Saturday, April 30, 2016

Use the Actuarial Approach to Win the “Retirement Finance Game”

In three recent posts in The Retirement Cafe, Dirk Cotton, winner of the 2015 RIIA Practitioner Thought Leadership Award, has developed a “top-level” model for Retirement Planning.  In his third installment Dirk, who likes to use game theory in explaining his concepts, said “Retirement finance is a random walk along a Markov chain, or to a game theorist, a sequential game against nature. Each year we make forecasts based on what we know (our current financial status and the financial environment), what we expect to happen in the future, and what unexpected outcomes we believe we might experience in the future (risks). We make our move based on this analysis and our risk tolerance. Then nature takes its turn and we repeat.” I recommend reading all three of Dirk’s posts for a different (and eloquent) description of the complicated problem with which most of us retirees must struggle in order to meet our financial goals in retirement. 

I believe the Actuarial Approach (and its annual valuation, or “discrete-time states” process) is entirely consistent with the top-level conceptual model developed by Mr. Cotton and provides very useful tools to help retirees win the “retirement finance game.”

Monday, April 25, 2016

Please Call Off the Search for a Safe Withdrawal Rate

I know that I sound like a broken record on this issue, but as long as retirement experts keep touting safe withdrawal rates (the 4% Rule, etc.), I will continue to warn my readers that these approaches may not be consistent with their spending objectives in retirement.  While not necessarily advocating the use of a safe withdrawal rate in his latest article, “The 4% Rule And The Search For A Safe Withdrawal Rate”, Dr. Wade Pfau points out that “75% of surveyed financial planners either ‘always’ or ‘frequently’ use systematic withdrawals with their clients. [So] They care about the safe withdrawal rate.” 
For the umpteenth time, I will summarize some of the major downsides using a safe withdrawal rate approach:

  1. It doesn’t coordinate with other sources of income (particularly fixed dollar sources like pensions) 
  2. It ignores certain types of expenses such as long-term care expenses, other unexpected expenses and bequest motives. 
  3. It doesn’t distinguish between different types of future expenses, so there is no ability to assume different rates of future increases for different types of expenses and no ability to consider variations in the retiree’s aversion to risk for different types of expenses. 
  4. It is designed to “draw-down” accumulated savings; not be part of a “bigger picture” spending budget 
  5. It is a “set and forget” strategy that requires faith that future investment experience will duplicate historical investment experience (or adjusted historical investment experience). 
  6. It assumes that each year’s retiree spending will exactly equal the safe withdrawal amount. 
  7. It assumes that the retiree will invest at least 50% of accumulated savings in equities and maintain at least this percentage in equities throughout retirement.  
  8. It contains no adjustment mechanisms to keep future spending on track if investments fail to earn rates assumed in the model (or investments earn more than assumed) or if actual spending deviates from the safe withdrawal amounts.
Perhaps the best way to illustrate the short-comings of a safe withdrawal rate approach and how those short-comings are handled under the Actuarial Approach, is to look at an example.   Let’s assume Roberta Retiree is 65 years old and a renter with no home equity, she receives a $40,000 annual fixed dollar pension in addition to her $20,000 annual Social Security benefit and has $300,000 in accumulated savings.  She would like to leave $200,000 at her death to her daughter.  She has no long-term care insurance.  She wants to determine her 2016 spending budget. 

Roberta enters her information and the recommended assumptions for 2016 into the Actuarial Budget Calculator.  It tells her that the present value of her assets are $1,540,623 and when reduced by the present value of the amount she wants to leave to her daughter leaves a present value of her future spending budgets of $1,487,223.

Roberta then goes to the “Budget by Expense Type” tab.  She inputs $100,000 as her reserve for future long-term care expenses (using the methodology described in our January 12, 2016 post, assuming 4.5% future annual cost increases and reflecting only 60% of the expected present value since other expenses will be reduced if and when Roberta enters a long-term care facility).  She also enters $50,000 for the present value of her unexpected expenses. 

She determines her 2016 non-medical essential expenses to be about $40,000 per year and she believes those expenses will stay relatively constant in real dollar terms in future years, so she enters the recommended inflation assumption of 2.5% per annum for the expected increase for this expense type.  The total present value budget attributable to her current and future non-medical essential expenses is $919,494.  She enters $6,000 for essential medical expenses with a 4.5% future increase assumption giving her a total present value budget for this item of $180,000.  This leaves her with a $229,728 total spending budget for non-essential, discretionary expenses.  She decides that she can live with the same dollar amount of non-essential expenses each year, so she inputs a 0% increase assumption for this item, giving her a 2016 non-essential spending budget of $13,966.

Roberta’s total spending budget determined using the Actuarial Approach (excluding any amounts attributable to long-term care or unexpected expenses) is $59,496.  Note that this amount is $504 less than the sum she expects to receive during 2016 from Social Security and her pension.  Thus, under the Actuarial Approach, in order to meet her spending objectives on an expected basis throughout her retirement, she must actually save $504 of her 2016 pension (or Social Security) in addition to spending $0 from her accumulated savings.  By comparison, the 4% Rule would tell her to go ahead and spend $16,000 of her accumulated savings in 2016 in addition to her pension and Social Security. 

The Actuarial Approach (and the Budget by Expense Tab) also tells Roberta approximately how much of the present value of her assets are dedicated to each expense type.  If she is more concerned about her essential expense budgets, for example, she can choose to invest assets dedicated to those budgets more conservatively than assets dedicated to non-essential expenses.  Or, at the end of 2016, she can transfer assets from one expense-type budget to another depending on actual experience during the year.

Most importantly, the Actuarial Approach tells Roberta where she stands each year depending on her actual spending and actual investment performance.  Roberta can always choose to smooth her budgets or spending from year to year, but she doesn’t have to rely on blind faith in historical investment results (or restrict actual spending) to develop a reasonable spending budget each and every year of her retirement. 

Because of all the unknowns involved, determining a spending budget can sometimes be more art than science.  If you a greater than average risk taker, you can always spend more of the present value of your assets now rather than later (with the risk that you may have to spend less later).   However, don’t be misled into thinking that just because retirement experts refer to an approach as a “safe withdrawal rate” approach that it is necessarily safe or without risk. 

Thursday, April 21, 2016

Use the Logical “Big Picture” Retirement Budget Setting Alternative

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.

Wednesday, April 20, 2016

Determining the Retirement Income Strategy that is Best for You is Not Necessarily an Easy Task

Last week, as part of his continuous effort to challenge financial advisors to provide better service to their clients, Michael Kitces shared an interesting blogpost entitled, How DO You Measure Which Retirement Income Strategy Is Best?  In his post, he examined possible “best” strategies for a 65-year old couple “trying to decide how much to spend for a 30-year retirement from their $1,000,000 portfolio, and how that portfolio should be invested.”  He looked at three possible strategies:

A) Spend an inflation-adjusting $30,000/year from the portfolio, by putting 90% of it into an immediate annuity and keeping the other 10% in cash reserves

B) Spend an inflation-adjusting $45,000/year from the portfolio, and invest it 50/50 in stocks and bonds

C) Spend an inflation-adjusting $60,000/year from the portfolio, and invest it 100% in stocks

Making assumptions about future inflation (3%) and expected returns on cash (3%), intermediate bonds (5%) and stocks (10%) and relevant standard deviations and correlations (undisclosed) for Monte Carlo projections, Michael determined which of the three strategies was “best” based on eight possible ways to measure the outcomes (including three levels of how risk-averse the retiree is).  His analysis is summarized nicely in a chart.  Michael concludes that “careful thought about how a strategy will be evaluated is actually an essential aspect of the process in crafting financial planning recommendations.”

Kudos to Michael for suggesting such an approach.  I worry, however, about how comprehensive and meaningful the process would be in actual practice.  The results are very much dependent on the assumptions made for future expected returns of the various asset classes.  Projections of future experience that are based on poor assumptions will yield poor results.  How would the results change, for example, if instead of assuming a 7% expected risk premium for stocks, Michael had assumed “only” 4%?  If current annuity purchase rates are used for the most conservative options, expected future returns should properly reflect current economic conditions as well to make sure that comparisons are “apples to apples.”  Perhaps a more comprehensive process would involve several charts illustrating variations in expected assumptions (a suggestion that I would also make for Monte Carlo simulations in general).

As Michael points out, the situation is further complicated by the fact that “most clients have multiple and complex goals and preferences.”  Certainly, many retirees may have different risk preferences for different types of budget expenses (essential vs. non-essential for example), so the strategies examined may have to be more complicated than the three examined by Michael in his example.  In addition, the existence of other sources of retirement income can further complicate the analysis as can funding for long-term care and unexpected expenses. 

Finally, even if simple strategies are chosen, care should be taken to make sure that they represent potentially best strategies.  For example, if I go to, I get a quote of $555 per month per $100,000 premium for a 65-year old male payable as a fixed dollar immediate 15-year certain and life annuity and a quote of $502 per month per $100,000 premium for a 65-year old female payable as a fixed dollar immediate 15-year certain and life annuity.  If I split Michael’s $900,000 premium equally for the husband and the wife, I’m looking at total annual payments from the contracts of $57,078 as long as both the husband and wife are alive.  Using the Actuarial Budget Calculator spreadsheet from this website and inputting $100,000 invested in cash (and Michael’s 3% assumptions for expected return on cash and desired future increases to adjust for expected inflation), I come up with a total amount spendable in the first year of retirement of $41,774.  (Note that in order to provide inflation increases throughout the 30 period of retirement, a significant portion of initial year’s annuity payments would have to be saved). This strategy would provide about 39% higher benefits than Michael’s Strategy A.  I would imagine that this strategy would fare better under Michael’s comparisons than Strategy A. 

While I believe that Michael chose these three strategies to illustrate how his process night work, I become skeptical when someone tells me that I can spend 33% more in retirement if I simply increase my investment in equities from 50% to 100% (Strategy C vs. Strategy B).  Unless you are very conservative with your investments, I recommend that you assume about the same rate of future investment return that is “baked” into insurance company life annuity pricing, as this is approximately the discount rate at which you can “settle” your future budget liabilities.  My rational for making this recommendation is that while you might expect to achieve higher rates of investment return by investing in riskier assets, you are taking on more risk, and this increased risk tends to counterbalance the positive effect of higher expected returns when it comes to determining how much of your assets you can afford to spend. 

FYI, you can use the Actuarial Budget Calculator to determine that the future deterministic real rate of investment return implied by Michael’s Strategy B is about 2.3% per annum, while the future deterministic real rate of investment return implied by Strategy C is about 4.8%.

Saturday, April 2, 2016

You Can Do Better Than the IRS Required Minimum Distribution (RMD) Rules for Your Withdrawal Strategy

A number of financial experts tout the benefits of using the same IRS Publication 590 life expectancy factors required for determining required minimum distributions from qualified plans for the purpose of determining annual spending withdrawals from accumulated savings in retirement.  They argue that these factors are readily available, reflect remaining life expectancy, generally must be applied (for RMD purposes) in each year beginning with the year a retiree reaches age 70.5 and are conservative.

In his March 31 article, Henry K. “Bud” Hebeler sets forth seven essentials in retirement planning that do-it-yourself planners should not ignore.  I am in total agreement with the first 6 essentials and the first part of the seventh.  In this post, however, I’m going to take issue with the last few sentences of Bud’s article.

Even casual readers of this blog will know that I’m not a big fan of any withdrawal strategy that doesn’t properly coordinate with other sources of retirement income to produce a reasonable spending budget.  As I have discussed in prior posts, the RMD approach will generally not work very well for a retiree who has other fixed dollar sources of retirement income [pensions, immediate or deferred annuities] and who desires to have relatively constant dollar spending throughout retirement.  I did, however, give kudos to Henry “Bud” Hebeler in our March 26 post for developing an adjustment to apply to fixed dollar pension benefits/annuities so that he could add withdrawals determined the RMD approach and still develop a reasonable spending budget.  Notwithstanding the existence of Bud’s fixed dollar adjustment (which would be appropriate to use with any rule of thumb approach), I believe the RMD approach is just too conservative for most retirees. 

The table below shows rates of withdrawal by age for the RMD approach vs. the Actuarial Approach using recommended assumptions for discount rate, inflation rate and expected period of retirement.  Note that the withdrawal rates shown for the Actuarial Approach were developed by assuming no fixed dollar pensions/annuities exist and assuming no bequest motive to facilitate an “apples to apples” comparison of withdrawal rates. 

(click to enlarge)

The first column shows withdrawal rates by age under the RMD approach.  These rates are obtained by dividing 1 by the life expectancy from the IRS Publication 590 tables.   The second column shows withdrawal rates under the Actuarial Approach under our current recommended assumptions (4.5% discount rate, 2.5% inflation and period of retirement equal to 95-attained age or life expectancy if greater).  The withdrawal rates in the second column are designed to produce constant real-dollar withdrawals at least until about age 90 (after which time real-dollar withdrawals would be expected to decline somewhat from year to year) if the recommended assumptions are exactly realized.  As can be seen in the table above, the RMD withdrawal rates are consistently significantly lower than the rates using the Actuarial Approach.  The primary reason for this is that instead of assuming a 2% real discount rate (4.5% - 2.5%), the RMD approach effectively assumes a 0% real discount rate.   The net effect, then, of using RMD withdrawal rates would be to back-load real dollar spending to later years of retirement under the recommended assumptions.

The final two columns of this table, show withdrawal rates for males and females using the 2% real discount rate but instead of assuming death occurs at 95, these columns assume death occurs at the end of life expectancy determined using the 2012 SoA Individual Annuity Mortality Table with 1% mortality improvement (a link to which may be found in our Other Calculators and Tools section).  Also shown in these columns in parentheses are the remaining life expectancies for applicable ages. 

While Mr. Hebeler indicates that every year you live your life expectancy grows, this is technically not an accurate statement.  As can be seen from the table, your life expectancy decreases as you age, but your expected age at death (i.e., the sum of your age and your life expectancy) does increase.  This is probably what Bud intended to say.  Using your life expectancy as your expected period of retirement produces higher withdrawal rates than the age 95 approach, all things being equal, but as you age this results in declining real dollar withdrawals if all other assumptions are realized.  Therefore, unless you consciously want to front-load real dollar spending earlier in your retirement, we recommend planning to live until age 95.  We also recommend that you avoid using the RMD approach (with possible necessary adjustments of fixed dollar pensions, etc.) and just stick with the Actuarial Approach.