Sunday, February 28, 2016

Is a 10X Pay Retirement Savings Target Too High?

The primary focus of this website is helping retirees develop a reasonable spending budget in retirement.  However, the Actuarial Approach can also be used by individuals who are close to retirement (and by their financial advisors) to see whether they are financially ready to retire.  This is done by comparing the spending budget developed by the Actuarial Approach with desired levels of spending in retirement.   I last discussed this process in our post of November 19, 2014 and why I thought a savings target of eight to ten times salary was a better target than four to six times pay in our post of May 24, 2014.

Last December, Fidelity released revised recommendations for how much savings you should have at age 67 in addition to your Social Security benefit in order to be able to retire and maintain your pre-retirement standard of living.  In the past, they had recommended accumulating 8X gross pay for this purpose.  In their most recent study, they increased this target to 10X salary. 

Some experts believe that the Fidelity estimates are way too high for most people.  For example, in a recent article, Frederick Vettese, an actuary, argues that both Fidelity’s 10X salary savings target and the 70%-80% income replacement target rule of thumb are “unrealistically high and clearly wrong for a majority of savers.”  So, let’s take a look at some numbers and you can decide for yourself.

Let’s assume Rita is single, age 67 and considering retirement.  Her annual salary is $60,000 and her accumulated savings is $600,000 (note we are assuming that this figure may or may not include the equity in her home that she could pull out if she chose to downside or rent).  Thus, her accumulated savings is ten times her annual salary.  We will also assume that her Social Security Normal Retirement Age is age 67, her annual benefit is $22,800 and she has no other sources of retirement income.  She also has no bequest motive.

Rita and Rita’s financial advisor go to the Actuarial Budget Calculator V 1.1 spreadsheet and, using recommended assumptions, they determine Rita’s total assets to be $1,097,821 ($600,000 plus the present value of her Social Security benefit of $497,821).  This amount is the present value of her future spending budgets.  They estimate that her long-term care costs for the final three years of her life will be $180,000 in today’s dollars, but since her other expenses will be reduced for this three-year period, she will reserve for only 60% of this cost and because she believes these costs will increase by 3.5% (inflation + 1%) in the future, she determines the current reserve (present value) for LTC costs to be $85,000.  She also establishes a reserve for unexpected future expenses equal to $50,000. 

Rita’s current medical expenses are about $7,000 per year.  She assumes that these expenses will increase by 4.5% (inflation + 2% per year) and develops a budget for future essential medical expenses (present value) of $196,000 based on her expected retirement period of 28 years.  This leaves Rita with $766,821 ($1,097,821 - $85,000 -$50,000 -$196,000) as the present value of her future non-health and non-essential expenses (including taxes).  If she wants this portion of her budget to increase with inflation each year, her initial year’s budget for this item will be $35,120 and her total spending budget for her first year of retirement will be $42,120 ($35,120 + $7,000 in medical expenses).  This amount represents about 70% of her gross $60,000 salary. 

If she retires, she will no longer have to pay 7.65% of her salary in FICA taxes.  She will also no longer have to save for her retirement and she will no longer have work-related expenses.  If we assume that she was contributing 15% of her salary to her 401(k) plan and her work-related expenses were about 10% of her salary, then her comparable post-retirement standard of living would be about $40,400 (and that assumes that she would not increase her spending for other items such as traveling or entertainment).

Bottom Line:  In my opinion, a savings target of 10X salary and a 70% replacement target is not outrageously high for the majority of savers.  Why?  1) the numbers above don’t indicate that this example retiree will be living a profligate lifestyle if she retires at age 67 with accumulated savings of 10X salary, 2) we are facing potential 25% benefit reductions in Social Security down the road and 3) there is a real possibility that individuals younger than 67 won’t be able remain employed until age 67.  Yes, a 10X pay savings target is a tough target to achieve, but just because it is tough to achieve doesn’t mean it isn’t a reasonable target. 

Saturday, February 27, 2016

Actuarial Budget Calculator V 1.1—Develop Your Spending Budget by Expense Type

As discussed in prior posts, we recommend developing a total spending budget by building it as the sum of separately calculated budgets for different expense types.   We make this recommendation because (i) budgets for some types of expenses (such as unexpected expenses and long-term care expenses) should be established but may not be incurred in the current year, and (ii) future increase assumptions for different expense types may differ.  We have added a new tab to the Actuarial Budget Calculator spreadsheet to enable you to do this.  The new spreadsheet is called “Actuarial Budget Calculator V 1.1.”

The Actuarial Budget Calculator is based on the following simple equation:

Assets (value of current investments plus present value of income from other retirement sources) = Liabilities (present value of future spending budgets + present value of amounts left to heirs)
The new tab does not change the validity of this basic equation, it just replaces the “present value of future spending budgets” item with the sum of “present value of expense type #1 future budgets” + “present value of expense type #2 future budgets” etc. where the expense types are:

  • Long-term care expenses 
  • Unexpected expenses 
  • Essential non-health related expenses 
  • Essential health related expenses, and 
  • Non-Essential expenses
Where the spending budget shown in the Input tab spreads Assets less the present value of amounts left to heirs (net assets) over the input retirement period based on one input future increase percentage, the spending budget develop in the new tab spreads these same net assets separately by expense type and in accordance with the specific future increase percentage input for each expense type.  Therefore, the total spending budget developed by expense type in this new tab will generally differ from the amount developed in the Input tab.  This will be especially true if amounts are budgeted for future long-term care expenses or unexpected expenses.

See our post of December 21, 2015 for a discussion of recommended 2016 assumptions for the purpose of developing your budget by expense type.  Also see our posts of January 9 and January 12 of this year for additional discussion of assumptions and an estimation approach for adjusting your spending budget for long-term care expenses. 

Wednesday, February 24, 2016

Tick All the Core Financial Planning Boxes with the Actuarial Approach

Thanks to Dr. Wade Pfau for another fine article on Retirement Planning.  His latest is called, “Eight Core Ideas to Guide Retirement Income Planning.”  In this article, Dr. Pfau presents the key messages and themes that guide his research and writing.  I have to say that his key messages are pretty darn consistent with the Actuarial Approach and recommended assumptions discussed in this website.

In his first key message, “Play the long game,“ Dr. Pfau recommends planning for a long life.  This recommendation is consistent with our recommendation to plan on living until age 95 or your life expectancy if longer.

His second key message is to try to find “efficient” solutions that will increase both lifetime spending and legacy goals.  While the Actuarial Approach can be used to determine which retirement income tools can maximize a retiree’s assets (the present value of future benefits under a given set of assumptions), it generally will not address the benefits of different tax strategies.

Wade’s third and fourth key messages caution retirees against using overly optimistic portfolio return assumptions.  Unless the retiree is significantly invested in cash, we recommend the approximate interest rate currently available to settle the retiree’s liabilities with annuity purchases, irrespective of the retiree’s actual investment mix (or alternative investment mix recommended by the retiree’s advisor).

Wade’s fifth and sixth key messages encourage retirees and their advisors to consider retirement income diversification strategies to better manage retirement risks.  These messages are certainly consistent with our recommendations and spending budget spreadsheets.

Wade’s seventh and eight key messages are the cornerstone messages of the Actuarial Approach.  Both Wade and I encourage retirees and their financial advisors to tackle the household retirement problem in the “same way that pension funds [and their actuaries] treat their obligations.  Assets should be matched with Liabilities with comparable levels of risk.” Wade prefers the term “Household Balance Sheet” where I use the term “Actuarial Balance Sheet” from my pension actuarial training. 

Bottom Line:  If you agree with Wade’s key messages/themes, you are going to like the Actuarial Approach. 

Wednesday, February 17, 2016

How Long Can I Afford to Live in Retirement? —Part 2

No sooner had I finished my most recent post, when I ran across this article in US News Money Personal Finance section that serves to illustrate some of the concerns expressed by Moshe Milesky in his article that I discussed in my last post.  The US News article asks the question for a specific hypothetical client situation of whether the client could satisfy his goals of having adequate retirement income over an expected 40-year retirement, leave a significant legacy to his children and still maintain a conservative investment strategy.  Much to the hypothetical client’s presumed delight, his financial advisor determined that there was a 96% probability of achieving the client’s goals with a small tweak in the client’s investment strategy.  The article implies that the client used this good news to go ahead and actually retire, assured that he could indeed “have it all.”

Now I don’t want to pour cold water on the client’s rosy view of his retirement.  But, I am an actuary and  prone to being perhaps a little more conservative than the next guy.  So, let’s look at the facts presented in the article and see if we reach the same conclusions for this hypothetical client.

The hypothetical client is age 66 and still working.  He has accumulated $1,200,000 in pre-tax savings (401(k) and IRA assets).  He is eligible to receive Social Security and an “old pension” totaling $3,500 per month, which we are told is “net of taxes.”  It isn’t really clear to us whether the client’s annual income goal of $6,500 per month is net of taxes or before taxes.  I’m going to assume that this income goal is before taxes and that his Social Security benefit is $2,000 per month ($24,000 per year increasing with inflation) and his “old pension” benefit is a fixed dollar amount of $1,500 per month ($18,000 per year). 

There is no discussion in the article about other assets that the hypothetical client may have, such as long-term care insurance or even home equity.  So, I’m going to assume that the client and the financial advisor decided in a separate discussion that the client’s home equity, if any, would cover his future long-term care costs or perhaps even some of his desire to leave money to his children.

There is also no discussion in the article about setting aside assets for future emergency expenses or about how future medical expenses may increase at a faster rate than expected inflation.  We are simply told that the client believes “he could live very comfortably and do all the things he wants on $6,500 per month.”  Fair enough. 

So if we input the hypothetical assumed data into the Actuarial Budget Calculator V 1.0 spreadsheet from this website with the recommended assumptions and we further assume that the hypothetical client desires to have constant real dollar spending in retirement for his 40-year desired retirement period and no amounts left to heirs at the end of this period, we come up with a first year spending budget $78,965, or $6,580 per month.  If he wants to leave $1,000,000 at death ($372,431 in real dollars under these assumptions), his monthly income would be $6,071 according to the calculator on an expected basis.  So, under these assumptions, the Actuarial Budget Calculator would not deliver the good news that the client wanted.  On the other hand, if the client used the recommended retirement period of 29 years (rather than a 40-year period), the Actuarial Budget Calculator would indicate that his assets would be expected (under the recommended assumptions) to be able to support a spending budget of $6,500 per month and a legacy bequest of $1,000,000 at death.

Of course the most important aspect of the Actuarial Approach is that it is a dynamic strategy and not a static “set and forget” strategy.  There is no probability of ruin (or success).  There is only this year’s actuarially determined budget that balances the present value of the retiree’s assets with the present value of his liabilities.  Next year, the actuarially determined budget would be based on next year’s data, assumptions and goals.  I realize that this process may not be as comforting as having someone tell you that your plan is 96% bullet-proof and you don’t have to worry about it ever again.  But remember that Monte Carlo modeling (generally) uses historical experience (which may or may not be adjusted for future expectations) to model future experience.  It is no better (and depending on assumptions employed, may be worse) at predicting actual future experience than using best-estimate deterministic assumptions.   And while MC modeling may be great at giving some clients comfort, in many ways it is just a black box that requires a high level of faith and does very little to educate the client on the reasonableness of the assumptions being made on his behalf. 

But, I’m not saying that Monte Carlo modeling is useless.  It can be very useful for certain purposes, such as modeling different asset allocations or kicking the tires on alternative strategies.  I am, however, saying that just as some experts have concerns about using deterministic models, these same concerns also apply to Monte Carlo simulations. 

Perhaps a few less esoteric items can be taken away from this article:

  • It is probably a good idea to consider all relevant assets and liabilities (such as Long-Term Care costs and unexpected expenses) when developing a spending plan. 
  • It is probably a good idea to determine whether the comparison of assets and liabilities is going to be on a pre-tax or a post-tax basis.  While conceptually the Actuarial Approach can match a retiree’s assets and liabilities on an after-tax basis, it is generally anticipated that this comparison will be on a pre-tax basis and that the retiree’s spending budget will include taxes.  
  • It is probably a good idea to quantify specific bequest motives.   
  • It makes a difference whether future benefits received from an “old” pension or annuity are fixed dollars or indexed. 

Sunday, February 14, 2016

How Long Can I Afford to Live in Retirement?

As can be inferred from its title, our website is mostly about developing a reasonable spending budget in retirement based on the assets you have (or if you are a Financial Advisor, how much assets your client has).  It is my hope that you will manage your finances in retirement by (1) periodically calculating the actuarial budget discussed in this website, (2) periodically comparing your actual spending with this actuarial spending budget and (3) making necessary adjustments to bring the two in line.  I know, however, that there are some retirees who don’t want to fuss with a budget and just want to spend $X real dollars each year.  Somehow many of these folk got it in their collective mind that there is a Y% (with Y being a fairly high probability) that they can spend this $X per year come hell or high water and not run out of money.  The good news for these folk is that they may still find our Actuarial Budget Calculator V 1.0 to be of value.  They can use it to solve for the expected period of retirement that they can spend their $X per year and not run out of money.  It involves a trial and error process to back into this period, but it can be accomplished fairly easily.  The retiree can then compare this expected period with the probability of living this long to see what her probability of ruin (or probability that she will have to change spending in the future) is.

The inspiration for this post comes from a new article from Moshe Milesky, Associate Professor in Finance at the Schulich School of Business and Graduate Faculty in Mathematics and Statistics at York University, Toronto.  The article is entitled, “It’s Time to Retire Ruin (Probabilities)” and is scheduled to appear in the March/April issue of Financial Analysts Journal.  Thanks to Martin from Maine for pointing me to a pre-release version.

In his article, Mr. Milesky hits the widespread and generally accepted use of Monte Carlo modeling to determine ruin probabilities of specific spending strategies pretty hard.  He refers to this approach as a “very trendy metric for wealth management” and expresses his concerns about “how these probabilities are being used (and abused) to simultaneously reassure and scare clients about the viability of their retirement plans.” Many of Mr. Milesky’s remarks echo comments I have made in prior posts about deficiencies of Monte Carlo modeling.  In addition, Mr. Milesky advocates the use of fairly low real rates of investment return for planning purposes, so all-in-all I would have to agree with Martin from Maine’s assessment that Mr. Milesky’s article was “right up my alley.”  I encourage you to read Mr. Milesky’s brief article.

Tuesday, February 9, 2016

QLACs vs. Deferral of Social Security Commencement, Part 2

I received a fair amount of feedback from readers who took issue with various aspects of my post of January 31, 2016, “Which is the Optimal Strategy?  Deferring Commencement of Social Security, Buying a QLAC or Neither?”  Turns out that the January 31 post might not have been my best ever.  In it I said, “Which is the optimal strategy?  Well, that depends on the retiree’s age of death.  If he dies before age 85, he is better off under the commence immediately with no QLAC alternative.  If he dies on or after age 85 and before age 88, he is better off under the defer to age 70 strategy.  If he dies on or after age 88 and before age 95, he is better off under the commence Social Security now and buy a QLAC commencing at age 80 strategy, and if he dies on or after age 95, he is better off under the commence Social Security now and buy a QLAC commencing at age 85 strategy.”

Ok.  Well, nobody’s perfect, especially me.  Since I do these calculations myself, I’ve come to the conclusion that I need more competent staff.  Turns out the comparisons are significantly more complicated than I implied.  In this post, I will attempt to gracefully back away from the above statement and perhaps even leave my readers with a few items of information that they may find to be of value.

Here are some of the problems with the previous post:

More than one reader indicated that the results would be different with different assumptions.  I agree.  The use of higher nominal discount rates (but the same real 2%) would lower the value of the QLAC options relative to the Social Security options, all things being equal. 

Other readers noted that I did the comparison for a single male and values of Social Security could be higher for married couples.  I agree. 

Ben Peters, Financial Planner at Burton Enright Welch, pointed out to me that if I had gone the next step and requested a QLAC quote from the site instead of simply relying on the website quote of $31,524 per annum starting at age 80 (with no death benefit protection either before or after commencement), I would have received an actual quote of only about $26,112 per year for a $100,000 premium.  I have no idea why such a disparity exists (and it didn’t seem to exist for the QLAC commencing at age 85), but such a disparity will certainly have a big impact on any comparisons and reduce the value of this option.  I went back to the website and confirmed that such a disparity still exists (or at least it did yesterday).  The news from Mr. Peters was depressing to me for two reasons:  1) my trust in the quotes is somewhat shaken and 2) I found out that Mr. Peters is the son of an actuary (younger than I) with whom I worked, so not only am I feeling less competent, I’m also feeling old.  

I actually screwed up a couple of the calculations.  The good news here (if there is any) is that I discovered these calculation errors when I started using our new improved spreadsheet.  

Based on facts I assumed, the hypothetical retiree would experience cash flow problems if he took $100,000 of his $400,000 in accumulated savings and purchased a QLAC of $52,884 commencing at age 85 and all the assumptions I made were realized in the future.  So, while the present values (or at least most of them) are correct for the QLAC commencing at age 85 scenario, the runout tab of the new spreadsheet shows that the retiree would run out of savings before the QLAC commencement age if he tried to have a constant real dollar spending budget.  To avoid these cash flow problems, I estimated that the hypothetical retiree would have to limit his QLAC purchase to about $50,000, or about 12.5% of his pre-purchase accumulated savings.

Is there some value here?

Here is what I learned:

I’m not perfect.

I need to check and double check my work (or get better and younger staff).

Website quotes may not be accurate.

At this time, based on the revised QLAC quote and all the other (possibly flawed) assumptions used in the January 31 post, it appears that the defer Social Security to age 70 strategy is the winner among these strategies for deaths on or after age 85 and before age 92.  Readers can use the new spreadsheet to confirm this if they want. 

QLACs that commence at age 80 are less likely to present cash flow problems than QLACs that commence at age 85.   If you do purchase a QLAC commencing at age 85, be sure that you (or your financial advisor) look at future expected cash flows, especially if the premium for such QLAC exceeds about 10% of your pre-purchase accumulated savings.  Having more accumulated savings or other sources of immediate income (such as a pension benefit) can help with this cash flow problem.  The runout tab of our new spreadsheet can help with this exercise.

Sunday, February 7, 2016

We have a New Spreadsheet to Help You (or Your Financial Advisor) Develop a Reasonable Spending Budget

Continuing our “Back to Budget Basics” theme from our last post on February 2, we have revised our clunky “Excluding Social Security V 3.1” Spreadsheet to help you (or your Financial Advisor) develop a reasonable spending budget.  We will keep the “Excluding Social Security V3.1” spreadsheet on our website for a while for those who like using it, but it is our hope that the new Actuarial Budget Calculator V 1.0 will quickly make the older spreadsheet obsolete.

The new spreadsheet has all the functionality of the old one and more.  It enables you to input your Social Security benefit and a future year of commencement if it hasn’t already started.  It also enables you to enter a separate indexed annuity if you have one.  Both of these benefits are assumed to increase with input inflation each year. 

As with the old spreadsheet, you can enter fixed dollar pension/annuities that are either immediately payable or commence sometime in the future.  You can also enter the present value of income (or outgo) you expect to receive (or pay) in the future from other sources.  This additional present value from other sources will be added to your accumulated savings for calculation purposes. 

Perhaps the most important thing that this new spreadsheet will do is to determine your Assets (current assets plus the present value of future income) based on the assumptions you input.  As discussed in our last post, once you have determined your Assets and how much you want to leave to your heirs upon death, the balancing item is the present value of your future spending budgets.  All that remains is to determine how you want to allocate the present value of your future spending budgets to your current and future years of retirement.  The new spreadsheet does this final calculation for you based on an assumption you input for future desired increases in your total spending budget.  It is likely, however, that you are going to want to use different future increase assumptions for the various components of your total budget (such as for essential health related expenses, essential non-health related expenses, non-essential expenses, etc.).  See our post of December 26, 2015 for an example.   The new spreadsheet does not do this for you (at least not yet).  But, at this time you can use the simple present value calculator spreadsheet on this website to determine the present values of the various components of your total budget such that the sum for the various component categories equals the present value of the total spending budget developed by the new spreadsheet.

As with the old clunky Excluding Social Security spreadsheet, we have two runout tabs that show how accumulated savings (including the present value of other sources of income) runs down over the period of retirement input in the input tab.  This is not meant to be a projection of future experience as much as it is to be a demonstration that if future experience actually follows assumptions and no changes are made in the assumptions over the expected retirement period (including no change in the assumed date of death), the accumulated savings will run-down to the amount input as “amount desired to be left to heirs” at the end of the expected period of retirement (in the Runout tab) or an inflation-adjusted amount (in the inflation-adjusted Runout tab).   Note that for purposes of these runouts, we have assumed that the retiree will actually spend the calculated budget amount for the year and withdrawals from accumulated savings will equal the calculated budget amount reduced by income from other sources expected during that year.  In some situations, this will result in what appears to be a negative withdrawal from accumulated savings.  This can occur, for example, when income from other sources exceeds the spending budget for the year.  If this occurs, it simply implies that such excess income from other sources will be saved and will serve to increase accumulated savings.  Such “negative” withdrawals should not be a cause for concern.  On the other hand, there may be some situations where the runout tabs show negative accumulated savings balances.  These situations typically involve significant amounts of deferred income and may indicate future cash flow problems.  If your (or your client’s) retirement portfolio includes significant amounts of deferred income (including situations where the present value of other income involves deferred payments or the retiree has significant inflation-indexed future payments and desires to have future spending budgets that do not keep up with inflation), you will probably want to look very closely at the expected future cash flows to make sure that accumulated savings can actually support retirement income objectives throughout the entire expected retirement period. 

As with the Excluding Social Security spreadsheet, we also have a 5-year projection tab to enable you to see the effect on accumulated savings and the total actuarial budget (determined by spreading future budgets using the assumption for this purpose in the input tab) resulting from differences between actual and assumed investment returns and spending.  

Limitations and Caveats

The Actuarial Approach used in the new (and old) spreadsheets is described in the one-page “back to the budget basic” explanation discussed in my last post.  That post also discusses some of the potential limitations of this approach.  Remember that the total spending budget produced using the actuarial approach is “before taxes” and must cover your taxes as well as other expenses. 

From the beginning of this blog, I have tried to make it clear that my purpose is to provide readers with tools and an actuarial process that can be used to determine “how much you can afford to spend in retirement.”  Here is a copy of the caveat that appeared in the first item that I posted, and it still applies today:

“As discussed in the March 2010 article contained in this website, there are many risks associated with self-insuring your own retirement. The general process described in the article and sample spending calculators in this website are made available to you as self-help tools for your independent use and are not intended to provide investment or financial advice. As with all planning tools, the reasonableness of the results (in this case, your “annual spendable amount”) [or spending budget] is a function of the accuracy of the data and assumptions that you input. Since you control these items as well as investment of your accumulated savings, we can make no claims or guarantees that you will not outlive your accumulated savings or experience significant decreases in amounts that may be spent in a future year if you follow the process described in this website. We assume no responsibility for those individuals who may outlive their accumulated savings or who may otherwise become dissatisfied in any way (or believe that they have suffered financially) by following the process described in this website as compared with some other strategy. All articles and sample spending calculators on this website are provided purely for your educational purposes. You are encouraged to seek professional advice from qualified investment/financial professionals before committing to any retirement spending plan and should not simply rely on the results you may obtain with the process and sample spending calculators described in this website.”

Always happy to have feedback on the tools provided in this website and any suggestions for improvement to facilitate the ongoing mission of this site.

Tuesday, February 2, 2016

The Actuarial Approach—Back to the Budget Basics

It’s been almost six years since I retired and started this blog with a lot of help and encouragement from my buddy, Kin Chan.  Initially I started out with a simple spreadsheet (Excluding Social Security V 1.0) and a description of a recommended process to be used to determine the amount a retiree could afford to withdraw from accumulated savings each year. 

While the calculations have remained the same since 2010, the primary focus of this blog has morphed somewhat away from simply determining the amount to withdraw from savings to developing a reasonable spending budget.  And I have to admit that my skills as a number-crunching actuary have sometimes made it difficult for my readers to figure out what I was talking about.   

While the Excluding Social Security (now version 3.1) spreadsheet can be a good tool for some readers, others may benefit from just the basics.  Therefore, I have put together a one-page explanation of the Actuarial Approach that discusses how to use basic actuarial principles and present values to develop a spending budget (or to check to see that your spending plan is otherwise on track).