Thursday, September 29, 2016

How Much Do You Really Need to Save Each Year to Achieve Your Financial Goals?

Since its inception in 2010, this website has been primarily focused on helping retirees develop a spending budget in retirement.  We have advocated using several basic actuarial principles to do this.  The first basic actuarial principle involves matching your assets with your spending liabilities using this balance equation:

Accumulated savings
PV future income
PV expected non-recurring expenses
PV future spending budgets

A second basic actuarial principle is to revisit this calculation periodically (we recommend annually) to maintain the actuarial balance in the equation above.  Actuaries call this basic principle “annual actuarial valuations.”

Most of the calculations required to match one’s assets with one’s spending liabilities involve making assumptions about the future, and calculating PVs of streams of payments.  Our website includes a Present Value Calculator spreadsheet for this purpose, and the ABC spreadsheet that anticipates some of the more common PV calculations for individuals, and is thus designed to reduce much of the math burden for users.  When in doubt, however, it is always wise to go back to the basic principle embodied in the equation above.

While we have focused on helping retirees determine how much they can afford to spend in retirement, these same actuarial principles (including the asset/liability matching equation above) can be applied to the question of:
  • how much a pre-retiree can afford to spend and 
  • how much he or she should be saving in order to meet financial goals. 
This post will discuss how pre-retirees can use the new Pre-Retirement Spending Savings tab we have added to the ABC spreadsheet to develop a reasonable pre-retirement spending/savings budget.  An example of how to use our new tab will be included in a future post. 

How Much Do You Need to Save?

So, how much do you really need to save each year to achieve your financial goals?  Most “experts” recommend saving as much as possible or some rule of thumb percentage.  For example, a recent Nerdwallet study suggests that 22% of income may be the new retirement saving target for millennials.  Our advice is that it depends on many factors, including:
  • Your financial goals 
  • Your accumulated savings 
  • Your other expected sources of income 
  • How much your assets will earn, how long you will live, and the rate of future inflation and its impact on your expected future expenses 
  • Other non-recurring expenses you may have 
  • How long you want (or will be able) to work 
  • Your capacity and willingness to save, etc.
The new Pre-Retirement Spending Savings tab in our revised ABC spreadsheet gives you the ability to model the impact, on your expected retirement spending budget, of variations in your assumed future savings rate, as well as variations in the items above.  If you are already retired, you can continue to use the ABC spreadsheet and simply ignore the new tab. 

How to Use the New Pre-Retirement Spending Savings Tab in the ABC

In order to determine how much of your current gross pay you can afford to spend while saving the remainder in order to accomplish your financial goals, we expanded the PVs in the equation above to cover both pre-retirement and post-retirement periods.  The ABC already considers post-retirement, so the new tab includes assets and liabilities for the pre-retirement period.

The first step in this process is to determine the PV Future (Retirement) Spending Budgets, by entering data into the Input tab of the ABC spreadsheet:
  • Accumulated savings (cell B7) 
  • Estimated amounts of future retirement income, such as Social Security (cell B9) and any life annuity (cells B13, B17 or B21), and expected commencement of such income (cells B11, B15, B19 or B23) 
  • The PV other sources of income in retirement, including proceeds from asset sales or reverse mortgages, income from part-time employment, rental income, etc. (cell B25) 
  • Assumptions about the future, including future investment returns (cell B27), future rates of inflation (cell B35), and lifetime planning period (pre-retirement period + expected payout period) (cell B29), and Desired amount remaining at end of lifetime planning period (cell B33)

Note:  If you have an estimate of your Social Security benefit payable at some age in the future that is in current dollars, you will need to increase that estimate based on future pre-retirement inflation.

The significant result of inputting these items is the PV Future (Retirement) Spending Budgets found in cell B41 (row 41 and column B) of this Input tab of the ABC spreadsheet, which becomes the starting value on the new Pre-Retirement Spending Savings tab.  Once you have completed this first step, proceed to the new Pre-Retirement Spending Savings tab.

In Step 1 of the new tab, PV future gross pay (cell C9) is developed, which, when added to the PV other pre-retirement income (such as employer contributions to a defined contribution plan) (cell B10) becomes PV Pre-Retirement Assets (cell C11).  This is added to the starting value of PV Future (Retirement) Spending Budgets (cell D3).  If you anticipate working on a part-time basis after retirement, that expected PV should be entered as part of PV Other Sources of Income (cell B25) of the Input tab, not here.  Also note that Social Security applies an earnings test to employment earnings prior to your Social Security Normal Retirement Age.  Therefore, you need to coordinate the Desired number of future years until retirement (B7) with the Social Security benefit commencement year (cell B11 on the Input tab).

Next, in Steps 2 and 3 input expected PV Long-term Care Costs (cell B13) and the PV Unexpected Expenses (cell B15).  The program then subtracts these amounts from the remaining PV from the previous step.  If there are other expected non-recurring expenses, such as expected college expenses, add the PV of such items in one of these two steps.  (See our post ofJanuary 12, 2016 for a discussion of how you can modify your estimate of Long-term Care Costs to reflect a reduction in normal annual expenses associated with moving into an assisted living facility.)

In Step 4, the spreadsheet calculates PV Pre-Retirement Spending and subtracts it from the remaining PV from the previous steps.  It does this by asking you to input the percentage of your pre-retirement gross pay you intend to save this year and every year until you retire, Desired percentage of annual gross pay savings (cell B18).  This percentage multiplied by your gross pay is your savings budget.  The remainder of your pre-retirement gross pay constitutes your pre-retirement spending budget, and is intended to cover all your expenses including taxes.

In Step 5, the spreadsheet takes the amount of remaining PV after Step 4 (cell D20) and spreads it over your expected period of retirement (your lifetime planning period (Input tab B29) minus the Desired number of years until retirement (cell B7)), based on the input desired annual increase in post-retirement spending budget (cell B23).  As discussed in previous posts, if most of your expenses in retirement will be essential expenses, you will probably want your post-retirement spending to keep up with inflation.  If a significant portion of your post-retirement expenses are discretionary, it may be ok to assume future spending increases less than assumed inflation.

These calculations produce a retirement spending budget replacement ratio (ratio of first year retirement spending budget to final working year spending budget, in real dollars (cell E26) under the assumptions entered into the spreadsheet.  It is not unrealistic to plan on some decline in real dollar spending in the first year of retirement, as taxes will generally be lower, work-related expenses will be lower and mortgages may be paid off.  How much of a reduction in your pre-retirement standard of living you are comfortable with is, of course, the purpose of this exercise.  For example, if you are not comfortable with the estimated decrease in your post-retirement spending, you may need to increase your Desired percentage of annual gross pay savings (cell B18) or increase your Desired number of years until retirement (cell B7) or both.  Or you may need to increase the PV of post-retirement part-time work you entered in cell B25 of the Input tab.  There are many levers in this spreadsheet you can vary in your pre-retirement spending/savings budget planning.

Caution: Note that the Runout, Inflation Adjusted Runout, 5-year Projection and Budget by Expense-Type tabs in this spreadsheet will not be valid for this pre-retirement spending/savings budget exercise.  They were developed to provide additional information to retirees who have commenced spending their retirement assets.

Thursday, September 22, 2016

Got Those “Conflicting Social Security Deficit Estimate” Blues Again

This post is a follow-up to my post of January 22, 2016, where I noted that relatively small tweaks in assumptions about the future appeared to have a fairly large impact on Social Security’s 75-year actuarial balance calculation, and my post of July 30, 2016, where I called upon the actuarial profession to advocate adoption of automatic approaches to maintain Social Security’s actuarial balance as part of the next round of system reform to enhance the system’s sustainability. 

This week, Keith Hall, the Director of the Congressional Budget Office (CBO), appeared before the House Subcommittee on Social Security to explain why CBO’s calculation of Social Security’s 75-year actuarial deficit was so much higher than the deficit calculated by Social Security’s actuaries and included in the official Trustee’s report.  Here is a link to his testimony.  Mr. Hall explained that by tweaking a few assumptions, the CBO calculated the 2016 75-year actuarial deficit to be 4.68% of the system’s taxable payroll vs. the 2.66% figure calculated by the Trustees.  In other words, the CBO calculated deficit, when measured as a percentage of taxable payroll was about 75% higher than the deficit calculated by the Trustees.  It is also important to note that neither of these two calculations recognizes the significant deficits projected for years after the 75-year projection period under current law, and therefore both actually understate the long-term problem.

As discussed in my post of January 22, I have no idea whose assumptions are more accurate, and frankly that is not the point of this post anyway.   The point is that no one can predict the next 75 years accurately, and it is just foolish to believe that changes made today, tomorrow or five years from now based on 75 years of assumptions about the future are definitely going to solve the system’s long-term funding problems for 75 years or more.  Yet that is just what we heard when Congress supposedly solved the system’s problem for 75 years back in 1983, and that is just what we heard more recently from the Bipartisan Policy Commission when they proudly announced that, “the commission’s package of recommendations would extend Social Security’s ability to pay benefits without abrupt reductions through the end of the 75-year projection period” and “if adopted, the commission’s recommendations would secure the program’s trust funds for 75 years and beyond…”  Statements such as these are conditioned on future experience closely following the assumptions made by the Trustees.  So, if actual future experience is just a little worse (say like experience assumed by the CBO), all bets are off.  

Common sense tells us that rather than waiting to have Congress make very significant changes to the Nation’s retirement program every thirty years or so to put it back into actuarial balance, it would be preferable to have minor changes made on a more frequent basis.  This why I have recommended consideration of automatic adjustments to the system’s tax and/or benefit structure to maintain the system’s actuarial balance.  This is what they do in Canada for the Canada Pension Plan.  This is what is done in almost all financial programs funded using basic actuarial principles.   I believe that adoption of such an automatic adjustment approach would go a long way to enhancing the sustainability of and faith in this critical program.

So, in my post of July 30, 2016 I called on my profession to fulfill its duty to the public and advocate automatic adjustments to maintain the program’s actuarial balance.  I also sent a link to my post to all of the leaders of all of the U.S. actuarial organizations.  Despite my many years of volunteering for most of these organizations, I received essentially no response, and certainly nothing resembling an explanation of why the profession wouldn’t even consider suggesting or recommending such an approach to Congress. 

I believe that the actuarial profession fumbled the Social Security football back in 1983.   With potential and significant Social Security reform on the horizon, it looks like the actuarial profession will be given another chance to carry the ball.  Unfortunately, based on actions I’ve observed to date, it appears the profession will once again fumble the ball.  One has but to look at the American Academy of Actuaries’ Social Security Game for an example.  Simply make a couple of changes in the current tax/benefit structure to solve the 2015 Trustees estimate of the 75-year actuarial deficit and the Game congratulates you for winning the Game by fixing Social Security.  If only it were that easy.

Sunday, September 4, 2016

Recommended Assumed Annual Rate of Investment Return Lowered Again

From time to time I look at immediate annuity purchase rates for the purpose of possibly revising my recommendation for the expected annual rate of investment return assumption and the rate of inflation assumption to use in the Actuarial Budget Calculator.   The assumption for the expected annual rate of investment return is also referred to as the discount rate as it is the rate used in the Actuarial Budget Calculator to discount future expected payments to obtain present values.  Readers of my blog know that I like to recommend a discount rate that is roughly consistent with the discount rate implied in immediate annuity purchase rates, as this rate is approximately the discount rate at which a retiree could settle some or all of his or her retirement liabilities (generally the present value of future spending budgets).  It also gives a retiree a pretty good estimate of the relatively low-risk cost to fund their retirement.  Yes, investment in risky assets may result in higher investment returns (and a potentially higher discount rate), but risky assets also carry greater risk.  Therefore, while I don’t make recommendations on how you should invest your assets, I do recommend that you assume that your assets will earn a fairly conservative rate.  If your assets actually earn more than this conservative rate in the future, you can increase your future spending budgets (or you can increase your rainy day fund as discussed in our post of July 4, 2016). 

Historically, I have also recommended using a future inflation assumption that is 200 basis points below the discount rate as this is roughly the historical difference between inflation and returns on bonds; the investments used in annuity products.

Only the actuaries at the actual insurance companies know the assumptions and methods they use to price their immediate annuity products.   These assumptions and methods include mortality, mortality improvement, anti-selection, interest rates and other factors, such as desired levels of insurance company profits, commission schedules and whether they have already written their quota of business for the year.  So, I don’t claim to really know the discount rate (or more likely different discount rates by year) assumption they use.  I can only make a crude educated guess.   Historically in prior posts, I have done that by solving for the discount rate that is approximately consistent with age 65 annuity purchase rates using the age 65 life expectancy for a 65-year old male (22.9 years) or a 65-year old female (24.9 years) under the 2012 Society of Actuaries’ Individual Annuity Mortality Table with 1% per year mortality improvement. 

Recently I looked at how much monthly immediate fixed dollar annuity income could be purchased for $100,000 in California by 65-year old males and females from the following three online sources:

The table below shows the highest quoted monthly income for age 65 males and females and the respective implied discount rate for each quote based on the methodology described above. 

(click to enlarge)

As shown in the table, the annuity quotes and implied discount rates from appeared to be significantly higher than those from, which, in turn, appeared to be higher than those from  The annuity quotes from list the actual insurance company and their AM Best rating, while the quotes from the other two online sources do not.  For example, the quote from Met Life on on September 3rd for a 65-year old male was $490 per month and was $467 per month for a 65-year old female.  Under the methodology described above, this translates into about a 2.74% annual discount rate for the male annuity and a 2.84% annual discount rate for the female annuity offered by Met Life.  

Based on the data in the table above, I have decided to lower my recommended discount rate and inflation rate by 0.5% to:
  • Recommended discount rate: 4.0% 
  • Recommended inflation rate:2.0%
I would certainly not argue with you, however, if you wanted to use a lower discount rate and a consistent assumed rate of inflation.

What are the implications for your spending budget of using a lower assumed discount rate?  All things being equal (i.e., your future inflation assumption remains unchanged), it means that your spending budget will decrease somewhat, as the anticipated cost of your retirement will be more expensive.  If your assumed inflation assumption is reduced by 50 basis points as well, however, your spending budget may actually increase depending upon how much fixed dollar income you anticipate receiving and how you plan to spread the present value of your future spending budgets.