As discussed many times in this website and in the Workbook Overview tab of our Actuarial Budget Calculator (ABC) for Retirees:
The ABC produces an actuarially determined spending budget that balances a retiree’s current assets with his or her future spending liabilities. This actuarial spending budget can and will increase or decrease from year to year based on many factors, including actual investment performance, actual spending, changes in assumptions used to estimate spending liabilities, etc. There is no requirement to spend the actuarial spending budget each year. A retiree can spend more or less than such budget, can decide to smooth such budget or can decide to smooth actual spending from year to year.
All things being equal, most retirees prefer relatively predictable spending budgets in retirement. On the other hand, most retirees have at least some of their retirement assets invested in risky assets that can fluctuate from year to year. Too much smoothing of spending can subject the retiree to significant sequence of return risk. Not enough smoothing can cause unnecessary and undesirable fluctuations in spending. Several of our readers have asked us for our recommended algorithm for smoothing the actuarially calculated spending budget. While there is no one perfect approach, we like the approach we initially recommended in our post of October 11, 2013 which is an attempt to balance the smoothing characteristics inherent in a “static” safe withdrawal approach with the asset/liability balancing inherent in the “dynamic” actuarial approach.
Recommended Smoothing Algorithm
The recommended smoothing algorithm involves taking the spending budget amount from the previous year, increasing that amount by the desired increase in spending budget for the previous year (relative to actual inflation) and testing that the resulting value is not more than 110% of, and not less than 90% of, the current year’s actuarially determined value. If the previous year’s adjusted value falls within this corridor, that adjusted value becomes the spending budget for the current year. If the previous year’s adjusted value falls above or below the corridor limit, the applicable corridor value is used as the current year’s budget.
For example, consider Sarah, a sample retiree, who wants her spending budgets in retirement to remain relatively constant from year to year, measured in real dollar terms.
Let’s assume her 2016 spending budget was $40,000, while her 2017 Actuarial Spending Budget from the ABC for Retirees workbook is $46,000. She wonders whether she can safely increase her spending budget for 2017 in real dollar terms.
The steps she uses in utilizing the recommended smoothing algorithm are:
A. Increase her 2016 Spending Budget by actual inflation (this is her preliminary 2017 spending budget),
B. Determine the 10% corridor around her 2017 Actuarial Spending Budget,
C. Test where her preliminary 2017 spending budget falls relative to the corridor determined in step B above.
Because the cost-of-living increase for 2017 Social Security benefits is 0.3%, she assumes that the actual cost of living (or inflation) for 2016 for purposes of her calculations is this same 0.3% (https://www.ssa.gov/cola/).
Step A: Sarah’s 2016 spending budget increased by actual inflation is:
$40,000 x (1.003) = $40,120. This is her preliminary 2017 spending budget
Lower end of corridor = 90% of 2017 Actuarial Spending Budget = (.9 x $46,000 = $41,400)
Upper end of corridor = 110% of 2017 Actuarial Spending Budget = 1.1 x $46,000 = $50,600.
Step C: Sarah tests to see whether her preliminary 2017 spending budget falls inside or outside the 10% corridor around her 2017 Actuarial Spending Budget of $46,000. She determines that it is slightly below the lower end of the corridor, so she decides to increase her spending budget for 2017 from the preliminary value of $40,120 to the lower end of the 10% corridor of $41,400.
Note that if Sarah has decided that she wants her future spending budgets to increase by inflation minus 0.5% each year (to front-load her spending in real terms), then strict application of the recommended algorithm would involve calculation of a preliminary 2017 budget equal to $39,920 ($40,000 x .998).