Sunday, January 29, 2017

Why the Actuarial Approach Works Even Better

In his January 19 article, “Why this works better than the 4% rule for retirees,” Tom Anderson touts the benefits of using BlackRock’s cost of retirement income (CoRI) index over the 4% Rule for determining how much you will need to retire.  In this post, we point out that if you like the cost-determination concept of BlackRock’s CoRI index for calculating how much you will need to retire, you will like it even better when you use essentially the same cost-determination-concept and the Actuarial Approach to help you calculate how much:
  • you will need to retire, 
  • you will need to save during your pre-retirement period, and 
  • you can afford to spend during your post-retirement period. 
For readers unfamiliar with the CoRI index you can find it here.

BlackRock’s CoRI index and the Actuarial Approach Utilize Essentially the Same Cost-Determination Basis and Spreading Approach

If you use the Actuarial Approach with recommended assumptions and desired increases in future spending budgets equal to the assumed rate of future inflation (i.e., constant real-dollar spending budgets in retirement), you are using approximately the same cost basis (current insurance company annuity pricing) as is anticipated with the CoRI index to spread your adjusted assets (PV of assets minus the PV of future non-recurring expenses) over your expected lifetime planning period after retirement.

This can be illustrated by taking the basic actuarial equation that forms the foundation of this blogsite, and manipulating the terms as we did in our blog post of January 12 of this year, to develop the following equation:

The CoRI index is essentially the same calculation as the PV of future years in retirement, increasing each year by the assumed rate of inflation based on BlackRock’s analysis of current annuity purchase rates.  Here at How Much Can You Afford to Spend in Retirement, we don’t analyze annuity purchase rates every day (like they do at BlackRock) to develop our recommended assumptions, but we do look at them periodically for reasonableness.

The details of the calculations in our Actuarial Budget Calculator (ABC) workbooks are in the PV Calcs tab, where “Present Value of Future Years with Desired Increases” is shown.  This is the present value of future years of retirement used in the equation above, and should be very close to the CoRI index, when you input the recommended assumptions and desired increases equal to inflation into the ABC.  The good folks at BlackRock use somewhat different assumptions for the remaining lifetime planning period after age 65 and use different assumptions for future inflation and the discount rate consistent with life insurance annuity purchase rates, but for spending budgeting purposes, we believe the differences should be fairly insignificant.  The values shown in the ABC workbooks should be somewhat higher since we generally recommend assuming a longer period of retirement.  Since we encourage you to revisit your budget setting process at the beginning of each calendar year, we don’t believe it is necessary to adjust our recommended assumptions unless we become aware of significant changes in life insurance company annuity pricing.

We have no problem if you would rather use BlackRock’s CoRI index in your spending budget calculations if you believe they more accurately represent current insurance company annuity purchase rates.  If you do, however, you will need to solve for the discount rate(s), inflation rate(s) and lifetime planning periods after retirement assumed by BlackRock to develop their CoRI index, so that you can also calculate the present value of your future non-recurring expenses and the present value of IFOS in your budget setting calculations using the equation above.

If you are a big CoRI fan and you think it is time for us to update our recommended assumptions to reflect current insurance company annuity pricing, please let us know and we will review the relevant data and make appropriate changes.