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.


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.


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).


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.

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.”

Sunday, March 26, 2017

Hey Millennials, How Much of Your Pay Should You Be Saving?

So, you are a Millennial who is employed but hasn’t started to save yet. The “experts” tell you that you need to start saving like yesterday and you need to save as much as possible. This post will walk you through how to use our Actuarial Budget Calculator for pre-retirees so that you (or your financial advisor) can develop a spending/savings budget that will help you accomplish your financial goals. 

In their recent article in the Journal of Financial Planning, “Planning for a More Expensive Retirement,” PH.D.’s Blanchett, Finke and Pfau develop a life cycle model to determine, among other things, savings rates required in a low investment return economic environment to replace hypothetical individual’s pre-retirement standard of living, assuming retirement occurs at various ages.  These gentlemen conclude,

  • “Savings rates would need to rise sharply for households hoping to maintain the same standard of living in retirement if real asset returns are low” 
  • “Advisers may need to modify expected returns in planning software to provide clients with more realistic projections on meeting long-term spending goals.”, and 
  • Advisers using historical asset return data or outdated mortality assumptions may be providing clients with an unrealistically optimistic estimate of either the age at which they can comfortably retire or the amount of savings needed to maintain their current lifestyle.”
In Table 3, the authors’ model shows that if returns remain low, the necessary current savings rate for a single 35-year old making $50,000 per annum with no current savings who wants to retire at age 65 with the same standard of living is 18.1%. This savings rate jumped to 23.66% for an individual currently making $200,000. If retirement is deferred to age 70, however, the savings rates are reduced to “just” 12.74% for the $50,000 individual and 19.76% for the $200,000 individual.

The authors’ model is reasonably complicated and not particularly transparent.  With a little bit of work, however, we were able to use our Actuarial Budget Calculator for Pre-Retirees and our recommended assumptions to come reasonably close to their low investment environment savings rates for hypothetical 35-year old’s currently earning $50,000 and $200,000, respectively. We describe the assumptions and method we used below, so that Millennials and other pre-retirees (or their financial advisors) can duplicate our results and use our workbook to develop their own spending/saving budget based on their own situation and assumptions.

Assumptions and method:
  • No initial accumulated savings (B7) (including no initial 401(k) balance) 
  • Desired number of years until retirement (B 11): 30 years for retirement at age 65 and 35 years for retirement at age 70 
  • No income from other sources except Social Security and company sponsored 401(k) plan that matches employee contributions $.50 for each dollar up to 6% of the employee’s pay.  
  • 401(k) plan matching contributions (B 17): Each hypothetical worker is assumed to contribute at least 6% of pay each year, so the initial match is $1,500 for the $50,000 worker and $6,000 for the $200,000 worker.  Subsequent years matches are assumed to increase at the same rate (B 19) as used for assumed pay increases.  
  • Investment return/discount rate (B 21): 4% per annum (2% real return) 
  • Inflation (B 23): 2% per annum 
  • Lifetime planning period (B 25): 60 years (death at age 95) 
  • Pay increases (B 13): For $50,000 worker: 3% per annum; For $200,000 worker: 3.6% per annum 
  • Present value of unexpected expenses (E 39): For $50,000 worker:  $25,000; For $200,000 worker: $100,000 
  • Present value of Long-term care expenses (E 37): For $50,000 worker: $75,000 or $0; For $200,000 worker: $75,000 
  • Desired amount remaining at end of lifetime planning period (E 35): $0 for both workers 
  • Annual increases in spending budgets after assumed retirement (E 33):  For $50,000 worker: 2% per annum (maintain real dollar purchasing power); For $200,000 worker: 1% per annum (decreasing real dollar purchasing power). 
  • Reduction in expenses on retirement: For $50,000 worker: 15% of gross pay just prior to retirement; For $200,000 worker:  10% of gross pay just prior to retirement.  See below for more discussion of the implications of these assumptions.  
  • Except as noted above, no other non-recurring pre-retirement or post-retirement expenses (such as education expenses, home improvements, etc.) 
  • Social Security benefit at assumed retirement age (E 15): We used the Social Security Online Quick Calculator for this purpose.  We selected amounts to be shown in future dollars and adjusted future earnings where necessary to approximately match our pay increase assumption. For the $50,000 individual, this meant that we used a -.9% adjustment to the default earnings used by the calculator to produce about a 3% per year increase in future earnings. For the $200,000 worker, we entered 2017 earnings of $127,200 with no adjustment to the default increase assumption. The resulting estimated benefits for the $50,000 worker were $52,344 (annual) assuming retirement (and commencement) at age 65 and $86,448 assuming retirement and commencement at age 70. Benefits for the $200,000 worker were $92,232 at age 65 and $153,804 at age 70.  The runout tab of our workbook shows pay in future dollars for the year prior to desired retirement, so that you can approximately match that amount with the pay amount shown for the year prior to assumed retirement in the Quick Calculator. 
  • Social Security start year (E 17): 30 years for retirement at age 65 and 35 years for retirement at age 70 
  • Process used to solve for savings rate needed to replace pre-retirement standard of living (B 15): This is where it gets just a little more complicated.  We had to use a trial and error process to solve for the necessary savings rate that would replace the hypothetical workers’ pre-retirement standard of living because increasing the savings rate decreases the target pre-retirement standard of living. The equation we used for this purpose for the $50,000 individual was:
[(1 – Savings Rate (SR)) - .15] / (1 – SR) = ratio of first year spending budget to final working year spending budget, in real dollars from our workbook (E 60). The .15 factor was our estimate of the proportion of the $50,000 worker’s pre-retirement gross pay represented by FICA taxes, work-related expenses and other factors that we assumed would not need to be replaced after retirement.  We estimated this percentage to be about 10% for the $200,000 worker. Note that this process is more complicated, but more consistent with the concept of replacing one’s pre-retirement standard of living than simply solving for the savings rate that will produce say a 80% ratio in E 60.


The table below shows our workbook results for the two hypothetical 35-year olds based on the assumptions and method above vs. the authors’ results.

(click to enlarge)

While our results are comparable, we tend to show a bigger decline in the required savings rate associated with working until age 70, rather than retiring at age 65 than the authors. This may be due to our constantly increasing pay assumptions. 

So how much of your pay should you be saving?

Our Actuarial Budget Calculator gives you a tool to develop a spending/savings budget based on your situation, your assumptions and your financial goals. You may feel that savings rates developed using our workbook and our recommended assumptions are too high because you will earn a higher real rate of return than 2%, you will never retire, you will work part-time after retirement or you will have other sources of income. On the other hand, it is certainly possible that:
  • your estimated Social Security benefit under current law may be reduced in the future (see our post of December 15, 2016),   
  • your employment may cease prior to your desired retirement date, 
  • you may desire a higher standard of living after retirement than before, or 
  • you may have other expenses such as college education costs or home improvements for which you also need to save.  
You will also need to decide whether saving for purchase of a home requires additional saving or whether the value of your home can ultimately be used to meet some of your expenses in retirement. 

Even though our workbook simplifies the calculation process to some degree, this planning and budgeting stuff may seem too complicated to you, too much work or just too painful to consider at this time. We understand that you may not be currently focused on saving for your retirement. It is not too early, however, to develop a financial plan for the future, and we encourage you to consult with a financial advisor or use our ABC for pre-retirees for this purpose. We know that this is a tough task, but we assure you that it can be done.  We just read about a 31-year old who saved over one million dollars in just 5 years.  His motivation for starting to save? He used a retirement calculator that told him he needed $1.25 million to retire. 

Monday, March 20, 2017

You Can Spend It Now or You (or Your Heirs) Can Spend It Later – Part II

When to Spend Your Assets – It’s a Balancing Act

This post is a follow-up to our post of October 24, 2014, which pointed out that determining the right amount to spend each year is a balancing act.  If you spend too much early in your retirement, you may fall short later when you get older.  If you spend too little early in your retirement, you may have more assets than energy when you get older.  If you could only predict exactly:

  • when you will die, 
  • how your investments will perform, and 
  • how your expenses in retirement will change each year,
you could determine exactly how to spread your spending over your remaining lifetime period to best meet your financial objectives.


An example of this balancing act is illustrated in the graph below, which we originally included in our post of December 3, 2014.  This graph shows initial and projected budget amounts (in inflation-adjusted dollars and excluding Social Security benefits) for a 65-year old retiree with $600,000 in accumulated assets.  The budgets were determined using the Actuarial Approach (and recommended smoothing) using two different assumptions for the retirement payout period, what we call the lifetime planning period.  If you know that you will earn 5% per annum, inflation will be 3% per annum and you will live to age 95, you can structure your spending to remain constant each year in real dollars (the straight green line).  On the other hand, if the only thing you don’t know is how long you will live, and you assume that you will live only as long as your life expectancy, your initial spending (red line) will be higher than the green line spending. In the future, however, you will experience actuarial losses each year you survive, and your spending budget will decrease and ultimately decline below the green line as you get older.  We used this graph in 2014 to support our recommendation that retirees, who aren’t aware of a specific health issue that would definitely shorten their expected lifetime, should assume that they live until age 95 or their life expectancy, if greater to avoid these actuarial losses until approximately age 90.
(click to enlarge)

We Must Make Assumptions

Unfortunately, we won’t know the answers to how long we will live, how much our assets will earn or how our expenses will increase each year until we die.  And by then, it will be too late for this information to help us much.  So, we must make assumptions about the future and hope that they are about right.  Equally important, as discussed in our previous post, retirees (and their financial advisors) need to periodically value their assets and spending liabilities to see how actual experience about the future compares with the assumptions previously made about the future.  Actual experience more favorable than assumed (gains) will increase future actuarial spending budgets (determined before application of any smoothing) and actual experience less favorable than assumed (losses) will decrease future actuarially calculated spending budgets.

Experience Gains

As a practical matter, most retirees prefer to err on the “too conservative” side, so that if experience deviates from assumptions, their future actuarial spending budgets are more likely to increase rather than decrease.  For this reason, we recommend using relatively conservative assumptions about the future.  Note, however, that there is nothing in the Actuarial Approach that implies that retirees must actually increase their future spending if future experience does turn out to be more favorable than assumed.  Retirees can always save these “experience gains” in a rainy-day fund.

“Safe” Spending Approaches May Not Be All That Safe

In our experience, spending budgets developed using the Actuarial Approach and our recommended assumptions are generally consistent with initial spending budgets developed using well-designed Monte Carlo models, as many financial advisors are also reasonably conservative and don’t relish the thought of telling their clients that they will need to reduce their spending in the future.  Thus, these financial advisors tend to recommend conservative spending strategies.  Because their spending recommendations are generally communicated with relatively high probabilities of success for the entire lifetime planning period, there is often less discussion about the need for periodic valuations and future adjustments.

We believe it is important for retirees to understand, however, that if they invest a significant portion of their assets in equities and other risky investments, very few spending strategies will be truly “safe” in terms of guaranteeing against future spending decreases.  As we noted in an article included as the second post in our website in 2010:

“[Nobel Laureate William] Sharpe says what's really wrong with the 4% plan is its insistence on fixed spending coupled with investing in a portfolio with variable returns.”

Therefore, most retirees need to be prepared for possible decreases in their spending budgets, in the event their investments earn less than the assumption(s) used to develop their initial spending budget or other experience is less favorable than assumed.  

If you (or your financial advisor) believe our recommended assumptions are too conservative, you don’t have to use them.  By using more optimistic assumptions about the future, however, you must realize that you are increasing the possibility of future spending budget decreases, relative to your desired spending goals, all other things being equal.

Impact of Using More Optimistic Assumptions

The chart below shows the impact on an initial spending budget of using our current recommended assumptions and alternative assumptions for a hypothetical 65-year old male retiree with $800,000 in accumulated savings and a Social Security benefit of $22,000 per year.  Our hypothetical retiree assumes his home equity will cover his long-term care expenses, has budgeted $50,000 for unexpected expenses, and has no bequest motive.  You can check these calculations by using our ABC for Retirees workbook.
(click to enlarge)

The first column, labeled Base Assumptions, uses our current recommended assumptions of:

  • 4% Expected rate of return / discount rate (2% real rate of return), 
  • 2% Expected rate of inflation, 
  • Lifetime planning period (LPP) of (95 - current age = 30), and 
  • Constant real dollar future spending (Desired increase in future budget amounts of 2%)  
Subsequent columns show the effect on the base assumption initial budget of selecting different rates of future spending increases, different real rates of investment return, and different lifetime planning periods.  Note that the dollar and percentage increases may differ for different retiree situations.  Also, note that the dollar and percentage increases may not be additive if two or more different assumption changes are combined.  

Developing different spending budgets under different assumptions provides retirees with additional “data points” to help them make better spending decisions.  For example, our hypothetical retiree may decide that he is comfortable using something closer to his life expectancy (22 years) to determine his spending budget, rather than assuming a 30-year lifetime planning period.  This could be based on a combination of rationales, for example:  

  • he doesn’t need to have constant real dollar spending in retirement, 
  • his parents did not live very long or 
  • he will earn more than a 2% real rate of return on his assets, and those investment gains will counterbalance the potential actuarial losses if he lives too long.  

If you use the Actuarial Approach, changes to your spending budget can either occur by

  • evolution (gradually as actual experience emerges) or 
  • revolution (in the year you change assumptions).  
You can either use the recommended assumptions and increase your future spending budgets as experience gains emerge (assuming they do), or you can use more optimistic assumptions to develop a higher initial spending budget with an increased risk that you will have to reduce your spending budget in the future.  The choice is yours.  The assets that you don’t spend now will be available for you (or your heirs) to spend later.  The ABC for Retirees can provide you with data points to help you with this difficult spending balancing act.

Sunday, March 12, 2017

The Actuarial Approach—Much More Than Just a Measure of Where You Stand Financially

In his post of March 10, Bob French touts the benefits of comparing one’s assets to one’s liabilities to determine where an individual or couple stands financially.  Bob calls this calculation “the funded ratio.”  This is the second recent discussion advocating what is essentially the Actuarial Approach to develop a funded ratio.  See our post of March 5, “Actuarial Approach with a Different Name” for discussion of the “personal funded ratio” proposed by Messrs. Hill and Pittman.

The concept of comparing one’s assets to one’s liabilities is the foundation of the Actuarial Approach advocated in this website.  Readers of this website are quite familiar with the following equation, which we employ frequently:

where items on the left-hand side of the equation equal the individual’s assets and the items on the right-hand side equal the individual’s spending liabilities.

The funded ratio proposed by Messrs. French, Hill and Pittman divide assets by aspirational liabilities (the individual’s spending goals) to help the individual determine where he or she stands in meeting retirement goals and how much the individual’s assets would need to be to meet these goals.  And while this aspirational funded status measurement is easily accomplished under the Actuarial Approach with the assistance of our Actuarial Budget Calculator (ABC) workbooks (by backing into how much assets are required to produce the aspirational spending budget), individuals can also use this basic actuarial equation to develop an actuarially calculated spending budget for the current year, by manipulating the above equation, to get:

The denominator of the item on the right-hand side of this equation is the present value of future years of retirement, with desired increases in future recurring spending budgets of x% per year (similar to the cost of retirement developed in the Blackrock CORI index, as discussed in our post of January 29, 2017).

So, if you like how the Actuarial Approach helps you determine how much assets you will need to fund your aspirational spending liabilities, you will really like how it helps you develop a spending budget, based on the assets you actually have.

Thursday, March 9, 2017

The Consequences of Overestimating Retirement Expenses

This week, Advisor Perspectives published our article, The Consequences of Overestimating Retirement Expenses.  The article discusses some of the weaknesses of using traditional planning approaches that target constant real dollar spending for a retiree’s entire planning period.  It also discusses how these weaknesses can be addressed using the Actuarial Approach advocated in this website.  We provide an example for a hypothetical couple that uses our Actuarial Budget Calculator (Retirees) workbook. 

Sunday, March 5, 2017

Actuarial Approach with a Different Name

In their article, “Rethinking Retirement Liability,” authors Russ Hill and Sam Pittman introduce us to a financial planning technique that they call the “personal funded ratio.”  From what we can tell from the article, this technique is nearly identical to the Actuarial Approach we advocate in this website, where a retiree’s total assets are compared with her total liabilities (the authors prefer the terms “resources” and “claims”). 

It’s nice to read from these gentlemen what we have been saying in this website for a long time: 

“We believe the personal funded ratio [Actuarial Approach], a technique adapted from the world of defined benefit pension plans, can serve as a valuable addition to the financial advisor’s tool kit and provide a useful gauge for clients to understand how they can pursue their lifestyles both before and during retirement.”

Thursday, February 23, 2017

The Actuarial Approach and the Importance of Ongoing Financial Planning

Many financial advisors utilize Monte Carlo analysis (MCA) to help their clients develop financial plans in retirement.  We have written in the past about the potential problems of using MCA, and frankly we are not big fans of relying on it exclusively.  The Actuarial Approach that we advocate utilizes transparent deterministic assumptions and anticipates ongoing (generally annual) valuations of a retiree’s assets and liabilities to help keep a retiree’s spending on track throughout retirement.  Because it does not use MCA and appears to be more volatile than the approach they use, the Actuarial Approach is looked upon by many academics and financial advisors as somehow inferior. This post will once again:
  • attempt to defend the approach we advocate as just as good, if not better than MCA, and 
  • encourage individuals and their financial advisors to consider using the Actuarial Approach for financial planning, at a minimum as another data point to be considered in the spending decision process.
The inspiration for this post was a recent Michael Kitces’ blog post written by Derek Tharp, which set forth steps financial advisors can take to avoid having their clients misinterpret their MCAs.  We agree with Mr. Tharp that there are several potential problems with MCAs and some of these problems can be mitigated if financial advisors:
  • stress that “Clients should understand planning is not a one-time occurrence”, 
  • “Emphasize the importance of ongoing planning”, and 
  • “Present information in more than one way.”

We believe financial planning is a process that benefits from periodic attention.  As pension actuaries in our former lives, we performed annual actuarial valuations to determine annual contribution ranges for our plan sponsor clients.  Like the process anticipated by the Actuarial Approach, the pension contribution determination process involved periodic measurements of assets and liabilities, along with deterministic assumptions about the future.  We and our clients both knew that the assumptions we made about the future in a pension actuarial valuation would not be exactly realized in subsequent years, and the plan’s future annual contribution ranges would change somewhat from year to year as actual experience emerged.

This pension actuarial process was not then and is not now a “set and forget” process.  We did not, as a general rule, do a MCA with 10,000 simulations of the future, tell our clients that keeping this year’s contribution level and the current asset mix fixed in future years had a 92.3% probability of successfully funding the plan for the indefinite future, and leave it at that.  It was understood that there would be ongoing valuations and changes to keep the plan’s funding on track.  The client also understood that there was considerable contribution flexibility built into the process, as the impact of future experience deviations and changes in assumptions on future contribution ranges could be smoothed to some degree.  It is with this same “deterministic assumption and annual valuation process” background that we approach personal financial planning.

Monte Carlo Analysis

Monte Carlo analysis (or Monte Carlo modeling) attempts to forecast the future based on historical experience.  This is somewhat analogous to trying to drive a car while looking out the back window.  There is an excellent likelihood that future experience won’t be anything like prior experience, and the projection will be inaccurate.  Running 10,000 simulations does not improve one’s ability to forecast the future.  Under MCAs used by many financial advisors, historical real rates of return and probability distributions of returns for various asset classes are assumed to continue.  For the client, MCA is a non-transparent process that requires a fair amount of faith.

To make these projections somewhat more realistic, some financial advisors adjust historical returns to reflect current economic conditions.  Since the primary output of a MCA is a probability of success for a given level of real dollar spending, there is an implication, if the probability of success is high enough, that the resulting spending level is essentially guaranteed and need never be changed. To achieve this result, the analysis assumes not only that historical returns will repeat themselves, but that the client will spend exactly the specified real dollar spending budget each and every year in the future.  Mr. Tharp is correct that clients may be easily mislead by MCAs.  What the clients do know is that MCAs involve lots of sophisticated calculations, so they figure they must be right.

Monte Carlo Analysis vs. the Actuarial Approach

By comparison, the Actuarial Approach (utilizing recommended assumptions) assumes future deterministic investment returns based on current insurance company annuity pricing.  These investment return assumptions are independent of the client’s actual investment strategy.  If the client’s actual future investment returns deviate from this assumed rate, the assumed rate is changed or if actual spending deviates from the spending budget, the client’s future actuarially determined spending budget will increase or decrease accordingly.  This does not imply, however, that the client’s spending must fluctuate from year to year, as the client’s annual spending budget (or actual spending) can be smoothed to some degree.

It has been our experience that an initial spending budget for a retiree who desires a relatively high probably of success under a well-conceived MCA approach that properly recognizes all sources of income and all significant expenses, is generally comparable to the spending budget developed under the Actuarial Approach with recommended assumptions.  In fact, the Actuarial Approach may produce higher initial spending budgets than the MCA approach under these circumstances.  It has also been our experience that initial spending budgets developed using adjusted historical experience and high probabilities of success don’t vary greatly based on the client’s asset mix, as the higher expected returns expected from mixes containing more equities are mostly counterbalanced by the larger amount of risk in such investment portfolios.

While initial spending budgets developed by the two approaches may be comparable under certain circumstances, the Actuarial Approach offers several features that are not generally available under a traditional MCA:

  • It allows one to easily model investment risk and spending risk.  Our workbooks contain a 5-year projection tab that gives the client the opportunity to model the effect on future actuarial spending budgets of deviations in future investment returns and spending.  This type of information can be helpful in developing investment strategy and general financial planning. 
  • It allows one to model different future spending patterns.  Unlike MCAs which typically assume constant real dollar future spending, our workbooks permit the user to assume declining real dollar future spending more consistent with observed spending in retirement.  The budget by expense-type tab in the ABC for Retirees also permits the user to make different increase assumptions for different types of future expected expenses.

Monte Carlo Analysis and the Actuarial Approach Can Work Together

If the MCA properly considers all the client’s assets and future expenses/liabilities, uses reasonable assumptions about the future, and the client is comfortable with a given probability of success and constant real dollar spending in retirement, the MCA approach may produce a reasonable spending budget for the client.  As Mr. Tharp says in his article, however, it is important for clients to recognize that developing a spending budget is not a one-time event and should be revisited periodically.  In addition to reflecting actual investment performance and actual spending, the client’s spending budget may also change over time as the client’s spending goals change.  We believe the data points obtained by applying the Actuarial Approach on an annual basis can:

  1. Be an independent check on the reasonableness of a Monte Carlo analysis, 
  2. Be an important supplement to the data points developed by a MCA in keeping client spending on track and consistent with the client’s financial objectives, and 
  3. Present information in a different way to increase client understanding.
Therefore, we encourage retirees and their financial advisors to periodically compare the spending budgets they develop with their MCAs (or other approaches) with spending budgets under the Actuarial Approach.

We like the way Mr. Tharp thinks, and we look forward to future articles by him.  In a future blog post, we will discuss how Mr. Tharp’s post of February 22 regarding development of spending budgets that are expected to decline in real-dollars as retirees age is yet another advertisement for using the Actuarial Approach. 

Saturday, February 4, 2017

Five Ways to Increase Your Near-Term Spending, Part II

This post is a follow-up to our post of November 30, 2015 in which we talked about ways to increase your near-term spending in retirement.   In that post we discussed:
  1. Finding part-time work or other sources of income 
  2. Deferring commencement of Social Security or purchasing annuities 
  3. Using more aggressive assumptions in your calculations 
  4. Using more aggressive assumptions for non-essential expenses, and 
  5. Simply increasing your budget (or your spending) by x%
We also cautioned our readers that, all things being equal, increasing near-term spending increases the risk of declining real (today’s) dollar spending later in retirement.  In this post, we will focus on a subset of the third approach discussed above; lowering the assumed annual target rate of increase for future spending budgets to increase current spending budgets (or reduce the assets needed to fund a given level of spending). 

Within the past few years, several researchers and retirement experts have observed that retiree spending appears to decline in real dollar terms as individuals age.  We discussed this research and how retirees could use our spreadsheets to anticipate declining real dollar spending in developing their spending budgets in our posts of March 31, 2016, August 20, 2016 and November 4, 2016.  More recently, a retirement expert from the UK, Abraham Okusanya, argued in this article that spending in retirement does not follow a “U-shaped pattern” as previously thought, but rather declines in real dollar terms throughout the entire retirement period.

Considering the growing volume of research showing declining real dollar spending in retirement, several retirement experts have suggested that individuals should consider developing their spending budgets so that they also decline in real terms throughout retirement. For example, Mr. Okusanya implies that, based on spending research in the U.S., it would be ideal to target inflation minus 1% (or more) for purposes of developing future spending budgets in the U.S. 

The retirement experts have concluded that this lower target for future spending means that either near-term spending can be increased or the amount a person needs to save for retirement can be reduced, compared with assuming a constant real dollar future spending target.  The experts are less clear, however, as to exactly how much spending may be increased (or savings decreased) by assuming the lower future spending target.

As with all spending matters, we at How Much Can I Afford to Spend leave decisions of how much you spend in a year up to you and your financial advisor.  We simply provide you with tools that give you data points designed to help you make your spending decisions.  However, unlike the retirement experts, we can easily quantify for you how much your current spending budget will be increased (or your necessary savings decreased) if you assume that your future spending budgets will increase by inflation minus 1% in retirement, rather than by inflation. We determine the relevant percentages by first taking the basic actuarial equation that is the foundation for this website:

and manipulating it to obtain: 

To quantify how much This year’s spending budget will increase by targeting future spending budget increases of inflation minus 1%, rather than inflationary increases, we need to divide PV future years increasing by the assumed rate of inflation by PV future years increasing by inflation minus 1%.  The PV future year values are available in the Present Value Calcs tab of our workbooks. 

Similarly, the reciprocal of this ratio will give us the % decrease of needed savings to produce a desired level of spending.

The table above shows the results under our current recommended assumptions at various ages. So, developing a spending budget at age 65 under these assumptions and further assuming future spending budgets increase by 1% per year, rather than the recommended inflation assumption of 2% per year, would increase the actuarially calculated spending budget by 13.3% (or decrease the adjusted assets needed to provide the desired level of spending assuming retirement at age 65 by 11.8%), all things being equal.

Note that if you are, or your financial advisor is, determining your spending budget by adding the results from a Systematic Withdrawal Plan (SWP) to your income from other sources (including Social Security), it may be somewhat more difficult than as described above to develop a spending budget designed to increase at a rate other than inflation.  As discussed in prior posts, SWPs are not really designed to work well unless Social Security is the only other source of income in retirement and the retiree’s spending objective is to have constant real dollar spending in retirement.

While research may support decreasing real dollar spending in retirement, we encourage our readers to develop their future spending increase assumption (or assumptions) by separately examining expected future increases for the three types of future expenses in our Budget by Expense Type tab in our Actuarial Budget Calculator (ABC) workbooks:

  • Essential non-health expenses 
  • Essential health expenses 
  • Non-essential expenses
Since it is not unreasonable to assume that future essential non-health expenses will increase with inflation and essential health expenses may increase at a faster rate than inflation, you may not be comfortable assuming total future recurring spending budgets will increase at a rate of inflation minus 1% (or more) unless your non-essential expenses are assumed to be a relatively large component of your initial spending budget.