Sunday, August 27, 2017

Front-Loading Your Spending Budget by Treating Travel Expenses as a Non-Recurring Expense

After our last post, we received several questions on what we meant (and what would be involved) when we suggested that retirees might wish to consider treating certain expenses as non-recurring to “front-load” their spending budgets.  This post will present an example that might be helpful in explaining this particular “budget-shaping” approach. 


Mary is a 65-year old with $500,000 in accumulated savings and she is receiving a Social Security benefit of $2,000 per month.  For simplicity purposes, let's assume these are her only two sources of income and her only expected non-recurring expense is $50,000 of unexpected expenses.  Using the Actuarial Budget Calculator for Retirees (ABC) and our recommended assumptions (4% discount rate, 2% inflation, 2% desired increases and 31 years LPP), Mary develops an annual recurring real dollar spending budget of $43,135.  This amount is equal to the present value of her future spending budgets of $1,014,425 divided by the present value of her future years with desired increases of 23.5177.  If all assumptions are realized in the future, Mary expects her spending budget to remain at this level in real dollars throughout her period of retirement. 

Mary has determined that her non-travel essential expenses are about $38,000 per year.  The spending budget that she has developed in the paragraph above therefore only leaves her with about $5,100 as an annual travel budget.  Based on her understanding of the “go-go, slow-go and no-go” stages of retirement, she understands that she may not have the same desire to travel when she becomes older, and she decides to consider “front-loading” her desired travel expenses over a limited period rather than spreading them equally over the remainder of her life.

So, let's assume that Mary decides that she is going to travel until she is 80 (15 years) and she would like to spend $10,000 per year in real dollars for travel each of those 15 years.  Since she does not anticipate traveling every year of her retirement, she treats her traveling expenses as a non-recurring expense rather than one that will last until she dies.  Using our Present Value Calculator spreadsheet, she determines the present value of her future traveling expenses to be $131,397 and enters this amount in the ABC along with the $50,000 present value she has budgeted for unexpected expenses.  This reduces her recurring non-travel budget to $37,547, but her total real-dollar travel and non-travel budgets for this year (and the next 14 years are expected to be $47,547 ($10,000 plus $37,547), or about 10% higher than her initial “non-front-loaded” spending budget.  All things being equal, however, she expects her real dollar total spending budget under this “front-loaded” approach for ages after 79 will only be $37,547 in real dollars, or about 13% less than the non-front-loaded budget.   Since this amount is a little bit more than her expected non-travel essential expenses, she considers this alternative front-loaded budget shaping approach as a possible way to go.  If Mary decided that a travel budget of $10,000 per annum may still not be sufficient to satisfy her desired travel plans, she could look at a higher travel budget and shorter travel period as another alternative. 

The graph below illustrates Mary’s choice, again assuming all assumptions made about the future are exactly realized. 

(click to enlarge)


The graph illustrates the general rule of spending in retirement that we refer to frequently in our blog:  You can spend it now or you (or your heirs) can spend it later.   There is no free lunch.  If you want a higher spending budget in retirement, you either need to increase your assets (for example, Mary could take a part-time job) or you can increase the risk that your spending will decrease in the future in real dollars by front-loading your current spending.

It is also important to note that assumptions made about the future will not be exactly realized.  For example, as you age, your lifetime planning period plus your age may increase (your expected age at death).  All things being equal, an increase in your expected age at death will result in an “actuarial loss” that will decrease your real dollar annual spending budget.  Therefore, it is critical to revisit one’s spending budget annually to reflect actual experience, actual spending and any changes in your desired spending goals.  Things change.  Budgeting your spending should not be a “one and done” process.

Tuesday, August 22, 2017

Are You Over-Estimating Your Future Retirement Spending Needs?

In this post, we will focus on the future estimated spending liabilities (right-hand side) of the Basic Actuarial Equation, which is frequently shown in this website and is advocated by us to develop your spending budget.

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

If you over-estimate your future spending liabilities, you run the risk of underspending today.  If you under-estimate your future spending liabilities, you run the risk of overspending today.  Clearly, the more “conservative” strategy is to over-estimate your future spending liabilities and spend less today.  On the other hand, if you are too conservative, you may be denying yourself the lifestyle you really want to enjoy today and may be unintentionally increasing the amount you ultimately leave to your heirs.  This is perhaps one of the most difficult trade-offs that you (possibly with the help of your financial advisor) will have to face in your financial planning.

We will address this important trade-off first for pre-retirees who may be considering retirement, and then for both pre-retirees and retirees.

Pre-retirees Considering Retirement

Some retirement “experts” tell us that we need to replace 70% - 80% of our pre-retirement gross income to enjoy the same lifestyle after retirement as before.  Other experts tell that we need to accumulate savings of 10 times or more of our pre-retirement gross pay to retire at age 67.  These “rules of thumb” frequently over-state post-retirement spending liabilities, particularly if, just prior to retirement, the individual (or couple) has been:

  • saving significant amounts, 
  • making large mortgage payments, or 
  • making large education payments
Since these types of expenditures are frequently not required throughout the entire period of retirement, it will generally not be required to consider them as recurring expenses to be replaced in retirement.  For this reason, we encourage pre-retirees to compare expected recurring spending budgets in retirement with expected recurring spending (in real dollar terms) just prior to retirement for retirement planning purposes.

The table below shows a distribution of mean spending by age and spending category.  The source of this data was the 2015 Consumer Expenditure Survey (table 1300) prepared by the U.S. Department of Labor Bureau of Labor Statistics.

click to enlarge

The first take-away from this table is that total mean spending decreases with age.  Mean spending (including taxes) for individuals (family units) age 65 - 74 of $54,465 was about 78% of mean spending for those age 55 - 64 ($70,059).

The second take-away from this table is that much of the decrease in mean spending between these two age groups may be explained from spending reductions generally associated with retirement:

  • Reduced FICA taxes 
  • Reduced taxes, and 
  • Reduced work-related expenses, including savings for retirement
This data suggests that a better target for an initial spending budget in retirement will be about 80% - 85% of one’s pre-retirement spending levels, if your goal is to approximately replace your pre-retirement living standards.  Therefore, you may wish to categorize your spending in a manner similar to that shown in the Consumer Expenditure Survey (CES) table for purposes of determining a more reasonable spending target and determining whether you can afford to retire.

The third key point from this table is that spending appears to decrease in real terms as we age after retirement.  This leads us to the next section, which discusses several approaches you can consider (either before or after retirement) to possibly avoid over-estimating your spending needs in retirement, when using the Actuarial Budget Calculator (ABC) or the Actuarial Approach to develop your spending budget.  These approaches are all designed to increase current spending budgets.  You should be aware, however, that increasing current spending budgets may also decrease future spending budgets, all things being equal, so these approaches should be considered more as “Budget Shaping” approaches.

Budget Shaping Approaches to Avoid Over-Estimating Your Spending Needs

Assuming Decreasing Real Dollar Spending

The CES survey data above and data from other surveys suggest that spending does not keep pace with inflation as we age.  While certain types of expenses may remain constant in real dollars, or even increase (like healthcare), total real dollar spending appears to decline with age.  Therefore, when using the ABC to develop your spending budget, you may wish to consider inputting a lower rate for “desired increase in future budgets” than you input for “expected rate of inflation.”

Use a Less Conservative Lifetime Planning Period (LPP)

For the Actuarial Budget Benchmark (ABB), we recommend using a lifetime planning period (LPP) developed using the 25% probability of survival from the Planning Horizon section of the Actuaries Longevity Illustrator assuming excellent health, non-smoker mortality.  If you are aware of health issues (or you are a smoker), you may wish to use average health or a shorter, more realistic, LPP to develop your spending budget.

Treat Certain Expenses as Non-Recurring

Many retirees want to travel and have that as one of their spending goals in retirement.  However, you may not want to travel as much when you are in your 80s as when you first retire.  Rather than plan on the same level of travel each year of your retirement (by spreading these expenses over your entire LPP), you should consider setting up a non-recurring expense reserve for travel that you plan to exhaust over a period shorter than your LPP.  You should consider doing this for other types of expenses that you do not anticipate lasting your entire retirement, such as mortgage payments that you intend to pay off before you die.

Spending After First Spouse Death

If you are married, you should consider what will happen to sources of income and spending after the death of your spouse (assuming you survive).  Some expenses may remain constant and some may be reduced.  We discussed how to adjust assets and spending liabilities to reflect different expected LPPs for married couples in our post of July 4, 2017.  It would not be unreasonable, however, to assume that recurring expenses drop by one-third after the first death.

Assume Lower Non-Recurring Costs

As we have previously discussed, if you are spending the budget determined under the Actuarial Approach and you are increasing your LPP as you age to determine such budget, it is likely that you will die with assets remaining.  As a result, you may be “doubling up” to a certain degree, by inputting a specific level of desired amount remaining at the end of the LPP.  Additionally, you may have other plans for near end of life care so that you may not want to build a large reserve for long-term care.

Use a Higher Discount Rate

If you believe that your investments will consistently achieve higher returns than those inherent in insurance company annuities with no additional risk, you can assume a higher discount rate than we recommend.  Unlike the items mentioned above, however, we are less enthusiastic about this option.


We are fine if you want to be conservative in estimating your future spending needs.  If you are still working, enjoy your job and have no trouble getting out of bed in the morning to go to work, we encourage you to keep working even if you might be able to afford to retire.  As we have indicated in previous posts, we estimate that an individual’s annual recurring retirement spending budget will generally increase by almost 10% for each year additional year of employment.  On the other hand, if you just can’t wait to retire, you might consider some of the Budget Shaping alternatives discussed above, to see if your retirement goals can be accomplished using somewhat more realistic assumptions about future spending needs.

By the way, if you are working and determine that you still can’t afford to retire even after trying some of the approaches above, we encourage you to increase your pre-retirement savings until it hurts.  Doing so has a double benefit.  It simultaneously increases your assets and decreases your post-retirement spending target.
We are also fine if you are already retired and just want to be more conservative in your spending.  We aren’t trying to push anyone to spend more now rather than later.  We are all about encouraging you to develop a reasonable spending budget that considers your specific situation and spending goals.  If you believe your current spending plan is not meeting your goals, however, you may wish to consider one or more of the Budget Shaping approaches discussed above.

Feel free to discuss meeting your spending goals with your financial advisor by applying these approaches, but don’t be terribly surprised if his or her planning software doesn’t handle some of them adequately.  You may also find it difficult to accomplish your spending goals if you use approaches that “cobble together” sources of lifetime income and involve strategic withdrawal plans (SWPs), like the 4% Rule or the Required Minimum Distribution (RMD) approach, as these approaches generally aren’t very flexible.  By comparison, if you are willing to do a little number crunching and are willing to live with the potential consequences of being a little less conservative, the Actuarial Approach can help you tailor your spending plans to better meet your anticipated spending needs and goals.

Happy Budget Shaping!

Tuesday, August 8, 2017

Budgeting to Meet Your Spending Goals in Retirement vs. Cobbling Together Sources of “Lifetime Income”

This post is a follow up to our post of April 9, 2017, The Whole is Greater than the Sum of its Parts (and several other of our previous posts) where we maintained that using the Actuarial Approach advocated in this website is superior to summing up sources of lifetime income (Sum of the Sources) for developing a reasonable spending budget designed to achieve your spending goals in retirement.  This post will include a “real world” example that we believe will demonstrate why it is worthwhile to spend the extra half hour to crunch your numbers using the Actuarial Approach, rather than to rely on a Sum of the Sources approach.

We at How Much Can I Afford to Spend are retired pension actuaries, not insurance company actuaries, academic retirement researchers, financial advisors, or investment advisors.  Our primary mission is to provide you (or your financial advisor) with an actuarial framework that can be used to develop an annual spending budget that reflects your specific situation and your lifetime spending goals.  It is not our mission to:

  • Convince you to buy lifetime income products from insurance companies 
  • Advise you on the best way to invest your assets 
  • Influence public policy to encourage plan sponsors or financial institutions to offer “lifetime income” options from qualified defined contribution plans or IRA’s 
  • Refine existing research relating to retirement, or 
  • Develop the optimal Systematic Withdrawal Plan (SWP) so that withdrawals under such plan may be added to other sources of lifetime income.
We are disappointed that the major actuarial organizations in the U.S. appear to be more focused on advocating the cobbling together of various lifetime income “solutions” (including lifetime income insurance products and SWPs) than advocating the use of basic actuarial principles to help individuals achieve their spending goals.  The American Academy of Actuaries (AAA) actually sponsors a Lifetime Income Initiative which claims, “The Academy has identified lifetime income as a top public policy issue and strongly supports initiatives that will lead to more widespread use of lifetime income options.”

We will be the first to admit that the actuarial calculations required to develop a reasonable spending budget, that reflects your specific situation and that is consistent with your goals, can be somewhat complicated.  For this reason, we have tried to make these calculations a little bit simpler by developing our Actuarial Budget Calculators (ABC).  Sometimes, however, your personal situation may not be adequately handled by the ABC.  In these situations, we recommend that you go back to the basics and apply the Basic Actuarial Equation to develop your spending budget.  The following is an example of such a calculation.


Data and Goals
Bill and Betty are a married couple who have retired and both are in relatively good health.  Bill is age 65 and has already commenced his Social Security benefit.  Betty is age 55.  They have a daughter.  Their financial goals include:

  • Betty would like to maximize her Social Security benefits 
  • Neither would like to become a burden on their daughter 
  • They don’t want to outlive their assets 
  • The would like to earmark $20,000 per year in real dollar spending for the next 20 years for travelling expenses, as they are quite interested in travelling while they are able to do so. 
  • They desire relatively constant real dollar non-travel spending from year to year while they both are alive, with about 2/3rds of such real dollar spending to continue after the death of the first spouse.
  • They plan to use about 1/2 of their existing home equity to finance recurring expenses, leaving the other half to finance expected long-term care costs.  They understand that they may have to downsize or take some other action during retirement to extract home equity assets. 
  • They establish an initial reserve for unexpected non-recurring expenses of $100,000. 
  • They have no desire to establish a separate reserve to fund a bequest motive for their daughter.  They understand that it is likely that some assets will remain for this purpose at the second death of the couple.
Bill’s assets:
  • Bill has commenced his Social Security benefit of $20,000 per annum 
  • Bill has a QLAC (deferred annuity contract) that will pay $20,000 per annum for his life, commencing at age 85
Betty’s assets:
  • Betty estimates (by using the Social Security Quick Calculator) that her Social Security benefit will be about $35,000 per annum if it commences at age 70 
  • Betty has a pension benefit that will pay her $12,000 per annum for her life, commencing at age 65
Joint assets:
  • The couple has combined accumulated savings (pre-tax and post-tax) equal to $1,000,000 
  • The couple estimates that the equity in their home is currently $600,000, with no mortgage.

For present value calculations, Bill, Betty and their financial advisor have selected:

  • 4% annual discount rate 
  • 2% annual rate of inflation 
  • Using the Actuaries Longevity Illustrator and a probability of survival of 25%, they determine that:
o    Bill’s lifetime planning period is 29 years,
o    Betty’s is 42 years, 
o    the expected period at least one of them alive is 42 years and
o    expected period both are alive is 27 years.
  • The couple expects their home equity will increase at 4% per annum, the same rate of annual increase as assumed for their other investments. 
  • The calculations of the present values in the table below can be duplicated using either our ABC (Retiree) or Present Value Calculator spreadsheets.
Actuarial Balance Sheet

Here is Bill and Betty’s Actuarial Balance Sheet

(click to enlarge)

The left-hand side of the Actuarial Balance Sheet shows the present value of Bill and Betty’s assets, and the right-hand side shows the present value of their spending liabilities.  Note that the total of the present value of their assets (the left-hand side) must equal the present value of their spending liabilities (the right-hand side).  The present value of Bill and Betty’s future recurring spending budgets ($1,946,707) is the balancing item that makes the totals equal (balance).

Spending Budgets

The final step in developing Bill and Betty’s first year spending budget is to divide the present value of their future recurring spending budgets shown above ($1,946,707) by the present value of their future years of life, based on the assumption that the spending budgets will increase by inflation of 2% per year until the first death, at which time real dollar spending budgets will be reduced by a third.  The calculation of this present value of future years (27.1890) is discussed in our post of July 4, 2017.  The resulting budget is the sum of:

  • non-travelling recurring spending of $71,599 ($1,946,707 ÷ 27.1890), plus 
  • their travelling budget for the year of $20,000, 
  • for a total spending budget for this year of $91,599.
If all assumptions are realized in the future, Bill and Betty’s spending budget is expected to increase each year with inflation for the first 20 years, after which it would be expected to drop to $71,599 (when their 20-year temporary travelling budget expires) in real dollars until Bill’s expected time of death, at which it would be expected to drop to $47,733 (2/3rds of $71,599) in real dollars.

“Sum of Sources” approach

By comparison, if they had used the “Sum of Sources” approach and used the 4% Rule for their SWP, their initial total spending budget would have been only $60,000 (Bill’s $20,000 Social Security benefit plus 4% of their accumulated savings of $1,000,000).  Of course, when Betty’s Social Security, Betty’s pension and Bill’s QLAC actually kick in, their spending budget under this Sum of Sources approach would be much higher in real dollar terms.  By that time, however, it might be too late for Bill and Betty to enjoy the travelling they so desired.  By using the Actuarial Approach, they increased their initial spending budget by almost 53% and, on an expected basis, satisfied all of their spending goals.

Note that if Bill and Betty’s spending goals included relatively constant real dollar non-travel spending on “essential expenses” (which they estimated to be $45,000 per annum while they are both alive) and declining real dollar spending on non-essential expenses (inflation minus 1% per year), their first-year spending budget could have been increased to $96,091, or about 60% greater than under the Sum of the Sources approach.

Final Words

You only get one attempt at enjoying your retirement.  There is no opportunity for a “do-over.”  This is why we believe it is important for you to spend a little bit more time and use basic actuarial principles to develop a reasonable plan (and spending budget) that is consistent with your spending goals rather than cobbling together sources of lifetime income.

Thursday, August 3, 2017

The American Academy of Actuaries Stumbles on Social Security “Sustainable Solvency”

This week, the American Academy of Actuaries (AAA) released An Actuarial Perspective on the 2017 Social Security Trustees Report.  Their primary recommendations were:
  • “Social Security’s financial soundness should be addressed now”, and
  • “The sooner a solution is implemented to ensure the sustainable solvency of Social Security, the less disruptive the required solution will need to be”
And while these recommendations appear to be non-controversial, this post will discuss the one big problem we have with the AAA’s actuarial perspective as well as several smaller concerns.


In our post of November 23, 2016, we asked the question of why the AAA was painting such a rosy picture of Social Security’s financial problems with its Social Security Game.  In response to our post, we were contacted by the Pension Fellow of the AAA to discuss our concerns about the “Game.”  We suggested some caveat language be added to the Game to avoid potentially misleading the public.  In response, on December 8 of last year the AAA added the following caveat language to the Game:

“The following should be noted when interpreting results from the Social Security Game:

  • The 75-year actuarial balance calculation used in the game does not consider significant revenue shortfalls expected to occur after the end of the 75-year projection period, and thus possible solutions illustrated in this game are generally not sufficient to achieve “sustainable solvency,” a concept discussed in the Trustees Report. 
  • The possible solutions assume immediate adoption of System changes, rather than gradual implementation. If changes to the System are gradually implemented, the required increases in tax revenue or benefit decreases will need to be larger than noted in the game to achieve actuarial balance. 
  • The success of reforms will depend on how well actual future experience compares with the assumptions made by the trustees and the Social Security actuaries. There is no mechanism in current Social Security law to maintain the program’s actuarial balance once it has been achieved. Thus, there can be no guarantee that the System’s long-term problem will be “solved” for any specific length of time by enacting various system changes.”
The Big Problem—Sustainable Solvency

The major problem we have with the recently released AAA actuarial perspective is their call for Congress to adopt a solution that will “ensure the sustainable solvency of Social Security.”  The concept of “Sustainable Solvency” was developed by the Office of the Actuary after the 1983 Amendments to the System in an attempt to correct the serious deficiency in the 75-year actuarial balance calculation discussed in the first caveat bullet above.  While this was a move in the right direction, the name of this concept is potentially misleading, as it conflicts with common language usage and the AAA’s own definitions of “sustainability” and “solvency” included in its Sustainability in American Financial Security Programs White Paper.  The condition of “Sustainable Solvency” developed by the SSA actuaries is based on exact realization of assumptions made today about the next 75 years.  Therefore, the System could meet the conditions for “Sustainable Solvency” this year, but not next year.  As noted in the third caveat bullet above, there exists no mechanism in current Social Security law to maintain actuarial balance (or Sustainable Solvency) over time.  Therefore, a condition of Sustainable Solvency achieved at the time of eventual System reform will not guarantee or “ensure” sustainable solvency for any specific period of time, and the AAA’s call for implementation of a solution “to ensure sustainable solvency of Social Security” is, in our opinion, potentially misleading to the public, Congress and other intended users of the AAA’s Issue Brief.

We would like to see the AAA recommend adoption of mechanisms to maintain the System’s actuarial balance (or the condition of Sustainable Solvency) over time.  Adjustments for experience gains and losses is a fundamental actuarial concept that actuaries generally use to keep financial security systems solvent and sustainable.  We are not sure why the AAA is reluctant to make such a recommendation for Social Security.   However, if it is reluctant to do so, it should, at a minimum, take reasonable steps to make sure the public and Congress appreciate the limitations of not having such mechanisms. 

Smaller Concerns in the Issue Brief

We have several other smaller concerns about this AAA Issue Brief, in no particular order:

Adoption date of reform changes vs. effective date of changes

We believe the Issue Brief could be clearer about the implications of when reform changes are adopted vs. when they become effective.  The longer the delay in the effective date, the more significant the changes needed to achieve actuarial balance or the condition of sustainable solvency as of the reform date.   This is clearly stated in the middle paragraph on page 5 of this year’s Trustee’s Report but not adequately addressed in the AAA Issue Brief.

Giving Baby Boomers adequate time to adjust?

The Issue Brief implies that something should be done to address the Baby Boom bulge at the same time it argues that prompt action will enable affected individuals to modify their plans in response to changes in the System.  It isn’t clear to us how these AAA recommendations would work for Baby Boomers who are close to retirement or who have already retired. 

Significant changes on the horizon—What’s the big deal?

We are now looking at significant reform changes.  For some reason, the AAA wants to tell us that when the System was last amended in 1983, the SSA actuaries knew about the deficiency in the 75-year Actuarial Balance calculation, so “more than 30 years later it should come as no surprise that large and growing actuarial deficits are now projected at the end of the long-range projection period.”  We note that the System went out of close actuarial balance in 1990, just 7 years after adoption of the 1983 Amendments and that no actions have been taken since that time to place the System back into actuarial balance.  We find the Academy’s 30 year reference to be confusing, and the tone of this paragraph is inconsistent with the AAA’s expressed desire to improve public trust in the System. 


It will not be an easy task for Congress to make the significant changes necessary to bring the System into a condition of “Sustainable Solvency.”  And without additional changes in the law to maintain this condition over time, it is unlikely that the condition of sustainable solvency will persist indefinitely.  We believe the public and Congress would be better served by adopting automatic adjustment mechanisms normally found in most financial security systems, but if these mechanisms are not adopted, the public and Congress need to fully understand the limitations of the actuarial term “sustainable solvency.” 

Friday, July 28, 2017

Got “Lumps” in Your Sources of Income or Your Expenses? Smooth Them Out with the Actuarial Approach

Ever notice when you are reading about the best way to spend down your invested assets in retirement how most retirement researchers or retirement experts will demonstrate how well their Systematic Withdrawal Plan (SWP) works by assuming:
  • Sources of retirement income will commence at the same time and will generally only involve Social Security and withdrawals under the SWP 
  • Any other sources of income will commence at the same time, will be paid for life and will generally increase with inflation 
  • Expenses in retirement will be smooth from year to year and will generally increase with inflation 
  • Individuals or couples will develop their annual spending budget by summing their retirement income sources (sum of the sources) each year and will spend exactly this amount every year, and 
  • The family unit’s goal is to have a recurring spending budget (and actual spending) that remains constant in Real Dollars for as long as they live.
For many individuals and couples, these just aren’t realistic assumptions, and application of the expert’s SWP can lead to undesired consequences under more real-world situations.  Amazingly, however, these potential problems don’t seem to stop the retirement researchers from continuing to tout the 4% Rule, the Required Minimum Distribution (RMD) Rule, some variation of these rules or some other rule of thumb SWP as the best way to spend down your assets.  We have previously discussed the potential shortcomings associated with SWPs and “sum-of-the-sources” budgeting if sources of income aren’t “smooth” throughout retirement (most recently in our post of April 9, 2017).  This post will focus on the problems associated with using SWPs that can also occur if expenses in retirement are expected to be “lumpy,” and how the Actuarial Approach can be used to smooth out such lumpy expenses, just as it works to smooth out lumpy sources of income.

How do lumpy expenses affect your annual recurring spending budget?

It is just kind of silly to assume that your expenses are going to remain constant in Real Dollars from year to year.  At some point during your retirement, you or your spouse is going to decide that your house needs a new roof, the kitchen needs to be remodeled, you need one or more new cars, etc.  As the old saying goes, “Expenses Happen.”  And these larger expenses are unlikely to fit into your recurring annual expense budget.  This is why we suggest that you establish reserves for unexpected expenses and other non-recurring expenses (in addition to your reserves for Long-Term Care and bequest motives, and general Rainy Day Funds to dip into if your investments perform poorly).  To the extent that these expenses are covered by reserves for this purpose, there may be no effect on your annual recurring spending budget (although you may have to build the reserves up again for the next unexpected expense, and this could reduce your annual recurring spending budget).

Sometimes these larger expenses, such as home improvements, can be considered as investments that increase (or do not decrease) the total value of your assets.  In this event, the diminution of your accumulated savings may be totally or partially offset by the increase in your home value, and depending on how you plan to use your home to finance your retirement, you may not have to experience a reduction in your annual recurring spending budget by incurring this type of expense.

Other expenses, for which you have established no reserves or that don’t increase the value of some other asset you own, are just large expenses, and you will have to decide whether they are “recurring” or “non-recurring.”  If you can’t (or don’t want to) absorb them entirely in this year’s recurring spending budget), then your assets will be reduced and your next year’s recurring spending budget may be reduced, just as it may be with any asset loss.
You may expect to incur some temporary, but not permanently, expenses over several years.  For example, you may have temporary family loans/support, plans to travel over a defined period of time or remaining mortgage payments when you retire.  As illustrated in the example below, you may wish to establish non-recurring expense reserves for these types of expenses, rather than have them significantly affect short-term and long-term annual recurring spending budgets.

Finally, research has shown that retirees tend to spend less in Real Dollar terms as they age.  If you are comfortable with developing a more “front-loaded” spending budget, you can use the Actuarial Approach to “smoothly” reflect this reality.


Let’s assume we have a retired 65-year old female with:

  • $500,000 in accumulated savings 
  • a Social Security benefit of $20,000 per annum payable immediately 
  • four years left on her home mortgage at $24,000 per annum that she does not want to pay-off early.
For calculation simplicity, let’s also assume that she inputs $0 for
  • bequest motive, 
  • PV Long-Term care costs 
  • PV unexpected expenses

She desires to have constant Real Dollar recurring spending in retirement.  However, she establishes a reserve to pay off her current mortgage of $96,602.

Using the Actuarial Budget Calculator and our recommended assumptions, she determines her annual recurring spending budget for this year to be $37,408.  If all her assumptions about the future are realized, this will be her Real Dollar recurring spending budget for her first year of retirement and for the rest of her life.  If she actually spends this amount plus the $24,000 of mortgage payments from her non-recurring fund, she will spend a total of $61,408.  By comparison, if she used the 4% Rule and didn’t set up a separate mortgage payment reserve, her total spending for her first year would be limited to $40,000, and would be expected to remain at this Real Dollar level throughout her retirement.  In her first year of retirement, however, her non-mortgage spending would only be about $16,000, compared with non-mortgage real dollar spending of $40,000 after her mortgage is paid off.


If you live in the real world where sources of income and expenses may not always follow the simplifying assumptions made by retirement researchers, we encourage you (or your financial advisor) to use the Actuarial Approach to develop a more reasonable recurring spending budget.  Even if your situation is consistent with the assumptions above, we still encourage you to become familiar with and apply our Actuarial Budget Calculators.

Sunday, July 23, 2017

What is an Appropriate Discount Rate for Personal Financial Planning?

In our previous post, we got excited because several financial advisors appeared to be endorsing the use of basic actuarial principles in personal financial planning.  So, we were more than a little bit surprised and pleased when Michael Kitces decided to discuss discount rates, the time value of money and present values in his July 19, 2017 post Choosing An Appropriate Discount Rate For Retirement Planning Strategies, as these concepts are fundamentals of actuarial science and key elements of the Actuarial Approach recommended in this website.  And while we want to encourage financial advisors and others to think more like actuaries, we feel compelled, in this post, to push-back on Mr. Kitces’ advice regarding selection of an appropriate discount rate.

While Mr. Kitces primarily focuses his discussion on selection of a discount rate for the specific purposes of comparing immediate commencement of Social Security vs. delayed commencement’ and electing a pension vs. a lump sum, we believe selection of an appropriate discount rate is critical for many personal financial decisions.  For example, in addition to the two items discussed by Mr. Kitces, we recommend using the Actuarial Approach for items including, but not limited to:

  • Determining assets needed to support aspirational spending (desired spending) 
  • Developing a spending budget based on actual assets 
  • Developing a savings strategy prior to retirement 
  • Determining timing of retirement 
  • Deciding whether to take a part-time job 
  • Deciding whether to purchase an annuity contract
Mr. Kitces’ post tells us how to select the appropriate discount rate.  He says, “the discount rate should be the expected return of the portfolio.”  He goes on to say, “Notably, this means that investors who are more aggressive and have higher expected returns will use a higher discount rate.”  And finally, he notes, “Of course, it’s still important to choose a realistic rate of return for the portfolio as a discount rate.”

Unfortunately, while Mr. Kitces’ advice seems relatively straightforward, we are left to our own devices to define his important terms, “expected return” and “realistic rate of return.” You might infer from his post that if you realistically believe you can earn a 6% real rate of return on your equities, then you should be using the 6% real rate as your discount rate in your personal financial planning.  And while historical asset class returns give us a sense of what we might expect in the future from various asset mixes, there are no guarantees that these historical returns will continue in the future, and higher expected investment returns generally do not come without additional risk.  We believe that consideration of this additional investment risk is an important part of the “appropriate discount rate” determination that should not be ignored.  Mr. Kitces’ advice is potentially inconsistent with the basic financial economic principle that the value of a future stream of payments should be determined by finding a portfolio of assets that matches the benefit stream in amount, timing and probability of payment.

To calculate your Actuarial Budget Benchmark (ABB), we advocate assuming a discount rate that is roughly consistent with the discount rates inherent in current annuity pricing (currently a 4% nominal, or approximately 2% real, discount rate).  This provides you with, for example, a benchmark spending budget based on the assumption that your investable assets are invested in relatively low risk-investments (i.e., you could effectively settle your spending liabilities by purchasing annuities).  We most recently discussed the rationale for this assumption recommendation in our post of July 10, 2017, where we referenced the column What Does Retirement Really Cost? by Dr. Moshe Milesvky, which included these comments on this subject:

"As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column.  Any other answer involves extra risk, possibly invisible to the naked eye.

Don’t get me wrong.  There is nothing wrong with investing aggressively and holding stocks — I have said many times that my portfolio is pretty much 100% equity.  And I absolutely do not “price” my retirement income plans at the long-term expected return from stocks.

In fact, this sort of thinking is precisely the mistake that got the pension fund industry (and many of their actuaries) into big trouble.”

One of the potential problems with using expected rates of return without consideration of risk to develop a discount rate is that individuals (and pension plan clients) can be seduced into investing too aggressively.  As Mr. Kitces suggests, individuals who are more aggressive and have higher expected rates of return can therefore assume higher discount rates and can therefore develop higher spending budgets (or lower pension contributions).  Unfortunately, this desire to have a larger spending budget (or lower pension contributions) can easily lead to poor financial decisions.

Our Actuarial Budget Calculators permit you to enter your “expected return on your portfolio” if you want to develop your spending/savings budget using this assumption (or assumptions other than the ones recommended to develop your ABB).  We recommend, however, that if you do so, you also calculate your ABB with our recommended assumptions and compare it with your more aggressive (or conservative) spending budget to see just how much additional risk you are assuming.  We also suggest that you monitor this ratio over time to see if your spending strategy is becoming relatively more or less aggressive.

The ABB can help you develop an investment and spending strategy (and make other personal financial decisions) with which you are comfortable, based on:

  • Your tolerance for future spending cuts 
  • The proportion of your retirement spending covered by sources outside of your investment portfolio, and 
  • The availability of reserves (such as Rainy Day funds, LTC reserves or flexible bequest motives, for example)
We do agree with Mr. Kitces that if you plan to always be invested in more conservative investments than annuity contracts, you might want to consider using a lower discount rate than those inherent in annuity contracts (or you might also want to consider investing in annuity contracts).

We have previously discussed the important personal financial decisions of whether to defer commencement of Social Security benefits (most recently in our post of November 14, 2016) and whether to elect a lump sum vs. pension (in our post of February 18, 2015).  As noted above, when making these decisions, we believe it is important to consider not only the expected return of an alternative strategy, but also the expected risk associated with the alternative strategy.  Applying basic financial economics principles, you should wind up in the current economic environment with an appropriate discount rate in the 3% - 4% (nominal) neighborhood for these comparisons.

Of course, Mr. Kitces knows that individuals should consider risks associated with alternative strategies, which is why he refers to the benefits of Monte Carlo modeling near the end of his post.  Fortunately, you can also get a good sense for the magnitude of these risks without using Monte Carlo modeling, just by using the Actuarial Approach and basic financial economics principles.

Happy present-valuing from the team at How Much You Can Afford to Spend!

Tuesday, July 18, 2017

McLean Asset Management Endorses Basic Actuarial Principles for Personal Financial Planning

We are thrilled to see that McLean Asset Management Corporation (MAMC) has endorsed the use of basic actuarial principles for personal financial planning.  In his July 14 Retirement Researcher blogpost, Dr. Alex Murguia said “We are really fond of the Funded Ratio because it allows us to provide a numerical picture of your retirement income plan.”  The calculations involved in determining MAMC’s “Funded Ratio” are, for all practical purposes, the same as those required by the Actuarial Approach recommended in this website.  So, if you like MAMC’s Funded Ratio concept, you (or your financial advisor) can use our workbooks to develop your own “numerical picture of your retirement income plan.”

The MAMC “Funded Ratio” is

_________________an individual’s (or couple’s) total assets_________________
total aspirational liabilities
(the present value of spending liabilities based on the individual’s spending goals)

(the present value of spending liabilities based on the individual’s spending goals)

This “Funded Ratio” is to help the individual determine:

  • where he or she stands in meeting financial goals and 
  • how much the individual’s assets would need to be to meet these goals.
This aspirational funded status measurement (or measure of financial wellness) is easily calculated using the Actuarial Approach with the assistance of our Actuarial Budget Calculator (ABC) workbooks.  Our Budget by Expense Type tab in the ABC for Retirees can also be used to estimate the present values of desired essential and non-essential expenses in retirement.

As discussed in our summary Actuarial Approach – Using Basic Actuarial Principles to Accomplish Your Financial Goals, the comparison of one’s assets and liabilities is a “bedrock” actuarial principle.

Principle #1—Comparison of Assets and Spending Liabilities

The Actuarial Approach can be used to:

  • determine the assets needed to support aspirational spending liabilities (desired spending), 
  • develop an annual spending budget based on the existing assets, and 
  • help one make personal financial decisions.
We are pleased that MAMC has discovered the benefits of using basic actuarial principles in personal financial planning, and we encourage you to use these principles to make better financial decisions.  If you are a financial advisor who doesn’t work at MAMC, we encourage you to include these actuarial principles in your consulting toolkit to better meet the needs of your clients.

Monday, July 10, 2017

Now, That’s What I’m Talking About

We recently came across a great Think Advisor column written in 2011 by Dr. Moshe Milevsky that we would like to share with you in this post and encourage you to read.  The column is titled, What Does Retirement Really Cost?  Dr. Milevsky is a Professor of Finance at the Schulich School of Business at York University, Toronto, Canada, and we have discussed his writings in several prior posts.

The obvious reason that we like this particular column so much is because in it Dr. Milevsky advocates using the same basic financial economics principles (annuity based pricing of spending liabilities) that we advocate in our website to develop your Actuarial Budget Benchmark (ABB).  He says:

“As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column. Any other answer involves extra risk, possibly invisible to the naked eye. It is often obscured from view thanks to heroic assumptions hardwired into financial calculators.”

In this column, Dr. Milevsky cautions us to be suspicious about retirement plan strategies (such as those that may be developed using Monte Carlo modeling or safe withdrawal approaches) that appear to offer higher levels of spending at little or no perceived additional risk.

Note that Dr. Milevsky is (and we also are) not recommending that retirees actually go out and purchase annuities, only that they be used to price the cost of retirement.  Combining this pricing concept with basic actuarial principles yields your Actuarial Budget Benchmark (ABB), which provides an indication of potentially how aggressive or how conservative your current proposed spending plan may be.

As discussed in our post of June 27, you can use your ABB to help you develop an investment and spending strategy with which you are comfortable, based on:
  • Your tolerance for future spending cuts 
  • The proportion of your retirement spending covered by sources outside of your investment portfolio, and 
  • The availability of reserves (such as Rainy Day funds, LTC reserves or flexible bequest motives, for example)
For someone with relatively high essential expenses and therefore a lower tolerance for future spending cuts, or who doesn’t have much other income from outside the portfolio or who doesn’t have much in the way of reserves, this may imply more conservative investment and/or spending strategies (i.e., lower ratios of proposed spending for the year to your ABB).  On the other hand, someone with relatively low essential expenses and a higher tolerance for future spending cuts, or someone who has significant amounts of income from outside the portfolio or has significant reserves may be comfortable with more aggressive investment and spending strategies (i.e., a higher ratio of proposed spending for the year to your ABB).