use this spreadsheet to look at different investment/spend scenarios to determine what his “change thresholds” might be and what the specific changes would be if such thresholds are exceeded in the future.

I encourage you (and/or your financial advisor) to play with the new spreadsheet to help you develop a true financial plan that addresses actions you will try to take if your spending falls off the actuarially balanced track.