Wednesday, May 24, 2017

Are You Being Too Frugal in Retirement? The Actuarial Budget Benchmark Can Help You Decide

You saved for decades for your retirement, and now it is time for you to simultaneously grow and protect your assets, and judiciously spend down your savings.  This process involves making assumptions about how much you will earn on your investments, how long you (and your spouse) will live, and how inflation will affect your future expenses.  Retirement experts tell you to be sure to reserve for long-term expenses, other unexpected expenses, and increasing medical costs.  With all this uncertainty and confusing advice, it is natural for you to be somewhat conservative in your spending.

Overly Cautious?

Now researchers are telling us that many retirees are being “overly cautious” with their investment and spending strategies.  In a recent analysis, “Living Too Frugally?  Economics Sentiment & Spending Among Older Americans,” Matt Fellowes, CEO of United Income, cites data from a University of Michigan study that shows, among other things, “adults become less optimistic about future economic growth and financial health as they age and “perhaps as a reaction to declining financial optimism, the average adult 60 years or older will trim their spending by about 2.5 percent every year, or by about 20 percent over a 10-year period.”

Not only is Mr. Fellowes concerned that this over-cautious behavior could result in retirees missing out on travel, entertainment, and other activities that they could otherwise enjoy, but, according to him, it could also have negative macroeconomic consequences, since “economic negativity among older Americans may limit spending, which would curb economic growth.”  While we won’t go as far as Mr. Fellowes and imply that you might be a “bad American” just because you want to be conservative with your investments or your spending, we will encourage you to try to find the “just right” middle ground between being overly cautious and overly aggressive, if it means being able to do more of the things you want to do in retirement.

How We Can Help

We at How Much Can I Afford to Spend won’t tell you how to invest your assets and, for that matter, we won’t tell you how much of your assets to spend each year, either.   As our name implies, we focus on how much you can afford to spend.   We provide you with Actuarial Budget Calculator (ABC) workbooks and recommended assumptions that you can use to calculate your Actuarial Budget Benchmark (ABB).  The ABB is a conservatively calculated Actuarial Spending Budget, based on your information, that provides a benchmark for determining how aggressive or conservative your spending is.  See our previous two posts for more discussion of the ABB.

If you have adequately reserved for your future non-recurring expenses, such as long-term care costs, unexpected expenses, and bequest motives; and your remaining recurring annual spending budget (or actual annual spending) is significantly less than the ABB, you may just be living too frugally.  And that is just fine with us if it is fine with you.  On the other hand, if you are missing out on trips or other opportunities because you feel you can’t afford them, you should consider increasing your spending budget.  Similarly, if your annual spending budget or your spending significantly exceeds your ABB, you may be spending too aggressively and you may want to cut back somewhat.

We Are Independent and Unbiased

Unlike some others, we aren’t trying to sell you investment services or financial advice.  The focus of our blog is to help individuals, mostly retirees and near-retirees, determine how much they can afford to spend, either before or after retirement.  To do this, we employ basic actuarial and financial economic principles.  We receive no compensation from hits to our website or from any activities associated with the website.  If you like our website, please refer it to your friends.  If you have suggestions for how the website might be improved, please forward your suggestions to us.

Wednesday, May 10, 2017

Introducing Your Actuarial Budget Benchmark (ABB)

We are happy to introduce your Actuarial Budget Benchmark (ABB).  In this post, we will discuss:
  • What it is 
  • How you can calculate it 
  • What some of its benefits are
We are convinced that no matter how you currently develop your spending budget in retirement, calculating your ABB annually and comparing the result with your spending budget for recurring annual expenses will serve you well.  If you are a financial advisor, we believe your clients will benefit from this annual comparison, and you can better assist them by adding this tool to your consulting tool box.

What is Your ABB?

Your Actuarial Budget Benchmark is a relatively transparent annual calculation of your recurring spending budget in retirement based on your spending goals and your data, but based on a specific set of assumptions about the future, that may change each year.  The calculation is designed to approximate the market value of your future spending liabilities.  Under these assumptions, which are consistent with discount rates used in insurance company life annuity pricing, the market value of a retiree’s (or the retired couple’s) assets are annually matched against the market value of spending liabilities to develop a “mark to market” spending budget, or ABB.

The recommended assumptions used in the ABB calculations generate a more conservative market value of spending liabilities than the current cost to settle your spending liabilities through annuity purchases, so therefore result in a lower recurring spending budget.   This is because individuals, who self-insure a portion of their retirement spending, will not be eligible for mortality credits with respect to that portion of their assets, as they would with an insurance annuity, and must therefore assume a longer lifetime planning period.

Your ABB considers your total retirement assets and liabilities, not just withdrawals from your investment portfolio.  It is based on a conservative estimates of future investment performance and lifetime planning period.  It is compared with, or benchmarked against, your pre-tax spending budget for annual recurring expenses, however that may be determined.  If your spending budget (or spending) significantly deviates from the ABB now or in the future, you will probably want to find out why so you can take appropriate actions to keep your spending on track to meet your financial goals.

How Do You Calculate Your ABB?

It is very easy and inexpensive to calculate your ABB.  You simply enter your data and the recommended input assumptions in the Actuarial Budget Calculator (ABC) for Retirees workbook located in this website.  The recommended assumptions and other input items were discussed in our post of May 8, 2017.

This workbook is free, and we repeat here that we receive no compensation of any kind from hits to this website or from any activities associated with this website.  Our advice is therefore unbiased and not motivated by any financial incentives. 

Benefits of Calculating Your ABB

The main purpose of the ABB is to benchmark your recurring spending budget against the ABB.  Is this year’s recurring spending budget about the same, significantly higher or significantly lower than the ABB?  And if your investments do well or really poorly this year, how will this experience affect next year’s comparison?  The ABB can quantify how far off the actuarially balanced “mark to market” track your spending plan has led you, and the amount and direction of spending changes you may need to make over to time to get your spending back on track.

The ABB can also help retirees find the “Goldilocks” solution discussed in our post of April 20, 2017 that balances a retiree’s desires to avoid unnecessary fluctuations in spending and mitigate sequence of return risk.  The ABB can be particularly helpful for retirees and their financial advisors who advocate somewhat static (non-dynamic) spending approaches.

Suppose your spending plan produces a significantly higher spending budget than the ABB this year.  There could be several reasons for this, including:

  • Potentially overly-optimistic assumptions about future investment returns, longevity or inflation 
  • Conscious desire to have declining constant real dollar spending in future years in retirement 
  • Over-smoothing of unfavorable prior investment experience 
  • Under-estimating non-recurring expenses or over-estimating other income sources 
  • Spending budget calculation may over-estimate long-term real spending budget (see post of December 21, 2016.)
And you may be fine with the difference between your spending plan and the ABB this year.  However, if experience significantly deviates from your assumptions during this year, the difference between the two at the end of the year may get out of your comfort zone.  The ABB provides you with important data points that you can use to help you adjust your spending.

And while the ABB is based on fairly conservative assumptions, it is possible that your spending budget might be significantly lower than the ABB.  There could be several reasons for this, including:

  • Potentially overly-pessimistic assumptions about future investment returns, longevity or inflation 
  • Conscious desire to underspend (or save) during retirement or have increasing constant real dollar spending in future years of retirement 
  • Over-smoothing of favorable prior investment experience 
  • Over-estimating non-recurring expenses or under-estimating other income sources 
  • Spending budget calculation may under-estimate long-term real spending budget
And again, this result may be fine, provided it is consistent with your financial objectives and your tolerance for risk.  If it isn’t, the ABB can give you the information you need to get you back on track.

As indicated in our post of April 20, 2017, the ABB can provide you or your financial advisor with the information to help you achieve your many spending goals in retirement.  Even if you use our ABC (Retirees) workbook with different assumptions, or you smooth the results from our workbook from year to year to develop your spending budget, we encourage you to benchmark the result for the year against your ABB for the year to see just how far away from “mark to market” you are.  Doing so gives you another important data point to help you make more informed spending decisions.

Monday, May 8, 2017

Recommended Assumptions & Other Inputs to Develop Your Actuarial Budget Benchmark

This post is a follow-up to our post of April 20, 2017, where we encouraged individuals and their financial advisors to use our workbooks and recommended assumptions to supplement their spending strategies, by developing another data point to be used to keep retiree spending on track and consistent with the individual’s financial goals.  In this post, we will:
  1. Name this specific data point the Actuarial Budget Benchmark (ABB), and 
  2. Summarize our recommended assumptions and other items to be input in our Actuarial Budget Calculator (ABC Retirees) workbook to develop the ABB for a retired individual or couple.
In this post, we will focus mostly on how to use our ABC (Retirees) workbook to calculate your ABB.  Our next post will focus on the benefits of doing so.

Background / Market Value of Spending Liabilities

Readers of this blog are very familiar with the basic actuarial equation below.  This equation balances the present value of an individual’s (or couple’s) total assets with the present value of total spending liabilities.  It does not limit the focus to assets that may be withdrawn from one’s Accumulated Savings.

Accumulated Savings
PV Income from Other Sources
PV Future Non-Recurring Expenses
PV Future Recurring Annual Spending Budgets

To determine the present values used in this equation, any reasonable assumptions may be used.  However, to match the market value of an individual’s assets with the approximate market value of the individual’s spending liabilities, we recommend assuming a discount rate assumption that is approximately equal to the discount rate currently used by insurance companies to price lifetime annuity products.  By using this assumption, we are essentially determining the market value of future spending liabilities as the cost today to purchase annuities that would cover such liabilities.

To make the calculations in the above equation somewhat easier, we have developed Excel workbooks for retirees and pre-retirees.  It has been a while since we have discussed recommended assumptions and other input items for the workbooks, so we thought we would summarize them in this post.  And while these recommended assumptions can also apply to pre-retirees, the ABB concept is primarily intended to apply to retirees. 

Multiple individuals
If you are trying to determine a spending budget for a couple, rather than an individual, you may need to:

  • combine data 
  • run the ABC more than once and combine results, 
  • enter data in an input item that functions best.  For example, if your spouse has a Social Security benefit that will commence at a different point in time than yours, you can enter her Social Security benefit and start date as an indexed annuity. 
  • go back to the basic actuarial equation above and use the PV Calculator spreadsheet in our website.
Recommended Input Items for ABC (Retirees) to Develop the Actuarial Budget Benchmark

Present Value Other Sources of Income:
There can be many other sources of income that may not be otherwise captured as an income source in the ABC.  The most common of these is home equity.  To the extent that these sources can be tapped to cover expenses in retirement, the present value of these other sources of income should be estimated and reflected in the individual’s total assets for ABB purposes.  You may need to use the PV Calculator spreadsheet to determine these present values (using the recommended discount rate).

Social Security benefit:
If you are already receiving your Social Security benefit, enter the annualized amount for the current year.  If this amount is net of Medicare premiums, make sure you treat such expenses consistently.  If you haven’t commenced your Social Security benefit, go to Social Security Quick Calculator to estimate your future benefit.  We recommend that “inflated (future) dollars”, which accounts for inflation, be used in the Social Security calculator for the result to be entered in the ABC.  The Social Security start year entered in the ABC should be the desired year of commencement.  Social Security is complicated.  For more information and an example, see our post of March 26, 2017.

Present Value of Long-Term Care Costs:
As indicated in our posts of January 9, 2016 and January 12, 2016, we recommend an individual or couple, who has no long-term care insurance, consider planning on 2 years of assisted living and 1 year of nursing facility care.

To develop the present value of such costs, determine the approximate current cost of such stays at nearby acceptable facilities.  Assume future cost increases (perhaps inflation + 1%) and discount the result by the assumed discount rate (using the PV Calculator spreadsheet), where these costs are assumed to be needed 3 years before the end of LPP.  Because such stays will generally reduce normal recurring spending budgets, we believe multiplying the result by approximately 60% (and not changing the LPP) will produce a reasonable estimate of the additional present value of costs associated with long-term care.

For ABB purposes, this present value may be further reduced or eliminated if the retiree has purchased sufficient long-term care insurance.

Present Value Unexpected Expenses & Other Non-Recurring Expenses:
Not all expenses will be recurring expenses.  Adequate reserves should be developed for unexpected expenses and expected but non-recurring items such as car repairs, new cars, home repairs, replacement of broken appliances or remodeling.  This category can also be a home for rainy day fund used to mitigate future spending budgets variations.  For ABB purposes, we recommend a present value equal to at least 6 months expected essential expenses be assumed.

Desired Estate at End of Lifetime Planning Period:
The amount you want to leave to heirs depends, of course, on your goals, but since we recommend, for ABB purposes, a LPP in excess of life expectancy and establishment of reserves for several types of non-recurring expenses that may not occur, there is a good probability that an individual will die with some excess assets.  Therefore, it may make sense to plan for a desired estate that is somewhat less than desired.  On the other hand, amounts set aside for this purpose can also be used as an emergency rainy day fund.  Note that the amount entered in the ABC for this item is not a present value like other input items.  It is also not a constant real dollar amount, it is a future constant nominal dollar amount.

Discount Rate:
Even though interest rates have increased somewhat since our last review of this assumption last September, we believe that 4% is reasonably consistent with the discount rates used to price insurance company annuities at this time, so is our recommended discount rate.

We continue to believe that a 2% assumption for inflation is reasonable, given the current economic environment and the recommended discount rate assumption for ABB purposes.

Desired increase in future budgets:
Research has shown that some expenses, such as discretionary expenses, may decrease as we age.  For ABB purposes, however, we recommend inputting the same assumption as is used for inflation, 2%.

Lifetime Planning Period:
Lifetime planning period (LPP) is the retirement payout period, which is age at death minus current age.

Since our July 12, 2013 post, we have recommended an LPP equal to:

  • age 95 - current age, or life expectancy if greater
This recommendation was primarily based on mortality tables developed by the Society of Actuaries, based on mortality experience of individuals who purchased annuity contracts.  Last year the Society of Actuaries and American Academy of Actuaries released the Actuaries Longevity Illustrator, which reflects the mortality experience of a larger population.

Therefore, we are changing our recommendation for the LPP input for ABB purposes to be:

  • the number of years shown in the Planning Horizon section of the Actuaries Longevity Illustrator with a 25% chance of survival, based on the age and health information entered.
For some individuals, who may not be in excellent health or are smokers, this will result in an assumed age at death less than 95.  Others, such as currently younger individuals or individuals over age 90, may have longer lifetime planning periods resulting from this assumption recommendation change.

Many individuals understate their period of survival.  For ABB purposes, we recommend that you assume you are in excellent general health unless you have a family background or other information that clearly contradicts this assumption.

Conclusion & Summary

We believe that the Actuarial Budget Benchmark (ABB) can be a useful tool for individuals, couples and their financial planners to keep spending budgets on track.  It is developed by comparing the market value of one’s total assets with the approximate market value of total liabilities, and provides an important comparison point with budgets produced by other approaches.

Our current recommended inputs to be used to calculate the ABB are summarized here:

Assumption/Input Item

Our Recommendation
PV Other Sources of Income
PV of any other income source not considered elsewhere in the workbook
Social Security benefit
If already receiving, enter the annualized amount for current year. Otherwise, go to Social Security Quick Calculator
PV Long-Term Care Costs (net of assumed reduction in recurring expenses)
60% of PV 2 years of assisted living and 1 year of nursing facility care payable at LPP -3 yrs.
PV Unexpected Expenses & Other Non-Recurring Expenses
At least 6 months expected essential expenses
Desired Estate at end of LPP
Desired estate, or a bit less (in future constant nominal dollars)
Discount Rate
Desired increase in future budgets
Lifetime Planning Period
Number of years from the Actuaries Longevity Illustrator, with a 25% chance of survival

Note that these recommended assumptions are subject to change as economic conditions change.

As always, we appreciate your suggestions for improving our workbooks or recommended input items for ABB purposes.