As discussed previously, The Actuarial Approach for developing a spending budget in retirement involves matching household assets (current assets/investments plus the present values of other sources of income) with household liabilities (the present value of future expected expenses to be incurred by the retiree/retiree's family over the remaining lifetime plus the present value of assets remaining at death). This balancing (which normally takes place at least once a year) is referred to as an actuarial valuation and can be summarized in what is called an "actuarial balance sheet."

But enough background. Let's take a look at two simple examples of how using The Actuarial Approach blows away rule of thumb withdrawal strategies for retirees with fixed dollar sources of retirement income. We will be looking at two 65-year old male retirees, each with a Social Security benefit of $20,000 per year, each with $500,000 in accumulated savings and each with the same spending objective to cover essential expenses of $50,000 per year with any remaining assets to cover non-essential expenses. Both retirees will be assuming a 4.5% discount rate, 2.5% inflation and a thirty year retirement period. The only difference between the two retirees is that Retiree #1 has an immediate fixed dollar pension of $30,000 per annum and Retiree #2 has a fixed dollar deferred annuity to commence at age 80 of $30,000 per annum.

To be consistent with the assumptions inherent in the 4% Rule, both retirees assume that their essential and non-essential expenses will increase with inflation of 2.5% per annum. As discussed in previous posts, it may be reasonable when using the Actuarial Approach to assume different rates of future increases for different types of expenses. For simplicity purposes, we are only looking at essential and non-essential expenses. Certainly other categories of expenses may be included when using the Actuarial Approach.

Here is the actuarial balance sheet for Retiree #1

(click to enlarge) |

Under the assumptions discussed above, the present value of Retiree #1's essential expenses of $50,000 per year increasing by 2.5% per annum over a period of 30 years is $1,149,368. This amount is shown in the liability column. In order to cover these estimated essential expenses, Retiree #1 dedicates his Social Security benefit (with a present value of $459,747), his pension benefit (with a present value of $510,657) and $178,964 of his accumulated savings ($1,149,368 - $459,747 -$510,657). This leaves an asset of $321,036 in accumulated savings dedicated to non-essential expenses, which is also equal to the liability for such expenses.

Retiree #1's actuarial spending budget for the first year of his retirement is equal to the sum of his essential spending budget of $50,000 plus the annual amount payable over a period of 30-years increasing by 2.5% per annum with a present value of $321,036, or $13,966 in year 1 (determined using the present value calculator spreadsheet). So his total actuarial spending budget for the year would be $63,966 ($50,000 + $13,966).

If he spends all of his pension benefit and his Social Security benefit to satisfy his essential expenses, he will spend $0 from the accumulated savings he has allocated to cover his essential expenses. Thus, for this portion of his spending budget, his withdrawal rate from accumulated savings is 0%, not some rule of thumb withdrawal percentage. By comparison, the withdrawal percentage from the assets he dedicates to his non-essential expenses represents about 4.35% of such assets ($13,966/$321,036).

In total, withdrawals from accumulated savings for Retiree #1 are $13,966, or about 2.8% of his total accumulated savings. By comparison, it is not entirely clear how the 4% Rule would be used to determine separate withdrawals from Retiree #1's assets dedicated to fund essential and non-essential expenses, but in total, 4% of $500,000 would be $20,000. Therefore, in total, withdrawals would represent 4% of Retiree #1's total accumulated savings vs. 2.8% under the Actuarial Approach.

Retiree #2 has the same situation as Retiree #1, except instead of having a fixed dollar pension of $30,000 per annum, he has a fixed dollar deferred annuity benefit of $30,000 per year commencing at age 80.

Here is the actuarial balance sheet for Retiree #2

(click to enlarge) |

The present value of Retiree #2's expected future essential expenses is the same as Retiree #1's, $1,149,368. The present value of Retiree #2's Social Security benefit is also the same as Retiree #1's at $459,747. The present value of Retiree #2's deferred annuity, however, is only $203,814 leaving $485,807 from his accumulated savings ($1,149,368 - $459,747 - $203,814) to cover the present value of Retiree #2's expected future essential expenses. This then leaves only $14,193 ($500,000 - $485,807 to cover future expected non-essential expenses, which is also the liability for such expenses.

Retiree #2's actuarial spending budget for the first year of his retirement is equal to the sum of his essential spending of $50,000 plus the annual amount payable over a 30-year period and increasing by 2.5% per annum with a present value of $14,193, or $617 in year 1 (determined using the present value calculator spreadsheet). So his total actuarial spending budget for the year would be $50,617 ($50,000 + $617).

Retiree #2 expects to spend $30,000 ($50,000 - $20,000 from Social Security) from the accumulated savings he has allocated to essential expenses. This withdrawal represents about 6.2% of such assets. In total for both essential expenses and non-essential expenses, he plans to spend $30,667, or about 6.1% of his total accumulated savings. By comparison, the 4% Rule would give him spending for the first year of retirement of $40,000 ($20,000 from Social Security and $20,000 from accumulated savings).

We see from these two examples that simply adding 4% of a retiree's accumulated savings to other retirement income payable during the year to determine a spending budget may either overstate or understate an actuarially sound spending budget. And this is only one of the problems associated with the 4% Rule or any rule of thumb that focuses on "tapping your savings" rather than properly coordinating with other sources of retirement income to develop a reasonable spending budget.