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.