Sunday, July 23, 2017

What is an Appropriate Discount Rate for Personal Financial Planning?

In our previous post, we got excited because several financial advisors appeared to be endorsing the use of basic actuarial principles in personal financial planning.  So, we were more than a little bit surprised and pleased when Michael Kitces decided to discuss discount rates, the time value of money and present values in his July 19, 2017 post Choosing An Appropriate Discount Rate For Retirement Planning Strategies, as these concepts are fundamentals of actuarial science and key elements of the Actuarial Approach recommended in this website.  And while we want to encourage financial advisors and others to think more like actuaries, we feel compelled, in this post, to push-back on Mr. Kitces’ advice regarding selection of an appropriate discount rate.

While Mr. Kitces primarily focuses his discussion on selection of a discount rate for the specific purposes of comparing immediate commencement of Social Security vs. delayed commencement’ and electing a pension vs. a lump sum, we believe selection of an appropriate discount rate is critical for many personal financial decisions.  For example, in addition to the two items discussed by Mr. Kitces, we recommend using the Actuarial Approach for items including, but not limited to:

  • Determining assets needed to support aspirational spending (desired spending) 
  • Developing a spending budget based on actual assets 
  • Developing a savings strategy prior to retirement 
  • Determining timing of retirement 
  • Deciding whether to take a part-time job 
  • Deciding whether to purchase an annuity contract
Mr. Kitces’ post tells us how to select the appropriate discount rate.  He says, “the discount rate should be the expected return of the portfolio.”  He goes on to say, “Notably, this means that investors who are more aggressive and have higher expected returns will use a higher discount rate.”  And finally, he notes, “Of course, it’s still important to choose a realistic rate of return for the portfolio as a discount rate.”

Unfortunately, while Mr. Kitces’ advice seems relatively straightforward, we are left to our own devices to define his important terms, “expected return” and “realistic rate of return.” You might infer from his post that if you realistically believe you can earn a 6% real rate of return on your equities, then you should be using the 6% real rate as your discount rate in your personal financial planning.  And while historical asset class returns give us a sense of what we might expect in the future from various asset mixes, there are no guarantees that these historical returns will continue in the future, and higher expected investment returns generally do not come without additional risk.  We believe that consideration of this additional investment risk is an important part of the “appropriate discount rate” determination that should not be ignored.  Mr. Kitces’ advice is potentially inconsistent with the basic financial economic principle that the value of a future stream of payments should be determined by finding a portfolio of assets that matches the benefit stream in amount, timing and probability of payment.

To calculate your Actuarial Budget Benchmark (ABB), we advocate assuming a discount rate that is roughly consistent with the discount rates inherent in current annuity pricing (currently a 4% nominal, or approximately 2% real, discount rate).  This provides you with, for example, a benchmark spending budget based on the assumption that your investable assets are invested in relatively low risk-investments (i.e., you could effectively settle your spending liabilities by purchasing annuities).  We most recently discussed the rationale for this assumption recommendation in our post of July 10, 2017, where we referenced the column What Does Retirement Really Cost? by Dr. Moshe Milesvky, which included these comments on this subject:

"As such, the annuity price is effectively the cost of your retirement income plans and the only answer to the question posed in the title of this column.  Any other answer involves extra risk, possibly invisible to the naked eye.

Don’t get me wrong.  There is nothing wrong with investing aggressively and holding stocks — I have said many times that my portfolio is pretty much 100% equity.  And I absolutely do not “price” my retirement income plans at the long-term expected return from stocks.

In fact, this sort of thinking is precisely the mistake that got the pension fund industry (and many of their actuaries) into big trouble.”

One of the potential problems with using expected rates of return without consideration of risk to develop a discount rate is that individuals (and pension plan clients) can be seduced into investing too aggressively.  As Mr. Kitces suggests, individuals who are more aggressive and have higher expected rates of return can therefore assume higher discount rates and can therefore develop higher spending budgets (or lower pension contributions).  Unfortunately, this desire to have a larger spending budget (or lower pension contributions) can easily lead to poor financial decisions.

Our Actuarial Budget Calculators permit you to enter your “expected return on your portfolio” if you want to develop your spending/savings budget using this assumption (or assumptions other than the ones recommended to develop your ABB).  We recommend, however, that if you do so, you also calculate your ABB with our recommended assumptions and compare it with your more aggressive (or conservative) spending budget to see just how much additional risk you are assuming.  We also suggest that you monitor this ratio over time to see if your spending strategy is becoming relatively more or less aggressive.

The ABB can help you develop an investment and spending strategy (and make other personal financial decisions) with which you are comfortable, based on:

  • Your tolerance for future spending cuts 
  • The proportion of your retirement spending covered by sources outside of your investment portfolio, and 
  • The availability of reserves (such as Rainy Day funds, LTC reserves or flexible bequest motives, for example)
We do agree with Mr. Kitces that if you plan to always be invested in more conservative investments than annuity contracts, you might want to consider using a lower discount rate than those inherent in annuity contracts (or you might also want to consider investing in annuity contracts).

We have previously discussed the important personal financial decisions of whether to defer commencement of Social Security benefits (most recently in our post of November 14, 2016) and whether to elect a lump sum vs. pension (in our post of February 18, 2015).  As noted above, when making these decisions, we believe it is important to consider not only the expected return of an alternative strategy, but also the expected risk associated with the alternative strategy.  Applying basic financial economics principles, you should wind up in the current economic environment with an appropriate discount rate in the 3% - 4% (nominal) neighborhood for these comparisons.

Of course, Mr. Kitces knows that individuals should consider risks associated with alternative strategies, which is why he refers to the benefits of Monte Carlo modeling near the end of his post.  Fortunately, you can also get a good sense for the magnitude of these risks without using Monte Carlo modeling, just by using the Actuarial Approach and basic financial economics principles.

Happy present-valuing from the team at How Much You Can Afford to Spend!