Thursday, January 12, 2017

Another Call for a Paradigm Shift in Retiree Spending Budget Thinking

In our post of October 27 of last year, we called for a paradigm shift in thinking about the use of a strategic withdrawal plan (SWP) in the development of a reasonable spending budget in retirement.  This post was followed by an article in Advisor Perspectives and our post of December 21, where we somewhat facetiously called for attachment of an “Actuaries’ Warning Label” to SWPs.  In these communications, we warned that the Old Paradigm of simply adding the amount determined under an SWP to income from other sources (IFOS) for the current year may not produce a spending budget that is consistent with the retiree’s spending goals.

Old Paradigm:  Take x% of invested assets per SWP and add to IFOS, to get this year’s spending budget.

We apologize to our readers who have already grasped the importance of changing their thinking about SWPs.  Unfortunately, there are still quite a few financial advisors and retirement experts out there who still don’t get it.  Why?  We can only imagine that it is due to a combination of several factors, including:

  • Poor communication skills on our part 
  • Lack of awareness of our call for change 
  • The Old Paradigm is strongly ingrained and some just don’t want to deal with a New Paradigm
Because we feel strongly about this subject, we are going to take another shot in this post at explaining the problems with the Old Paradigm and the benefits of using the New Paradigm.  We are going to do this by manipulating the basic actuarial equation, discussed in this website, to try to make our points clearer to those who are still having trouble grasping the issue.  It is our hope that after reading this post you will come away with two main take-aways:


  1. You shouldn’t just start developing your budget by spreading your current investments over your remaining lifetime using an SWP formula, as suggested by many retirement experts.  Before you develop a spending budget for recurring annual expenses, you need to set aside assets for future expected non-recurring expenses, such as long-term care expenses, unexpected expenses and amounts desired to be left to heirs.  This may involve determining the present values of at least some of these future expenses, and subtracting the results from your current investments.
  2. If you want to develop a recurring spending budget that is consistent with your retirement goals, you should spread the present value of your IFOS over your expected retirement period, and add the result to your SWP amount for the year (or you can simply use the actuarial approach set forth in this website rather than using an SWP approach).
Manipulating the Basic Actuarial Equation to Develop the New Paradigm

The basic equation for personal financial planning in retirement that is the foundation for this website is Equation (1):

where PV IFOS is the present value of your (and your spouse’s) future retirement income from all other sources and includes Social Security income, pension income, annuity income, income from part-time or full-time employment, proceeds from future asset sales, rental income, etc.

We now want to solve this Equation (1) for this year’s spending budget.

Step 1: Subtract PV Future Non-Recurring Expenses from both sides of Equation (1) and re-arrange terms, to get Equation (2):

Step 2: After deciding on the desired rate of increases in future recurring spending budgets (x%), divide both sides of Equation (2) by the present value of $1 payable per year for the expected lifetime planning period and increasing by x% per year (PV future years increasing by x%).  The result can be expressed as Equation (3):

Equation (3) supports the two take-aways discussed above.  The first item on the right-hand side of Equation (3) tells us that we must first reduce the current value of assets by the PV Future Non-Recurring expenses before we spread the net value over the retiree’s expected lifetime.  This is what you want your SWP to do (if you insist on using one).  The second item on the right-hand side of Equation (3) supports the second take-away discussed above.  It tells us that instead of adding the SWP amount to IFOS for the year to develop your spending budget, you should add the SWP amount to the present value of IFOS spread over the future expected lifetime.

When is the Old Paradigm Ok?

Under certain limited circumstances, the Old Paradigm will produce the same answer as the New Paradigm.  To accomplish this, advocates of SWPs will typically assume that:

  1. non-recurring expenses are separately funded elsewhere 
  2. IFOS consists only of immediate Social Security benefits or perhaps of immediate life annuity benefits indexed to inflation, and the retiree desires future spending budgets to be constant in real dollars.
Under these convenient assumptions, the present value of IFOS spread over the retiree’s future lifetime will be equal to the IFOS for the year, and the Old Paradigm will work.

In many instances, however, the two assumptions above necessary to make the SWP approach work will not be consistent with reality.  We can probably work around the first assumption relative to non-recurring expenses, but it isn’t all that easy to work around the second assumption relative to constant IFOS.  For example, my wife is younger than I.  I have started receiving my Social Security benefits and my company-provided pension.  She, however, wants to commence her company-provided pension in 6 years and wants to commence her Social Security benefit in 11 years.  In addition, I have a QLAC (deferred life annuity) scheduled to commence in 18 years.  We clearly don’t have the constant IFOS needed to make the Old Paradigm work well (and even if we did, we might not be happy with the Old Paradigm requirement that future spending budgets to be constant from year to year in real dollars).

But don’t just take our word for it.  Go to the Actuarial Budget Calculator (ABC) for Retirees in this website and develop a spending budget by entering different sources of income and different starting dates for this income.  Then go to either of the runout tabs and look at the expected pattern of future withdrawals from accumulated savings.  You aren’t going to find a “systematic” pattern of withdrawals.

The simple answer for most individuals or couples, who don’t live in a retirement researcher’s artificial bubble, is to avoid SWPs.  Just because the researchers may use Monte Carlo modeling with 10,000 (or more) simulations, to project the future to compare various esoteric SWPs, doesn’t make these SWPs any more relevant to individuals or couples who have several sources of income.  Yes, to get a more reasonable spending budget, we might have to calculate a present value or two.  But, we make that task easier for you (and your financial advisor) with our Actuarial Budget Calculator and Present Value Calculator on this website.

Those individuals and financial advisors who insist on staying with their SWPs, and who set aside sufficient assets for non-recurring expenses, will also need to appropriately adjust IFOS to develop a reasonable spending budget in instances where IFOS is not expected to be constant from year to year.  To add confusion to this issue, it is our understanding that many financial advisors who claim to use SWPs do, in fact, do these adjustments.   It is important to note, however, that if these financial advisors perform these adjustments correctly, withdrawals from current investments (increased or decreased as necessary for the difference between actual IFOS and adjusted IFOS) will not necessarily be equal to the amount determined under the SWP algorithm, so these financial advisors aren’t technically using SWPs and the Old Paradigm.