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  It does not limit the focus to assets that may be withdrawn from one’s Accumulated Savings.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 nominal (or future) 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 for a non-smoker with excellent health

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.