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.”