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.