Wednesday, May 10, 2017

Introducing Your Actuarial Budget Benchmark (ABB)

We are happy to introduce your Actuarial Budget Benchmark (ABB).  In this post, we will discuss:
  • What it is 
  • How you can calculate it 
  • What some of its benefits are
We are convinced that no matter how you currently develop your spending budget in retirement, calculating your ABB annually and comparing the result with your spending budget for recurring annual expenses will serve you well.  If you are a financial advisor, we believe your clients will benefit from this annual comparison, and you can better assist them by adding this tool to your consulting tool box.

What is Your ABB?

Your Actuarial Budget Benchmark is a relatively transparent annual calculation of your recurring spending budget in retirement based on your spending goals and your data, but based on a specific set of assumptions about the future, that may change each year.  The calculation is designed to approximate the market value of your future spending liabilities.  Under these assumptions, which are consistent with discount rates used in insurance company life annuity pricing, the market value of a retiree’s (or the retired couple’s) assets are annually matched against the market value of spending liabilities to develop a “mark to market” spending budget, or ABB.

The recommended assumptions used in the ABB calculations generate a more conservative market value of spending liabilities than the current cost to settle your spending liabilities through annuity purchases, so therefore result in a lower recurring spending budget.   This is because individuals, who self-insure a portion of their retirement spending, will not be eligible for mortality credits with respect to that portion of their assets, as they would with an insurance annuity, and must therefore assume a longer lifetime planning period.

Your ABB considers your total retirement assets and liabilities, not just withdrawals from your investment portfolio.  It is based on a conservative estimates of future investment performance and lifetime planning period.  It is compared with, or benchmarked against, your pre-tax spending budget for annual recurring expenses, however that may be determined.  If your spending budget (or spending) significantly deviates from the ABB now or in the future, you will probably want to find out why so you can take appropriate actions to keep your spending on track to meet your financial goals.

How Do You Calculate Your ABB?

It is very easy and inexpensive to calculate your ABB.  You simply enter your data and the recommended input assumptions in the Actuarial Budget Calculator (ABC) for Retirees workbook located in this website.  The recommended assumptions and other input items were discussed in our post of May 8, 2017.

This workbook is free, and we repeat here that we receive no compensation of any kind from hits to this website or from any activities associated with this website.  Our advice is therefore unbiased and not motivated by any financial incentives. 

Benefits of Calculating Your ABB

The main purpose of the ABB is to benchmark your recurring spending budget against the ABB.  Is this year’s recurring spending budget about the same, significantly higher or significantly lower than the ABB?  And if your investments do well or really poorly this year, how will this experience affect next year’s comparison?  The ABB can quantify how far off the actuarially balanced “mark to market” track your spending plan has led you, and the amount and direction of spending changes you may need to make over to time to get your spending back on track.

The ABB can also help retirees find the “Goldilocks” solution discussed in our post of April 20, 2017 that balances a retiree’s desires to avoid unnecessary fluctuations in spending and mitigate sequence of return risk.  The ABB can be particularly helpful for retirees and their financial advisors who advocate somewhat static (non-dynamic) spending approaches.

Suppose your spending plan produces a significantly higher spending budget than the ABB this year.  There could be several reasons for this, including:

  • Potentially overly-optimistic assumptions about future investment returns, longevity or inflation 
  • Conscious desire to have declining constant real dollar spending in future years in retirement 
  • Over-smoothing of unfavorable prior investment experience 
  • Under-estimating non-recurring expenses or over-estimating other income sources 
  • Spending budget calculation may over-estimate long-term real spending budget (see post of December 21, 2016.)
And you may be fine with the difference between your spending plan and the ABB this year.  However, if experience significantly deviates from your assumptions during this year, the difference between the two at the end of the year may get out of your comfort zone.  The ABB provides you with important data points that you can use to help you adjust your spending.

And while the ABB is based on fairly conservative assumptions, it is possible that your spending budget might be significantly lower than the ABB.  There could be several reasons for this, including:

  • Potentially overly-pessimistic assumptions about future investment returns, longevity or inflation 
  • Conscious desire to underspend (or save) during retirement or have increasing constant real dollar spending in future years of retirement 
  • Over-smoothing of favorable prior investment experience 
  • Over-estimating non-recurring expenses or under-estimating other income sources 
  • Spending budget calculation may under-estimate long-term real spending budget
And again, this result may be fine, provided it is consistent with your financial objectives and your tolerance for risk.  If it isn’t, the ABB can give you the information you need to get you back on track.

Conclusion
As indicated in our post of April 20, 2017, the ABB can provide you or your financial advisor with the information to help you achieve your many spending goals in retirement.  Even if you use our ABC (Retirees) workbook with different assumptions, or you smooth the results from our workbook from year to year to develop your spending budget, we encourage you to benchmark the result for the year against your ABB for the year to see just how far away from “mark to market” you are.  Doing so gives you another important data point to help you make more informed spending decisions.

Monday, May 8, 2017

Recommended Assumptions & Other Inputs to Develop Your Actuarial Budget Benchmark


This post is a follow-up to our post of April 20, 2017, where we encouraged individuals and their financial advisors to use our workbooks and recommended assumptions to supplement their spending strategies, by developing another data point to be used to keep retiree spending on track and consistent with the individual’s financial goals.  In this post, we will:
  1. Name this specific data point the Actuarial Budget Benchmark (ABB), and 
  2. Summarize our recommended assumptions and other items to be input in our Actuarial Budget Calculator (ABC Retirees) workbook to develop the ABB for a retired individual or couple.
In this post, we will focus mostly on how to use our ABC (Retirees) workbook to calculate your ABB.  Our next post will focus on the benefits of doing so.

Background / Market Value of Spending Liabilities

Readers of this blog are very familiar with the basic actuarial equation below.  This equation balances the present value of an individual’s (or couple’s) total assets with the present value of total spending liabilities.  It does not limit the focus to assets that may be withdrawn from one’s Accumulated Savings.


Accumulated Savings
+
PV Income from Other Sources
=
PV Future Non-Recurring Expenses
+
PV Future Recurring Annual Spending Budgets

To determine the present values used in this equation, any reasonable assumptions may be used.  However, to match the market value of an individual’s assets with the approximate market value of the individual’s spending liabilities, we recommend assuming a discount rate assumption that is approximately equal to the discount rate currently used by insurance companies to price lifetime annuity products.  By using this assumption, we are essentially determining the market value of future spending liabilities as the cost today to purchase annuities that would cover such liabilities.

To make the calculations in the above equation somewhat easier, we have developed Excel workbooks for retirees and pre-retirees.  It has been a while since we have discussed recommended assumptions and other input items for the workbooks, so we thought we would summarize them in this post.  And while these recommended assumptions can also apply to pre-retirees, the ABB concept is primarily intended to apply to retirees. 

Multiple individuals
If you are trying to determine a spending budget for a couple, rather than an individual, you may need to:

  • combine data 
  • run the ABC more than once and combine results, 
  • enter data in an input item that functions best.  For example, if your spouse has a Social Security benefit that will commence at a different point in time than yours, you can enter her Social Security benefit and start date as an indexed annuity. 
  • go back to the basic actuarial equation above and use the PV Calculator spreadsheet in our website.
Recommended Input Items for ABC (Retirees) to Develop the Actuarial Budget Benchmark

Present Value Other Sources of Income:
There can be many other sources of income that may not be otherwise captured as an income source in the ABC.  The most common of these is home equity.  To the extent that these sources can be tapped to cover expenses in retirement, the present value of these other sources of income should be estimated and reflected in the individual’s total assets for ABB purposes.  You may need to use the PV Calculator spreadsheet to determine these present values (using the recommended discount rate).

Social Security benefit:
If you are already receiving your Social Security benefit, enter the annualized amount for the current year.  If this amount is net of Medicare premiums, make sure you treat such expenses consistently.  If you haven’t commenced your Social Security benefit, go to Social Security Quick Calculator to estimate your future benefit.  We recommend that “inflated (future) dollars”, which accounts for inflation, be used in the Social Security calculator for the result to be entered in the ABC.  The Social Security start year entered in the ABC should be the desired year of commencement.  Social Security is complicated.  For more information and an example, see our post of March 26, 2017.

Present Value of Long-Term Care Costs:
As indicated in our posts of January 9, 2016 and January 12, 2016, we recommend an individual or couple, who has no long-term care insurance, consider planning on 2 years of assisted living and 1 year of nursing facility care.

To develop the present value of such costs, determine the approximate current cost of such stays at nearby acceptable facilities.  Assume future cost increases (perhaps inflation + 1%) and discount the result by the assumed discount rate (using the PV Calculator spreadsheet), where these costs are assumed to be needed 3 years before the end of LPP.  Because such stays will generally reduce normal recurring spending budgets, we believe multiplying the result by approximately 60% (and not changing the LPP) will produce a reasonable estimate of the additional present value of costs associated with long-term care.

For ABB purposes, this present value may be further reduced or eliminated if the retiree has purchased sufficient long-term care insurance.

Present Value Unexpected Expenses & Other Non-Recurring Expenses:
Not all expenses will be recurring expenses.  Adequate reserves should be developed for unexpected expenses and expected but non-recurring items such as car repairs, new cars, home repairs, replacement of broken appliances or remodeling.  This category can also be a home for rainy day fund used to mitigate future spending budgets variations.  For ABB purposes, we recommend a present value equal to at least 6 months expected essential expenses be assumed.

Desired Estate at End of Lifetime Planning Period:
The amount you want to leave to heirs depends, of course, on your goals, but since we recommend, for ABB purposes, a LPP in excess of life expectancy and establishment of reserves for several types of non-recurring expenses that may not occur, there is a good probability that an individual will die with some excess assets.  Therefore, it may make sense to plan for a desired estate that is somewhat less than desired.  On the other hand, amounts set aside for this purpose can also be used as an emergency rainy day fund.  Note that the amount entered in the ABC for this item is not a present value like other input items.  It is also not a constant real dollar amount, it is a future constant nominal dollar amount.

Discount Rate:
Even though interest rates have increased somewhat since our last review of this assumption last September, we believe that 4% is reasonably consistent with the discount rates used to price insurance company annuities at this time, so is our recommended discount rate.

Inflation:
We continue to believe that a 2% assumption for inflation is reasonable, given the current economic environment and the recommended discount rate assumption for ABB purposes.

Desired increase in future budgets:
Research has shown that some expenses, such as discretionary expenses, may decrease as we age.  For ABB purposes, however, we recommend inputting the same assumption as is used for inflation, 2%.

Lifetime Planning Period:
Lifetime planning period (LPP) is the retirement payout period, which is age at death minus current age.

Since our July 12, 2013 post, we have recommended an LPP equal to:

  • age 95 - current age, or life expectancy if greater
This recommendation was primarily based on mortality tables developed by the Society of Actuaries, based on mortality experience of individuals who purchased annuity contracts.  Last year the Society of Actuaries and American Academy of Actuaries released the Actuaries Longevity Illustrator, which reflects the mortality experience of a larger population.

Therefore, we are changing our recommendation for the LPP input for ABB purposes to be:

  • the number of years shown in the Planning Horizon section of the Actuaries Longevity Illustrator with a 25% chance of survival, based on the age and health information entered.
For some individuals, who may not be in excellent health or are smokers, this will result in an assumed age at death less than 95.  Others, such as currently younger individuals or individuals over age 90, may have longer lifetime planning periods resulting from this assumption recommendation change.

Many individuals understate their period of survival.  For ABB purposes, we recommend that you assume you are in excellent general health unless you have a family background or other information that clearly contradicts this assumption.

Conclusion & Summary

We believe that the Actuarial Budget Benchmark (ABB) can be a useful tool for individuals, couples and their financial planners to keep spending budgets on track.  It is developed by comparing the market value of one’s total assets with the approximate market value of total liabilities, and provides an important comparison point with budgets produced by other approaches.

Our current recommended inputs to be used to calculate the ABB are summarized here:



Assumption/Input Item

Our Recommendation
PV Other Sources of Income
PV of any other income source not considered elsewhere in the workbook
Social Security benefit
If already receiving, enter the annualized amount for current year. Otherwise, go to Social Security Quick Calculator
PV Long-Term Care Costs (net of assumed reduction in recurring expenses)
60% of PV 2 years of assisted living and 1 year of nursing facility care payable at LPP -3 yrs.
PV Unexpected Expenses & Other Non-Recurring Expenses
At least 6 months expected essential expenses
Desired Estate at end of LPP
Desired estate, or a bit less (in future constant nominal dollars)
Discount Rate
4%
Inflation
2%
Desired increase in future budgets
2%
Lifetime Planning Period
Number of years from the Actuaries Longevity Illustrator, with a 25% chance of survival


Note that these recommended assumptions are subject to change as economic conditions change.

As always, we appreciate your suggestions for improving our workbooks or recommended input items for ABB purposes.

Friday, April 28, 2017

Thursday, April 20, 2017

Spending Down Your Assets in Retirement – Finding the “Goldilocks” Solution

Typical spending goals for many retirees include:
  • maximizing spending while living 
  • not running out of accumulated savings 
  • avoiding year-to-year spending volatility 
  • having spending flexibility 
  • not leaving too much to heirs
Achieving these potentially conflicting goals generally involves gradually spending down most of one’s accumulated savings over the individual’s (or couple’s) remaining lifetime.  Helping individuals to accomplish these (and other) goals is our primary objective.  And while retirees understand that their financial plan in retirement may involve spending down most of their accumulated savings, they generally don’t want their assets to be depleted either too rapidly or too slowly, and they also want to achieve the other goals listed above.  In other words, they are looking for that “Goldilocks-just-right” solution.

Asset depletion that occurs too rapidly generally results from spending too much, from unfavorable investment experience or from a combination of the two.  Retirement experts generally refer to the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual's underlying investments as sequence of return risk (SORR).  In his excellent recent article, Dr. Wade Pfau discusses four ways retirees and their financial advisors can manage SORR.  They include:

  1. Spend conservatively 
  2. Maintain spending flexibility 
  3. Reduce volatility (when it matters most) 
  4. Buffer assets – avoid selling at losses
As discussed by Dr. Pfau, addressing SORR generally involves managing one’s spending or one’s investments, and, like most financial decisions, managing SORR involves tradeoffs.  We have talked about SORR mitigation approaches in prior posts and how the Actuarial Approach can be used by retirees and financial advisors to mitigate such risk, but we feel that the concepts are worth repeating, so we will once again tackle them below, this time in the same order suggested by Dr. Pfau.  But, before we do, we want to set the stage by talking about the two generic types of approaches used today to help retirees achieve their spending goals.

Dynamic vs. Static Spending Approaches

In theory, managing SORR is a relatively easy process.  All one must do is adjust spending each year to reflect actual experience.  This is what the actuarially determined spending budget recommended in this website does.  It automatically “marks to market” and tells a retiree how much spending must be increased or decreased to balance the retiree’s assets with her spending “liabilities.”  Because the Actuarial Approach involves a dynamic re-measurement of assets and liabilities each year, it can result in spending volatility if it is used without adjustment and can, therefore, bump up against the “anti-volatility” retiree spending goal discussed above.  See our post of November 17, 2015 for more discussion of dynamic vs. static spending approaches.

By comparison, SORR is much more of an issue with more static spending approaches that decouple spending determination from actual investment experience.  Safe withdrawal rate approaches and stochastic Monte Carlo approaches that imply that there is a 95% probability that a specific level of spending can be achieved (without future adjustment) with a given asset mix are examples of these more static approaches.

Unfortunately, neither a pure dynamic nor a pure static approach is likely to satisfy all of a retiree’s spending goals in retirement.  The Goldilocks solution involves making further adjustments to these approaches to make them work better.  For example, the more dynamic approaches like the Actuarial Approach may require some smoothing of the effects of investment fluctuations from year to year, and, as discussed by Dr. Pfau in his article, the more static approaches may require adjustments in spending or investments.  The optimal solution lies in combining the positive elements of both approaches.

The following sections discuss the four ways Dr. Pfau suggests SORR can be lessened for more static spending strategies and how the Actuarial Approach can be helpful in this regard.

Spend Conservatively

The first step suggested by Dr. Pfau is to spend more conservatively, particularly if significantly invested in risky assets.

We believe the actuarially calculated spending budget developed using our recommended assumptions is a conservative approach for most retirees.  It is based on reasonably conservative estimates of future investment returns (rates consistent with current immediate annuity purchase rates) and longevity (approximately 25% probability level of survival for healthy individuals).  As indicated in our post of March 20 of this year, less conservative spending budgets can be developed by assuming more optimistic future experience, but by doing so, increases the likelihood that future spending budgets may decrease relative to today’s.

Maintain Spending Flexibility


The second key to reducing SORR for more static approaches is the willingness, if necessary, to reduce spending in years following a year of poor investment performance.

Maintaining spending flexibility is a clear strength of the more dynamic Actuarial Approach.  As discussed above and in our post of June 27th of last year, the Actuarial Approach automatically tells you each year how much you need to reduce your spending to maintain the actuarial balance between your new (lower) assets and your spending liabilities.  However, this doesn’t mean that you must reduce your spending to this lower actuarially determined level, but it does give you an important “data point” that you can use to mitigate your SORR.  The closer your actual spending is to the new lower actuarially determined budget, the more you have mitigated the SORR, all things being equal.  However, if you have previously established a rainy-day fund (discussed below), you may not need to reduce your spending following a year of poor investment performance.

By the same token, if you experience a good investment year, the Actuarial Approach automatically tells you how much you can increase your spending and still remain in actuarial balance.  Again, however, you aren’t required to increase your spending to this new level.  In this somewhat more pleasant event, some retirees may wish to keep spending unchanged in real dollars and “pocket” some or all of the investment gains in your rainy-day fund to be used in the future to offset future investment losses.

Reduce Volatility

For more static approaches where spending volatility is presumably not as much of an issue, Dr. Pfau discusses reducing portfolio volatility to mitigate SORR as an investment strategy.  Generally, we avoid recommending specific investment strategies since we rapidly wind up in an area outside our field of expertise, but we do want to point out that our Actuarial Budget Calculator workbook can be used to help retirees and their financial advisors quantify the actuarial spending budget implications of increasing or decreasing investment risk in the investment portfolio.  Our 5-year projection tab shows the impact on the actuarially determined spending budget of alternative levels of spending or different investment returns.  For example, this tab could show you the impact on your actuarially determined spending budget of a -40% return on equities (similar to 2008) next year for various asset allocations.  As noted above, there is no requirement that you drop your actual spending to the actuarially determined spending level because of such a negative return, but the more you smooth your spending in such an event, the more you are decreasing your SORR, all things being equal.

Buffer Assets

Dr. Pfau suggests that having other assets available in the year following a poor investment year is another good way to manage SORR.

This suggestion is also one of our favorite approaches to manage spending volatility.  We refer to this strategy as utilizing a rainy-day fund, and we discussed this concept in our post of July 4, 2016.  Under this approach, instead of using gains to increase your spending budget, you bank some or all of the gains in the rainy-day fund to be used to mitigate the effects of future investment losses.

Conclusion

SORR is generally not as significant of an issue with those who use more dynamic spending strategies that periodically adjust for actual investment experience.  It is more of an issue with individuals and their financial advisors who disassociate spending decisions from actual investment performance.  Rather than having faith that such a decoupling approach will work, we suggest that an actuarially determined spending budget be determined each year and that the resulting amount be used as another “data point” in making spending decisions.  We encourage retirees and their financial advisors to use the Actuarial Approach in combination with their more static approaches to periodically check to see just how far off the actuarially balanced track their actual spending and actual investment performance has led them.  Judiciously utilizing the Actuarial Approach in combination with a more static approach may just provide the necessary adjustments that will enable retirees to find their Goldilocks solution.

Thursday, April 13, 2017

Safe Withdrawal Rates—The Good News Bad News Story

This good news bad news story was inspired by Dr. David Blanchett’s recent article in the Journal of Financial Planning entitled, “The Impact of Guaranteed Income and Dynamic Withdrawals on Safe Initial Withdrawal Rates.”  Dr. Blanchett is head of retirement research at Morningstar Investment Management and is one of the leading retirement researchers in the country.

You want the good news first?  The good news is that Dr. Blanchett’s latest research shows that retirees:

  • with a larger percentage of their wealth invested in a specific type of guaranteed income, 
  • who are willing to commit to Dr. Blanchett’s complicated dynamic adjustments, 
  • who can achieve higher investment returns, or 
  • who are willing to live with lower probabilities of success
can use higher initial safe withdrawals rates when determining how much they can withdraw from their investment portfolio upon retirement (and subsequently increase this initial amount with inflation thereafter unless they also employ Dr. Blanchett’s dynamic rule adjustments).  We think that the good news in this research is that:
  • it is a mistake to view portfolio withdrawals in isolation from other sources of income (as is the common practice), and 
  • risks retirees face in retirement can be mitigated by investing in guaranteed lifetime income sources and using dynamic rather than static spending strategies.
The bad news in this story, however, is that Dr. Blanchett is even talking about utilizing safe withdrawal strategies with the implication that there are still financial planners out there who continue to use such strategies for their clients.  Since we here at How Much Can You Afford to Spend are not big fans of strategic withdrawal plans (SWPs) in general, and we are definitely not fans of the subset of SWPs known as Safe Withdrawal Rate approaches, we find the phrase “optimal safe withdrawal rates” to be an oxymoron.  Further discussion of why we are so negative about SWPs can be found in our posts of January 12, 2017 and October 27, 2016, and our website is littered with posts almost from its inception in 2010 of why we believe the 4% Rule and its safe withdrawal rate cousins are inferior to the Actuarial Approach.

A Few More Thoughts

As we have discussed in previous posts, in making SWPs work, researchers will generally pair the SWP with lifetime income streams that are paid in constant real dollars.  This is exactly the type of lifetime payment stream that Dr. Blanchett is referring to when he uses the term “guaranteed income.”  It is important to note that Dr. Blanchett would probably not reach the same conclusion if he defined “guaranteed income” as the far more common fixed dollar (constant nominal dollar) stream of payments, because, under this scenario, greater portfolio withdrawals would be needed in later years to provide total constant real dollar spending.  We caution financial advisors and retirees who may be misled by conclusions reached by Dr. Blanchett’s because of how he defines “guaranteed income.”

Dr. Blanchett goes to significant lengths in his article to point out that the methodology he uses in his analysis weights the probability of the retiree household surviving to each age rather than using “some arbitrary fixed period.”  We note, however, that Dr. Blanchett makes a number of significant assumptions in his calculations to simplify his calculations, so we find the implied precision of this one particular assumption to be grossly exaggerated.  And, we tend not to get as excited as Dr. Blanchett (and others) about assuming fixed lifetime planning periods.  We note that, in real life, whether one lives or dies is a binary process, and little pieces of us do not die each year.

While on the subject of implied precision, we will once again tackle the common misperception that, just because a researcher runs 10,000 scenarios using Monte Carlo modeling, that:

  • employs lots of assumptions about future experience, 
  • employs lots of simplifying assumptions about hypothetical retiree sources of income, and 
  • assumes retiree future spending will exactly follow certain sophisticated algorithms each year in the future,
the resulting spending solution will necessarily be more precise or more “optimal” than making best estimate deterministic assumptions about the future each year, and annually adjusting the spending strategy for deviations in actual experience and actual spending that will inevitably occur.  We caution financial advisors and others to be skeptical of optimal strategies that may be based on unrealistic modeling of retiree circumstances or of the future.

Finally, the Society of Actuaries 2012 IAM table(s) are the Individual Annuity Mortality tables, not the Immediate Annuity Mortality table, as stated in the article.

Conclusion

As discussed many times in this website, we think the safe withdrawal rate strategies are deficient in a number of areas, and attempts like Dr. Blanchett’s and others to modify them to make them work better are probably not worth the effort.  We know that you find this hard to believe, but we actually think a better answer lies with the Actuarial Approach we recommend.  And the really good news here is that the Excel workbooks that we provide to help you implement the Actuarial Approach are available for free and are just a click away.

Sunday, April 9, 2017

“The Whole is Greater than the Sum of its Parts”

The above quote, generally credited to Aristotle, is the basis for this post and is reason #73 why we believe you should be using the Actuarial Approach to help you determine your annual spending budget in retirement.  In this post, we will look at various sources of income in retirement and discuss why, for many individuals, using the “holistic” Actuarial Approach is a better way to develop a spending budget than summing your sources of income.

Lifetime Income Sources


There are many sources of income in retirement.  Any asset that can be sold is a potential source of income that can be used to support retiree spending, as of course, are the more traditional streams of future payments.  Retirement experts, however, tend to focus on lifetime income sources.  These are generally streams of payments that are designed to last as long as the retiree (and in some cases, the retiree’s spouse) lives.  These lifetime income sources include “guaranteed” streams of payments and non-guaranteed streams of payments.  These lifetime payment streams may be paid in constant real dollars or in constant nominal dollars. Traditional guaranteed sources of income include payments from Social Security, pensions and life annuity products.  Technically, however, even these guaranteed lifetime payment streams may not be 100% guaranteed. 

Many retirement experts argue that lifetime income sources also include non-guaranteed streams of payments that may be withdrawn from a portfolio of invested assets using a pre-determined withdrawal algorithm.  This source of lifetime income is generally referred to as a systematic (or structured) withdrawal plan (SWP).  There are no guarantees, however, that either the SWP withdrawals will actually last for the retirees’ lifetimes or that future withdrawals will not decrease.  There are numerous SWPs, ranging from approaches that employ simply withdrawing interest and dividends earned on investments, to approaches that consider withdrawing some of the investment portfolio principal.  See our posts of December 21, 2016 and January 12, 2017 for discussion of why SWPs may work well in certain limited situations, but may not work well if the retiree’s total income sources are not expected to be paid linearly in constant real dollars throughout retirement.  This may occur, for example, if:

  • The retiree has lifetime income source(s) that are not indexed to inflation 
  • The retiree has lifetime income source(s) that are not paid for the entire period of retirement, 
  • The retiree has significant non-lifetime income sources (see below), or 
  • The retiree spending goals are not consistent with constant real dollar spending in retirement
Non-lifetime Income Sources

Any expected future single payment or stream of payments, even if not designed to last for a retiree’s lifetime, can also be used to support retiree spending.  These sources can include temporary loan repayments from family members or business associates, temporary part-time employment income, proceeds from future sales of assets, etc.

While lifetime income sources generally pay as long as a retiree lives, the stream of payments may not cover the retiree’s entire period of retirement.  In some cases, payments from these sources may commence long after the individual retires.  Examples of such deferred sources of income are deferring commencement of Social Security benefits and deferred annuities (such as QLACs).

Another significant source of income for many retirees today is home equity.  Home equity can be tapped in several ways, including selling the house, downsizing or taking out a reverse mortgage.  The payments under a reverse mortgage can be structured as a stream of payments to be paid for as long as at least one borrower continues to live in the property, as a stream for a shorter period of time, as a line of credit, or as a single lump sum payment.  Thus, this source of income may not always be a lifetime income source.

When comparing spending strategies, many retirement researchers make simplifying assumptions that individuals have Social Security and maybe one or two other lifetime income sources that are not deferred and, in total, are expected to be received linearly in constant real dollars over a retiree’s lifetime planning period.  They also assume that individuals will determine their annual spending by summing these individual sources of income and will spend exactly this amount each year.  In the next section, we will look at the potential problem with making such simplifying assumptions.

Summing Up Individual Sources of Income to Develop a Spending Budget

The primary problem with summing individual sources of income to determine how much one can spend in a year is that it increases the odds that a retiree’s spending strategy will be inconsistent with the retiree’s spending goals.  While each of us has potentially different spending goals in retirement, typical goals include:

  • Assets should last a lifetime, but retirees generally don’t want to significantly underspend and leave more assets to heirs than desired 
  • Assets should cover essential expenses now and in the future, and desired level of non-essential expenses 
  • Assets should cover non-recurring as well as recurring expenses 
  • Spending budgets should be relatively stable from year to year, and relatively linear over the retiree’s lifetime planning period (but not necessarily linear in constant real dollars).
To successfully accomplish these objectives, a retiree (with possible help from the retiree’s financial advisor) generally needs to consider all sources of retirement income, as well as the expected timing and amounts of such income over the retiree’s lifetime planning period.  The retiree also needs to consider all reasonable future expenses, as well as the timing and amounts of such expected expenses, and compare these expenses with the sources of retirement income.   To do this properly in situations involving nonlinear retirement income sources, the retiree will need to compare the present value of future sources of retirement income with the present value of future expected expenses.  This is exactly what the Actuarial Approach does.

Budgeting and Determining Withdrawals from an Investment Portfolio under the Actuarial Approach

An SWP approach prescribes an algorithm for spreading investment portfolio assets over a retiree’s lifetime and anticipates adding that amount to income from other sources to determine the retiree’s spending budget.  The Actuarial Approach, on the other hand:

  • first develops a spending budget for the current year that is consistent with the retiree’s spending objectives, and 
  • subtracts income from other sources for that year from that spending budget
to determine how much to withdraw from accumulated savings for the year.  In some cases, income from other sources can even exceed the spending budget, resulting in negative withdrawals (or savings).  Under the Actuarial Approach, the primary focus is developing a reasonable spending budget (the whole) and not how that budget is comprised (the sum of the parts).

Conclusion


We at How Much Can You Afford to Spend are big supporters of using lifetime income sources to manage longevity and investment risks.  We are not big fans, however, of SWPs or of summing sources of retirement income to determine a retiree’s spending budget. We believe that developing a reasonable spending budget using the more holistic Actuarial Approach is a better way for you to accomplish your spending goals in retirement.

Thursday, March 30, 2017

What’s in a Name? That Which We Call the Actuarial Approach…

We get questions from readers and “push-back” from retirement experts and others about the name we have chosen for the approach we advocate in this website for helping people make financial decisions.  Some don’t know what “the Actuarial Approach” is and are looking for a definition and some point out that there are many approaches that involve actuarial concepts to varying degrees, and it is presumptuous of us to lay claim to “the” actuarial approach.  This post will discuss:
  • what the approach is, 
  • common misperceptions about it, and 
  • why we call it the Actuarial Approach.
What is the Actuarial Approach?

The Actuarial Approach is the use of basic actuarial principles to accomplish one’s personal financial goals.  For many years, actuaries have been helping sponsors of financial systems accomplish financial goals using basic (or fundamental) actuarial principles (or concepts).  The Actuarial Approach advocated in this website applies many of these same principles to personal financial goals.  These fundamental actuarial concepts include:

  • Making assumptions about the future 
  • Time value of money 
  • Concept of probabilities 
  • Mortality 
  • Use of actuarial present values 
  • Use of a generalized individual model that compares assets with liabilities 
  • Periodic gain/loss adjustment to reflect experience different from assumptions (annual valuations), and 
  • Conservatism
These principles (and others that may not be applicable to a personal financial situation) are conveniently summarized in the 1989 monograph by Charles Trowbridge entitled, Fundamental Concepts of Actuarial Science.  We have included a copy of this monograph in our Other Calculators and Tools section, for those who may be interested in actuarial science.

We believe these tried and tested principles are mathematically superior to the strategic withdrawal plans advocated my many retirement experts and academics.

For additional discussion of the Actuarial Approach, you can read our brief description of the Actuarial Approach.

Common Misperceptions About the Actuarial Approach


We find that there are several misperceptions about the Actuarial Approach and, for the most part, they all stem from the same source: individuals believe the Excel workbooks we provide in our website and our recommended assumptions comprise the Actuarial Approach.  It is important to note that we provide the workbooks and recommended assumptions simply to make it easier for users to apply the following basic actuarial formula, which compares one’s assets with one’s spending liabilities:





This one misunderstanding apparently creates a lot of confusion and misperceptions.  For example, we have been told:
  • Because the Actuarial Approach uses deterministic assumptions, it is not as robust as approaches that use Monte Carlo modeling and stochastic assumptions 
  • Because the assumptions used in the Actuarial Approach are conservative, the results are too conservative 
  • Because the Actuarial Approach uses a fixed lifetime planning period rather than probabilities of death, it is not sophisticated enough 
  • Because it determines spending budgets on a pre-tax basis, it is not useful, etc.
These comments all reflect the same basic misunderstanding about the Actuarial Approach: Just because we make simplifying assumptions (like the ones discussed above) to make the calculations easier in our workbooks, doesn’t mean that these issues necessarily apply to the general Actuarial Approach model.  If you want to make the Actuarial Approach more complicated and theoretically more sophisticated, you can do it and still follow basic actuarial principles.

Why do we call it the Actuarial Approach?

We call it the Actuarial Approach for several reasons:

  • The name is sexier and more concise than “the approach that uses basic actuarial principles to accomplish personal financial goals” 
  • It is consistent with the approach used by actuaries to help sponsors of financial systems accomplish financial goals 
  • We are two pension actuaries who used a similar process for guiding pension plan sponsors 
  • It utilizes more of the basic actuarial principles than almost all the other approaches currently in use.
Summary

Actuaries use basic actuarial principles to help keep many financial security systems sound and sustainable.  These same principles can be used to help individuals achieve financial goals.  We encourage individuals and their financial advisors to consider using these time-tested and proven basic actuarial principles in their financial planning, at a minimum as a supplement to what they are currently using.  To paraphrase Juliet, “That which we call the Actuarial Approach by any other name just makes good financial sense.”