Wednesday, May 25, 2016

How Much of that Part-Time Income Can You Afford to Spend in Retirement?

Many individuals who are retired take a part-time job to supplement their income in retirement.  Frequently, these retirees believe that this income can increase their annual retirement spending budget by the net amount received during the year from such employment (wages minus increase taxes and increased employment-related expenses).  This post will encourage retirees who work to possibly consider taking a longer-term “actuarial” perspective by spreading the present value of this extra income over their remaining period of retirement.

Let’s look at an example of how this may work.  John is age 65 with an annual Social Security benefit of $20,000 and accumulated savings of $525,000.  He estimates his essential non-health expenses (including taxes) are currently about $36,000 this year, and he expects these expenses to increase with inflation in the future.  He estimates that his essential health expenses are currently $6,000 this year and will increase by inflation plus 2% in the future.  He believes that the equity in his home will cover his long-term care expenses (or will be used for his bequest motives), and he would like to have an emergency fund budget of $25,000.  The rest of his assets will be used for non-essential expenses, which he plans to budget spending at about the same amount each year of his retirement without any assumed future increases due to inflation (essentially decreasing in the future in real dollar terms).

John goes to the Input page of the Actuarial Budget Calculator V 1.1 and inputs his Social Security benefit and accumulated savings as well as the recommended assumptions (and no bequest motive).  He sees that the present value of his current and expected future retirement income is $984,747.   He then goes to the “Budget by Expense-type” tab of the spreadsheet and enters “0” for long-term care expenses, $25,000 for the present value of unexpected expenses, $36,000 increasing by 2.5% for essential health expenses and $6,000 increasing by 4.5% for essential health expenses.  At this point, John sees that his assets (the present value of his future spending budgets) are insufficient to provide for these three items, let alone provide for any non-essential expenses.   In fact, it looks like he has to reduce his budget for unexpected expenses by $1,823 to develop a $40,000 per year spending budget (excluding unexpected expenses) under these assumptions with a $0 budget for non-essential expenses.

John decides that he could use some more money in retirement and he also would like to get out of the house a little anyway.  He decides to take a part-time job that will pay him $1,000 per month.  After taxes and employment-related expenses, John figures that this job will net him about $700 per month in extra income, or about $8,400 per year.  John’s initial thought is that this job will be enable him to increase his unexpected expenses budget to $25,000 and increase his non-essential expense budget by almost $8,400 per year.

But, after John gives this a little more thought, he concludes that he really doesn’t want to do this part-time job for more than 5 years.  So if he spends all of the extra net income from the part-time job each year, he will have a significant drop in his spending budget once his part-time employment is terminated.  Instead of simply adding his expected net income from employment to his budget, John decides to treat the expected net income as another retirement income source like Social Security or his accumulated savings.   He goes to the present value calculator in this website and determines that the present value of $8,400 starting 0.5 years from now and payable for 5 years is $37,696.  He goes back to the input page of the Actuarial Budget Calculator and inputs this amount as the present value of other sources of income.  This increases the present value of his future spending budgets to $1,022,443 and enables John to establish his $25,000 unexpected expenses budget and increases the present value of his non-essential expense budget to $35,873.  If he decides to spread this present value over his expected retirement period with no future increases, it will provide him with a first year non-essential expense budget of $2,107 and a total spending budget of $42,107 (excluding unexpected expenses).  When he determines his spending budget for next year, John will input the present value of 4 years of part-time work assuming he still believes he will only work until age 70.  Using this alternative approach, John hopes to avoid the significant a decrease in his spending budget when his part-time employment is terminated.  In effect, he is saving some of his part-time income for his future retirement years. 

As I have said many times in this blog, developing a reasonable spending budget in retirement is part science and part art.  John can annually spend anywhere from an extra $2,107 to $8,400 as a result of his part time employment.  He has to decide the spending level that is most consistent with his objectives in retirement.   The Actuarial Budget Calculator and this website give him the tools to make a more informed decision.

Tuesday, May 17, 2016

What Went Wrong with the 1983 Social Security Fix?

This is a follow-up to several of my prior posts on Social Security’s financial problems, with the most recent being on November 5th of last year.   The inspiration for this post comes from an article entitled, Understanding Social Security’s Long-Term Fiscal Outlook, by Steve Goss, Chief Actuary, U.S. Social Security Administration.   In his article, Steve states, “The Social Security program faces a substantial financing challenge for the future, largely due to demographic changes that have been long known and understood.”  Steve also indicates that, “Remedying OASDI’s [Social Security’s] fiscal shortfall for 2034 and beyond will require a roughly 25 percent reduction in the scheduled cost of the program, a 33 percent increase in scheduled tax revenue or a combination of these changes.”  So, why are we facing this “substantial financing challenge” when the 1983 Amendments to the program promised system solvency for the foreseeable future?

Well, ok, while some media sources in 1983 indicated that the 1983 Amendments promised system solvency for the foreseeable future, it is more accurate to say that the 1983 Amendments brought the system into “long-term (or “long-range”) Actuarial Balance.”  Like the actuarial measurement of assets and liabilities recommended for retirees in this website, Social Security’s actuarial balance measurements compare system assets (including the present value of future revenues) with system liabilities based on assumptions made about the future and are recalculated annually based on actual data and possibly revised assumptions.   Unfortunately, Social Security’s long-term actuarial balance measurement is limited to 75 years, and the significant deficits expected after the end of the 75-year projection period in the 1983 measurement (that of would of course emerge in subsequent years’ measurements) were ignored.  So, the 1983 Amendments anticipated accumulation of large amounts of Trust Fund reserves during the first half of the 75-year projection period that would be expected to be used to fund tax-rate revenue shortfalls during the last half of this period, with reserves ultimately to be exhausted around 2060 if all assumptions about the future were realized.  After 2060, however, significant tax increases were expected to be required to pay scheduled benefits. 

So what is the big deal?  As Steve indicates in his article, these demographic problems have been long known and understood (well before 1983).  The actuaries thus knew that the 1983 Amendments were a “kick-some-of-the-problem-down-the-road” solution.  So, instead of the problem occurring as expected around 2060, we are now looking at possibly 2034 as the “fall-off-the-cliff-date” because actual experience after 1983 wasn’t quite as favorable as assumed back then and the actuaries changed some assumptions to reflect this less than favorable experience.  Not to worry, however, because according to Steve, “Whenever the reserves begin to decline and approach depletion, Congress must act to make timely adjustments.  Such adjustments to tax rates and scheduled benefit levels always have been made throughout the 80-year history of the program.”

Steve points out that the 1983 Amendments, “substantially improved the financial status of the program for decades into the future.”  You will get no argument from me on this statement.  And while reducing the 75-year actuarial deficit to zero (as was done in the 1983 Amendments) 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.
Both of these problems can be addressed through the use of traditional actuarial principles that automatically adjust the program’s tax rate to maintain the system’s actuarial balance in future years.

Some may legitimately question the wisdom of a long-term financing solution that is not expected to be sustainable in the long-run.  On the other hand, there are those who argue that it is beneficial for Social Security to actually have to go through a “challenging” periodic process of re-evaluation rather than operate on an automatic basis similar to the actuarial approach used for the Canada Pension Plan.

Social Security’s financial problem is an actuarial problem that requires an actuarial solution.  However, as discussed in my November 5 post, the public voice for the U.S. actuarial profession, the American Academy of Actuaries, appears to be sending out mixed messages on this topic.  While it’s 2015 public policy white paper, Sustainability in American Financial Security Programs, touts the benefits of sustainability and states the profession’s commitment “to working toward solutions that help restore confidence in and enhance the sustainability of these important programs,” the Academy’s Social Security Game congratulates players for fixing Social Security by adopting the same type of 75-year “kick-some-of-the-problem-down-the-road” solutions adopted in the 1983 Amendments. 

And so, how will Social Security’s latest “financial challenge” be addressed?  In addition to questions of when the “solution” will be effective, who will be effected by the solution and by how much, you can add the important question of how long will it be after the solution is adopted before we (or our children) can expect to address the program’s financial problems once again. 

Monday, May 9, 2016

Adjust the 4% Rule Enough and You Might End up with Something as Good as the Actuarial Approach

Charles Schwab recently released their guidance regarding how much a retiree can spend each year entitled, “Retirement Spending: How Much Can You Afford?”  The authors state, “The 4% rule is a simple rule of thumb, but needs adjustment to fit current market conditions and your situation.”  The adjustments to the 4% Rule recommended by the authors include:
  • Adjustments to reflect your investment allocation 
  • Adjustments to reflect your selected confidence level of not running out of money 
  • Adjustments to reflect your planned time horizon, and 
  • Possibly annual adjustments to reflect changes in future conditions
The authors provide a chart of recommended withdrawal rates based on time horizons, allocations and confidence levels. The interesting result of this chart to me is that differences in withdrawal rates resulting from different combinations of asset allocations confidence levels are much smaller than differences resulting from different time horizons.  In fact, I would say that for most combinations of asset allocations and confidence levels, the differences are almost negligible for the same time horizon. 

How different are these withdrawal rates from comparable rates developed using the Actuarial Approach?  Not very.  If we are looking at a retiree with only accumulated savings and a Social Security benefit that is currently payable, the withdrawal rates determined using recommended assumptions under the Actuarial Approach are 4.35% for a 30-year period of retirement, 5.97% for a 20-year period and 10.89% for a 10-year period, or very similar to the rates shown in Schwab’s chart above for confidence levels somewhere between 90% and 75%.

The authors suggest that retirees annually revisit their spending plan, “and increase the amount by inflation each year thereafter—or re-review your spending plan based on the performance of your portfolio.”  So retirees have a choice in the future between increasing last year’s spending by inflation or recalculating a new withdrawal rate based on the chart above (using interpolation methods if necessary).  This is very similar to the Actuarial Approach, where you essentially have the same choice (to use the actuarially calculated withdrawal or a smoothed value).

So, I believe the Schwab approach can probably produce a reasonable spending budget for a certain type of retiree.  That type of retiree:

  • Has already set aside separate reserves for long-term care costs (or has sufficient insurance), emergency expenses, and legacy costs 
  • Has no other sources of income, such as fixed dollar pensions, annuities, deferred annuities or deferred Social Security benefits.
If a retiree does not fit this criteria, then that retiree will have to make additional adjustments to the Schwab approach to develop a reasonable spending budget.  Of course, rather than making all these adjustments to the 4% Rule, the retiree could simply use the Actuarial Approach.

One final note on the Schwab article.  It strongly implies that since the life expectancy of a 65-year old male or female is currently much less than 30 years, the 30-year retirement horizon used to develop the 4% Rule may not be appropriate for time horizons for many retirees.  I encourage retirees not to use current life expectancy to develop a retirement horizon as 50% of all individuals are expected to live past their life expectancy.  See my last post for guidance on selecting retirement horizons.

Sunday, May 8, 2016

Actuaries Longevity Illustrator

This week the American Academy of Actuaries and the Society of Actuaries jointly released the Actuaries Longevity Illustrator, an online tool designed to illustrate the potential range of future lifetime based on input of four factors:  age, gender, whether or not you smoke and your general health.  The tool designers claim that these four factors have been shown to be reasonable predictors of a person’s longevity.  The results are based on the 2010 Social Security Administration mortality table, with future mortality improvement projected using the Society of Actuaries’ MP-2015 scale.  We will be adding a link to this tool in our “other calculators and tools” section. 

With one exception, I found the tool very easy to use and potentially helpful for determining the “expected payout period” input item for the Actuarial Budget Calculator in this website.  The one exception is the input item called “illustration age.”  Most (or all) of the time, you are going to want to leave that box blank, which was not particularly intuitive to me. 

The chart in the results section that I found most helpful was the “Planning Horizon” chart.  This chart shows probabilities of living “x” more years.  The 50% probability is your life expectancy under the assumptions used in the model.  As I have discussed in previous posts (see for example my post of December 3, 2014), if you use your life expectancy as your expected payout period, your spending budget will decrease as you age, all other factors being equal.  That is why I have recommended assuming death occurs at age 95, or life expectancy if greater.  Therefore, I recommend that retirees focus on the 25% probability of living “x” years in this chart when determining a spending budget.   If you do this and enter “no smoking” and “excellent health,” the tool will generally produce a 25% probability of living past age 94 for males and 96 for females unless you are over age 80.  This result is very similar to my recommendation of using age 95 or life expectancy if greater for the expected payout period in my spreadsheet.

Being an actuary, I found it interesting that inputting different general health assumptions had less of an effect on longevity than whether or not someone was a smoker.  For example, a non-smoking, average health 65-year old male had a life expectancy of 20 years and a 25% probability of living 27 years, while if he smoked, his life expectancy was 13 years and he had a 25% probability of living 20 years.  The smoker/non-smoker difference (7 years for males at age 65) was less for females (6/5 years).  General health variations were typically 2 years for each health category at age 65.

What does this tool (and others like it) tell us?  Generally, these tools confirm that we don’t know when we are going to die and that makes planning more difficult.  Based on average statistics, there can be a fairly wide range of results.  And the assumption we make today may change tomorrow.  The expected period of retirement you choose for planning purposes will likely depend on many factors, such as results from this tool, your knowledge about family health history, your race,  your income level, where you live, your personal eating and drinking habits, your smoking habits and most importantly, your risk tolerance for having to reduce your spending budget (or parts of it) if you live longer than you expect.   My recommendation to use age 95, or life expectancy if greater is a relatively conservative assumption that is consistent with enjoying excellent health, not smoking and not desiring decreasing real spending budgets until reaching your late 80s.  Using a less conservative assumption (fewer years of expected retirement) will increase your current spending budget and increase your risk of decreasing budgets later in life, all things being equal.  On the other hand, if you have solid information that indicates your life expectancy is less than average, it makes sense to factor this knowledge into your planning calculations.  For example, if you are a smoker, you may want to consider using fewer retirement years to determine your spending budget.  I don’t recommend, however, that you take up smoking just to increase your current spending budget.