The Actuarial Approach/Process
- Principle #1--Matching Assets and Spending Liabilities
- Principle #2—Annual valuations
- Principle #3—Modeling deviations from assumed experience to mitigate risks
This post will focus on applying the third principle—modeling deviations from assumed experience, a principle graphically described by boxing legend Mike Tyson when asked if he was concerned about Evander Holyfield and his fight plan. Mike’s now famous response was, “Everyone has a plan until they get punched in the mouth.” In this post, we will encourage you to “stress test” your financial plan with some “what if” analysis for the purpose of determining the potential negative implications of being wrong about the assumptions used in your plan, and the actions you may wish to consider now or in the future to mitigate these potential negative implications.
The Assumptions Used in Your Plan Will Be Wrong
As discussed in our post of September 22, 2015, “Retirement Planning in an Uncertain World—Part 2”, there are many possible reasons why forecasts made today will be wrong (deviate from expected results) in the future. These reasons include:
- Differences between actual and assumed investment returns
- Differences between actual and assumed longevity
- Differences between actual and assumed spending
- Differences between actual and assumed sources of income, and
- Differences between actual and assumed rates of inflation
Differences Between Actual and Assumed Longevity
Since our last post included an example of determining a spending budget for John and Mary, we are going to continue that example and start with stress testing their lifetime planning period (LPP) assumptions. You should refer to this previous post for the calculation details. As you may recall from that example, John and Mary went to the Actuaries Longevity Illustrator and the planning horizon section on the results page told them that the 25% chance (or probability) of survival was 29 years for John, 37 years for Mary, 37 years for “either alive” and 26 years for “both alive.” Based on these and other recommended assumptions used for developing their Actuarial Budget Benchmark (ABB), they developed a current year spending budget of $77,893.
The LPP assumptions they used for their plan may turn out to be about right, too long or too short for one or both of them. To stress test the LPP assumptions for the potential impact of being too long, we recommend that John and Mary look at the estimated effect on their spending budget assuming one of the couple (in this example, John) dies immediately. Because John elected a 50% Joint and Survivor form of annuity payment and because he has a $100,000 life insurance policy, Mary would receive $100,000 in proceeds from the insurance policy and would receive $1,300 per month under John’s pension upon John’s assumed demise. Based on her age (60), she would also be eligible for a survivor’s benefit from Social Security equal to 71.5% of John’s ($2,000 per month) benefit, which would be payable until she elected to receive the benefit based on her own Social Security earnings. For this purpose, Mary assumes that she will commence her benefit based on her earnings at age 70 and will receive her survivor’s benefit from John for 10 years. She therefore goes to our Present Value Calculator V 1.1 to determine the present value of $17,160 ($1,430 per month) payable annually for 10 years and increasing by 2% per year. She enters the resulting present value of $157,486 in C (7) of the ABC for Single Retiree workbook together with other relevant data and assumptions to estimate her spending budget assuming John’s immediate demise.
The screen shot below shows the entries Mary makes into the ABC for Single Retirees to develop an estimated spending budget of $53,505, or about 69% of the $77,893 spending budget anticipated for the couple while both alive. This amount is a little bit higher than their desire to have about a 33% decrease in spending upon the first death within the couple, so while Mary wouldn’t be overjoyed if John passed away this year, she is reasonably comfortable with the financial consequences.
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John can also examine what effect on his budget would be if Mary were to pass away this year. The important result of looking at the possibility of earlier than expected deaths is the effect such death could have on the spending budget of the survivor. If, for example, John had not elected a 50% joint and survivor form of annuity and/or did not have a life insurance policy, John’s early demise could have a significantly negative effect on Mary’s spending budget. If that were the case, the couple could mitigate this potential negative impact by deciding to either buy some life insurance protection for John or buy annuity income based on Mary’s life.
John and Mary could also look at the potential implications of living longer than the assumed LPPs they used for planning purposes by re-determining their spending budget assuming even longer LPPs. For example, instead of using the 25% probability of survival from the Actuaries Longevity Illustrator, they could use the LPPs based on a 10% probability and re-determine the additional present values of the benefits payable to Mary after John’s revised age of demise. In this case, the impact on their spending budget would be fairly minimal.
Additional stress testing of the longevity assumptions can also be accomplished by assuming different health assumptions for one or both of the couple, assuming one or both is a smoker or by assuming one or both is X number of years older or younger than their actual age.
Differences Between Actual and Assumed Investment Return and Actual and Assumed Spending
We have provided 5-year projection tabs in our ABC’s for single retirees and post-retirees to enable you to model the approximate impact on your spending budget of deviations from these assumptions. As discussed in the overview tabs of the ABCs for retired and pre-retired couples, if you are a couple, you can use the single versions of the ABC’s to approximately model these variations. Stress testing these assumptions can provide helpful information for developing investment and spending strategies, such as the possibility of establishing a robust Rainy-Day Fund. Given the current equity market, it may be prudent to model the impact on your spending budget of a significant correction in the equity markets in the near future.
Differences Between Actual and Assumed Sources of Income
If a significant portion of your assets is expected to come from one or two sources, you may wish to stress test your assumptions about receiving this income. For example, if you are not yet retired, a significant source of your expected income may be your future expected employment income or your Social Security benefit. Sources of income may also be lost or diminished in the event of death or divorce. Also, many individuals expect to tap into their home equity or other sources to fund their retirement expenses. If the potential loss or diminishment of these sources of income significantly reduces your expected spending, you may wish to consider taking steps to better protect these sources of income through insurance, through alternative investment strategies or you may wish to adjust your spending strategy to be more conservative.
Differences Between Actual and Assumed Inflation
While rates of inflation have been at historical low levels in recent years, it is certainly possible that higher rates may emerge in the future. You may wish to stress test this assumption as well to help you make choices between investments that may or may not be inflation sensitive.
This website encourages you to think like an actuary and use basic actuarial principles in addition to what you are currently doing when it comes to your own personal financial planning. In addition to making assumptions about the future and periodically balancing your assets with your spending liabilities, we encourage you to periodically stress-test important planning assumptions you make so that you can possibly mitigate negative outcomes if actual future experience punches you in the mouth.