Tuesday, June 27, 2017

Using the Actuarial Budget Benchmark (ABB) to Find Your Retirement Spending Comfort Zone

The title of our website is “How Much Can I Afford to Spend in Retirement?”, so quite a few of our posts and articles address the question of whether you might be spending too much or too little in retirement.  For example, just this year:
  • our May 24 post was “Are You Being Too Frugal in Retirement?  The Actuarial Budget Benchmark Can Help You Decide,” 
  • our March 20 post was “You Can Spend It Now or You (or Your Heirs) Can Spend It later, Part II” and 
  • we published an article in Advisor Perspectives that was originally titled, “Give Your Retired Clients Another Data Point Each Year to Help Them Make Better Financial Decisions.”
In this post, we will refer you to a nice Wade Pfau post that approaches this subject from a slightly different angle than we have, but in a way that we believe still supports the use of our recommended approach.

In his post of May 30, 2017 “Taking Portfolio Spending into the Real World for Retirees”, Dr. Pfau lists the following four factors that he believes should be considered when evaluating the trade-off between spending too much (and increasing the risk of undesired cutbacks later in retirement) and not spending enough (to better protect future spending potential):

  • Longevity risk aversion: How fearful are you about outliving your investment portfolio in retirement? This is an emotional characteristic unrelated to whether you may outlive your portfolio in an objective sense. 
  • Reliable income sources: What proportion of your retirement spending is covered through reliable income sources from outside the investment portfolio? 
  • Spending flexibility: Is it possible to reduce portfolio distributions without harming your standard of living in a significant way? 
  • Availability of reserves: What other resources are available that have not been earmarked to manage spending and can be used to cover contingencies?”

Dr. Pfau concludes “For someone who worries about outliving their portfolio, doesn’t have much additional income from outside the portfolio, faces mostly fixed expenses without much room to make cuts, and doesn’t have much in the way of back-up reserves, it may be necessary to plan for a high probability of success. This will imply using a lower stock allocation and a lower spending rate.”

Since we focus on total spending rather than just portfolio spending, we tend to combine the first and third factors listed by Dr. Pfau into the following factor:

  • Spending cut aversion:  What is your risk tolerance for unplanned future real dollar spending cuts?
Whether we look at Dr. Pfau’s four factors or just three factors, we agree with Dr. Pfau’s conclusions with respect to investment and spending strategies:  Depending on the answers to these questions, some retirees may benefit from either more aggressive or more conservative investment strategies and spending strategies.

Which brings us back to the Actuarial Budget Benchmark (ABB).  Annually benchmarking your spending budget against your ABB provides you with a measure of how aggressive your current investment and spending strategy is relative to a relatively low-risk annuity-based pricing strategy.  And while we also agree with Dr. Pfau’s conclusion as it also applies to investment strategies, we will not “wade” into that area, as it is not within our field of expertise.  We do, however, believe that the answers to these questions, in combination with using the ABB, can help retirees find their retirement spending comfort zone.  For an example of how you can find your retirement spending comfort zone, see the example in our recent Advisor Perspectives article.