Dirk Cotton has once again hit the nail on the head in his recent blog post when he said, “The details of retirement financial planning are easier to understand once you imagine the big picture and can see what the pieces are and how they fit together. It's easy to get stuck in the weeds. Most retirement literature, unfortunately, doesn’t start with the big picture. It often jumps right into asset allocations or sustainable withdrawal rates.”
The Actuarial Approach advocated in this website is a big picture approach that is based on the simple concept of matching total retirement assets with total retirement liabilities. As discussed in previous posts, the basic actuarial equation used to determine a retiree’s annual spending budget under the Actuarial Approach is:
Market value of Investments + Present Value of Future Retirement Income = Present value of future spending budgets + Present value of amounts left to Heirs
where the present value of future retirement income includes income from all sources, such as Social Security, pensions, annuities, rental income, future home sales, etc. The left hand side of the equation represents a retiree’s total assets while the right hand side of the equation represents the retiree’s total liabilities for future spending.
What does this basic actuarial equation tell us? It tells us that the total amount a retiree can afford to spend in retirement is a function of how much assets (investments plus present value of future retirement income) the retiree has accumulated. Well, of course, this conclusion is obvious, right? You can’t spend what you don’t have. On the other hand, a simple (and perhaps even an obvious) solution is often the best solution.
The basic actuarial equation also tells us that for a given set of assumptions relative to investment return and longevity, the answer to how much one can afford to spend each year is a function of 1) how much assets you have and 2) how you want to spread those assets over the period of your retirement (and after your retirement). You can spread the present value of future spending budgets as a constant real dollar amount, as a decreasing real dollar amount, as an increasing real dollar amount or in some other manner. Also, you can (and probably should) develop separate spending budgets for different expense types, such as expected long-term care costs, unexpected expenses, essential expenses and non-essential expenses. And there is nothing that says that you have to assume the same rate of future increase in these expense types when deciding how to allocate the present value of future budgets for these expenses between current and future years.
An important aspect of the Actuarial Approach is that the retiree (or the retiree’s financial advisor) should go through this exercise of balancing the retiree’s assets and liabilities each year to re-determinine the new spending budget that will make the balance equation work and satisfy the retiree’s spending objectives.
There are some individuals who don’t like that spending budgets may vary from year to year under the Actuarial Approach as a result of a number of factors (such as deviations of actual from assumed investment experience, changes in assumptions, deviations in actual spending from assumed, etc.). They prefer a constant real dollar withdrawal from investments from year to year. First of all, spending the same real dollar amount from a pool of risky assets for every year of retirement is a pipe dream for the reasons I have enumerated in many prior posts. Secondly, safe withdrawal rate strategies are not “Big Picture” strategies as they generally ignore other sources of retirement income and rarely focus on all expenses the retiree can expect. Finally, there is nothing in the Actuarial Approach that prohibits retirees from smoothing spending budgets determined under the Actuarial Approach. Alternatively, they can smooth actual spending or even use a combination of a safe withdrawal rate and the actuarial approach. The important considerations when deciding to smooth under any of these options, however, is to know how far off the actuarially balanced reservation you have strayed so that you can plan the steps necessary to get spending back on track.
Bottom Line: Don’t just tap your investments with a “small picture” safe withdrawal rate approach that may be based on overly optimistic assumptions about expected future rates of investment return. Develop a Big Picture spending budget based on all your assets and liabilities and sound (but relatively simple) actuarial principles.
