Monday, December 31, 2018

2018 Year-End Review and 2019 Budget Development - Part II

As part of our ongoing effort to encourage you to think more like an actuary when it comes to your personal finances, this post will recommend that you to perform an actuarial valuation based on your personal data as of January 1, 2019, and prepare an “Actuarial Report” to document your thought process and your planning decisions.  The purposes of this exercise are to:

Thursday, December 20, 2018

2018 Year-End Review and 2019 Budget Development-Part I

At the end of every calendar year, we encourage you to take just a little bit of the time that you might otherwise spend watching college football bowl games and devote it to reviewing your financial situation and developing your spending budget for the next year.  This year, we are going to devote two posts to this process.  In Part I, we are going to discuss year-end planning approaches in general.   In Part II, we will once again encourage you to perform an “actuarial valuation” of your assets and spending liabilities to measure how well you did in 2018 and to develop your 2019 spending budget “data points”.

Tuesday, December 4, 2018

Top 10 Reasons Why the Smoothed Actuarial Budget Benchmark is Superior to IRS RMD for Developing Spending Budgets

Since the name of our website is “How Much Can I Afford to Spend in Retirement,” we frequently receive requests from readers to comment on alternative retirement spending/budget strategies that they read about.  With the release last year of the research report, “Optimizing Retirement Income by Integrating Retirement Plans, IRAs and Home Equity,” there has been much written about using the IRS Required Minimum Distribution (RMD) approach recommended in the report to determine annual amounts to be withdrawn from accumulated savings.  The report was released by the Stanford Center on Longevity (SCL) in collaboration with the Society of Actuaries (SOA) under the direction of Steve Vernon, Joe Tomlinson and Wade Pfau.  Most recently Mr. Vernon discussed the use of the IRS RMD approach in his CBS MoneyWatch article, “An IRS Rule that can aid your retirement income strategy.” 

Tuesday, November 27, 2018

Optimal Equity Allocation?

Since we are retired actuaries and not financial advisors, we don’t advocate any particular investment strategy in this blog.  For example, we don’t tell you how much of your assets should currently be invested in life annuities, bonds, cash equivalents, real estate or equities (particularly in these somewhat turbulent times for investing).  We do, however, provide several tabs in our Actuarial Budget Calculators (ABCs) that you (or your financial advisor) may find useful in developing your investment strategy.  This post will discuss these tabs and how they might be used. 

Tuesday, November 6, 2018

Budgeting for Real-World Situations

This post is a follow-up to our post of March 3, 2018 where we discussed the distinction between Systematic Withdrawal Plans (SWPs) and Sustainable Spending Plans (SSPs).  In that post, we discussed why we believe it is important for you (or your financial advisor) to develop a SSP (and not use a SWP), particularly if your situation differs from the frequently overly-simplified situations assumed by many SWP advocates, academics and other retirement experts.  This post will discuss how the Actuarial Budget Benchmark (ABB) can be used together with our recommended smoothing algorithm to help you develop a robust SSP to properly handle most real-world situations.  We will also present an example to demonstrate how this SSP can work over a ten-year projection period and will encourage you (or your financial advisor) to model what your future spending budgets might be under reasonable assumptions so that you can test your financial plan.

Monday, October 29, 2018

Retired Actuary Comments on Proposed Changes to Actuarial Standard of Practice No.32 (ASOP 32) Applicable to Social Security

Because Social Security benefits are, for most people in the U.S., a major component involved in determining how much they can afford to spend in retirement, we periodically focus on Social Security financing issues in this blog (with apologies to our non-U.S. readers).  Most recently, we addressed some of these issues in our post of June 27, 2018, “A Slightly Different Actuarial Perspective on the 2018 Social Security Trustees’ Report”.

Tuesday, October 23, 2018

It is not “Absurd” to Express Expected Future Healthcare Costs as a Lump Sum Present Value

In his October 17 post, “Getting Real About (Annual) Health Care Costs in Retirement”, Michael Kitces discusses that, while the lump sum present value of expected healthcare costs in retirement may be “scary”, expected healthcare costs can become more manageable (or “plannable”) and less scary, to the average person, when expressed as a stream of annual costs with an equivalent present value.  He states “recognizing that health care costs may be ‘just’ about $5,000/year per person (or $10,000/year for a couple) for 20+ years of retirement is not necessarily as daunting as a $273,000+ lump sum obligation for retiree health care costs!”

Monday, October 15, 2018

ALRIE is a Better Nest Egg to Lifetime Income “Translator”

In his October 10, 2018 article, “Retirement savings:  How to translate your nest egg into monthly income,” Robert Powell suggests two possible ways of expressing accumulated savings as lifetime income.  According to Mr. Powell, the easiest way to do this is to obtain a quote for a single premium immediate annuity (SPIA) as, “Doing so will give you a sense of how much monthly income you would receive for life from an annuity based on the value of your retirement nest egg.” 

Sunday, September 16, 2018

What’s the Plan, Betty and Stan?

Periodically in our blogposts we take the time to remind you that in addition to using the Actuarial Approach to help you develop a reasonable spending budget and keep it on track over time, you can also use it to model deviations from assumed future experience.  As discussed in our post of November 26, 2017, modeling deviations from assumed future experience can be valuable in helping you develop a more robust personal financial plan.  It gives you the opportunity to think about what you would do, for example, if:
  • Your equity investments suffer a significant loss, 
  • Your spouse dies, 
  • Your or your spouses’ health deteriorates rapidly, 
  • Your children need money, 
  • You lose a source of income, or 
  • Your house needs significant repairs

Wednesday, September 12, 2018

Will You Really Need to Generate More Lifetime Income in Retirement Than You Think?

Last week, the Wall Street Journal published an article questioning the fairly common rule of thumb recommended by many retirement experts that individuals need to replace about 70% to 80% of their pre-retirement pay in retirement.  The WSJ article, written by Dan Ariely and Aline Holzwarth, was titled, “How Much Money Will You Really Spend in Retirement?  Probably a Lot More Than You Think.”  For those unable to read the WSJ article, you can read a related article in MarketWatch entitled, Retirement is going to cost a lot more than you think—here’s what to do.  The authors of these articles argue that instead of needing to replace 70% to 80% of pre-retirement pay in accordance with the commonly used rule of thumb, you should be looking at funding income replacement of 130% or more of your pre-retirement pay.  This post will respond to these articles.  In summary, even though we are not particularly big fans of using the 70%-80% of pre-retirement pay rule of thumb, we are even less impressed with the authors’ recommended 130% of final pay rule of thumb.

Wednesday, August 29, 2018

Saving Some of Your Part-Time Employment Income in Retirement for Later

In today’s relatively tight labor market, some employers have been looking to fill employment positions by hiring their retirees on a part-time basis.  The current low unemployment environment presents an opportunity for retirees who either need additional income or who may be disenchanted with full retirement to negotiate a potentially more rewarding and more balanced work relationship with their former employer on a less than full-time basis.  This opportunity was discussed in the New York Times article, “In a Tight Labor Market, Retirees Fill Gaps their Previous Employers Can’t” (subscription may apply). 

Sunday, August 12, 2018

Ten Possible Ways to Increase Your Current Retirement Spending Budget Under the Actuarial Approach

As soon as the ink had dried on our last post, in which we reminded readers that the only real way to guarantee the amount of retirement income you can expect to receive is through the purchase of life annuities, we started receiving feedback that we were being too conservative, and we should be giving equal (or more) time to self-insuring and more aggressive spending strategies.    In response to this feedback, this post will discuss more aggressive spending strategies and ten ways for you to possibly increase your current spending budget using the Actuarial Approach.  

Wednesday, August 8, 2018

There are No Guarantees if You Self-Insure Your Retirement

Periodically, we believe it is important to remind our readers that self-insuring one’s retirement is a risky business and the only real way to guarantee the amount of retirement income one can expect to receive from one’s accumulated savings is through the purchase of life annuities.  We are not necessarily recommending that you should do this (we don’t make investment recommendations); we are simply pointing out that there are risks associated with self-insuring that should be considered when developing your investment/spending strategies for retirement.

Thursday, July 19, 2018

So, How Much Does It Take to “FIRE”?

For every nineteen people who have trouble saving much of anything for retirement, there is one on the other end of the savings spectrum who is almost religious in his or her zeal for saving and retiring early.  And more power to these folks.  As proof that these “hyper savers” actually exist and to learn more about their philosophies, you can visit the Reddit forum called “Financial Independence,” which is closely related to FI/RE (Financial Independence/ Retire Early).  According to the forum (which has almost 400,000 subscribers), “FI/RE is about maximizing your savings rate (through less spending and/or higher income) to achieve FI and have the freedom to RE as fast as possible.”

Wednesday, July 11, 2018

Actuaries Want Plan Sponsors to Provide More Complicated Benefit Statements

In its July 6, 2018 letter to Senator Johnny Isakson, sponsor of the Lifetime Income Disclosure Act, the American Academy of Actuaries (AAA) suggested several “improvements” to Senator Isakson’s act applicable to hard-copy defined contribution plan statements provided to plan participants.  As opposed to the relatively simple and straight-forward requirement proposed by the senator that at least one participant statement per any 12-month period contain “the lifetime income stream equivalent of the total benefits accrued with respect to the participant,” the AAA would like to see plan sponsors provide significantly more information to their participants.  Needless to say, this additional information would make the hard-copy benefit statement required by law much more complicated to prepare and potentially more confusing to participants.

Saturday, June 30, 2018

One More Advantage of Using the Actuarial Approach—No Sequence of Return Risk

Sequence of Return Risk (SORR) is a common retirement planning risk discussed by financial advisors, academics and other retirement experts.  It is the risk of running out (or seriously depleting your) assets by continuing to spend constant amounts from those assets while experiencing an unfavorable sequence of investment returns.  In its unsmoothed form, the Actuarial Approach and Actuarial Budget Benchmark (ABB) advocated in this website is a dynamic approach that will avoid SORR.  It automatically recalculates the annual spending budget to maintain the balance between the market value of the retiree’s assets and the market value of the retirees’ spending liabilities.   As discussed many times in this website, if some other approach is used to develop a spending budget (because of a desire to smooth fluctuations, to establish a rainy day fund or for whatever reason), calculating the ABB annually can still serve as a valuable “data point” in the budget setting process.  At a minimum, it can tell you how much you need to reduce your spending in a down investment market to avoid SORR.    This post is a follow-up to our posts of June 27, 2016 and April 20, 2017, and its intent is to simply demonstrate mathematically why we make the claim that using the Actuarial Approach will avoid SORR. 

Wednesday, June 27, 2018

A Slightly Different Actuarial Perspective on the 2018 Social Security Trustees Report

Every year, the Social Security trustees release a new report discussing the financial status of the system and every year, the American Academy of Actuaries (AAA) releases their “Actuarial Perspective” issue brief explaining the new report.  In an effort to provide our readers a slightly different perspective on the system’s finances, this post will discuss some of the issues we have with the AAA issue brief (and to a lesser degree, with the Trustees’ report).  This post updates our post of August 3 from last year which discussed the 2017 Trustees report/AAA issue brief.  Clearly, our post from last year had very little effect on the AAA, as most of the language in their 2018 Actuarial Perspective remains unchanged from their 2017 issue brief.  Before diving into our issues this year, however, we will attempt to provide just a little background.

Monday, June 25, 2018

Top Ten Reasons Not to Save Now for Retirement

With tongue planted firmly in cheek and with apologies to David Lettermen’s top ten lists, this post will discuss the top ten reasons why you shouldn’t be saving now for your retirement.  Before jumping right into these reasons, however, we are going to attempt to build your excitement level a little by providing a brief background on how retirement finances actually work.

Saturday, June 23, 2018

We Have Updated Our Four Actuarial Budget Calculator (ABC) Workbooks

In our ongoing effort to simplify the present value calculations involved in the Basic Actuarial Equation used to help you develop a reasonable spending budget that is consistent with your financial goals, we have updated our ABC workbooks for:
  • Single Retirees 
  • Single Pre-retirees 
  • Retired Couple 
  • Pre-retired Couple
These Excel workbooks are available for download at no charge from the “Spreadsheets” section of our website.  We encourage you to download one or more of these workbooks and try them out.  Please remember to “Enable Editing” when you open the spreadsheets.

Tuesday, June 19, 2018

Wake Up Millennials: What the Latest Social Security Trustees Report is Telling You

On June 5th, the Social Security Trustees released their annual Trustees Report summarizing the financial status of the system.   In the press release announcing the new report, the Acting Press Officer of the Social Security Administration noted that the expected year of depletion of the system’s trust fund assets (under best estimate assumptions) remained at 2034, the same projected year of depletion as in the previous year’s report.   So, another year goes by and most of us simply shrug at this news and go about our business.

Saturday, June 9, 2018

Expressing Projected Accumulated Savings as Lifetime Retirement Income—Good News for Defined Contribution Plan Sponsors

We are pleased to announce the release of a new workbook—The Actuarial Lifetime Retirement Income Estimator (ALRIE).  Like our other workbooks, this Excel workbook may be downloaded at no charge from the “Spreadsheets” section of our website.   This workbook is a pared-down version of our Actuarial Budget Calculator (ABC) workbooks and is focused on developing an estimate of the amount of real dollar monthly lifetime retirement income (in today's dollars) that may be generated from an individual’s (or couple’s) current and projected accumulated savings.  Unlike the ABC workbooks, it is not intended to help individuals or couples develop a sustainable annual spending budget, but it does employ the same basic actuarial and financial economic principles in its calculations.

Wednesday, May 16, 2018

Actuarial Budget Benchmark (ABB)—A Much More Robust Spending Algorithm

In our post of May 1, we talked about how the ABB differs from Monte Carlo models, and we sort of promised that we weren’t going to talk about this subject again for a while.  Subsequent to our post, our friend Dirk Cotton over at The Retirement Cafe also discussed this subject in his post of May 14, 2018.  Dirk did a very good job of explaining the different uses of these models (better than we did), so if you are still interested in this subject, we encourage you to read Dirk’s post.  We also recommend that you read it just because Dirk said some nice things about the ABB.  Because of our promise, however, we are going to keep this post very brief.

Saturday, May 12, 2018

We Continue to be Baffled by the Two Primary U.S. Actuarial Organizations

One of the nice things about having your own website is that you don’t have to rely on the kindness of strangers to communicate your ideas.  Our mission at How Much Can I Afford to Spend is a simple one:   advocating the use of basic actuarial and financial economics principles to try to help reasonably intelligent numbers people make better financial decisions.  And while we include advice and free workbooks in our website in an attempt to fulfill this mission, we occasionally submit articles to other media to try to reach a larger audience.

Tuesday, May 1, 2018

The Search for Certainty in the Uncertain World of Personal Retirement Financing

This post is a follow-up to our last few posts discussing the pros and cons of stochastic modeling vs. the Actuarial Approach (including deterministic calculation of your Actuarial Budget Benchmark, annual valuations and periodic scenario testing).  Following our friend Dirk Cotton’s post of March 30 and our response post on April 6, we engaged in a number of very thoughtful and informative email discussions with Dirk on this subject, and Dirk added his post of April 23 outlining the limitations of simulations.  The substantive personal financing issues on which we and Dirk agree far outnumber the issues where we may have different viewpoints.  The purpose of this post is to bring this interesting discussion to a close on our end (at least for the time-being).  In order to avoid repeating a lot of what has been discussed in the recent posts, we will:

  • Briefly summarize the stochastic model vs. Actuarial Approach discussion.
  • Encourage you (or your financial advisor) to employ both models (or combine them) to facilitate better (more informed) financial decisions. 
  • discuss new EBRI research and its implications, and
  • attempt to tie these seemingly unrelated topics together.

Monday, April 23, 2018

OK, Retirees, What’s Your Plan for Dealing with the Upcoming Bear Stock Market?

This post is a follow-up to our previous post in which we defended the Actuarial Approach and our deterministic spreadsheets against those who tout the supposed superiority of stochastic models for purposes of financial planning.  In this post we will “drill down” on our concern that results of stochastic models may actual encourage a “set-it-and-forget-it” complacency that could result in either significant over-spending or under-spending as time goes by.  To illustrate this point, we are going to ask you to consider a real-life problem—what is your plan for dealing with the upcoming bear stock market?  We will discuss what the upcoming bear stock market might look like and walk through an example that shows how a hypothetical individual can use the Actuarial Approach and the Actuarial Budget Benchmark (ABB) to help develop a plan for this contingency.  We encourage you to consider performing a similar exercise to help with your planning. 

Upcoming Bear Market

At some point in the future, we are going to experience another bear market.  We don’t know when it will occur, but we feel pretty safe in predicting that it will happen.  As first discussed in our post of June 12, 2015, Greg Morris in StockCharts.com included lots of scary analysis about bear and bull markets in his article, “Bear Markets! Are They a Thing of the Past?”  Using the statistics gleaned from his analysis, Mr. Morris concluded, “if the average bear market lasts about 26 months and it takes an average of 56 months to get back to where it started, that translates into a little over 5 years of going nowhere.”  Note that Mr. Morris’ “going nowhere” conclusion assumes that no withdrawals are being made from the investment portfolio, so it may take a bit longer than five years for a retiree who is withdrawing funds from his or her portfolio during this period to recover from an “average” bear market.  

In addition to not knowing when the next bear market will occur, we have no idea how bearish it might actually be.  But, we are actuaries (retired) and actuaries make assumptions.  Since this a “what if” planning exercise, we are just going to assume 2018/2019 investment equity performance approximately the same as experienced in 2008/2009 in combination with Mr. Morris’ 5-year period of “going nowhere.”  Therefore, we are going to assume equity returns for planning purposes in the example below as follows:

  • 2018:  -40%
  • 2019:  -15%
  • 2020:   15%
  • 2021:   25%
  • 2022:   36%
You should feel free to develop your bear market response plan using different assumptions you believe to be reasonable for your “what if” analysis.  

Example

Mary is a 65-year old single retiree.  She has accumulated savings of $500,000 and is receiving a monthly Social Security benefit of $1,800.  She has reserved $75,000 as the present value of her expected long-term care expenses and $25,000 for unexpected expenses.  She has no reserve for desired amounts to be left to heirs upon her demise and she has no specific Rainy-Day reserve set aside to mitigate future investment losses.  Using our current recommended assumptions (4% discount rate, 2% inflation, 2% desired future budget increases and a 31-year Lifetime Planning Period) and our Actuarial Budget Calculator (ABC) for single retirees, Mary develops an actuarial spending budget for her recurring expenses for 2018 (Actuarial Budget Benchmark or ABB) of $38,608.

Using historical experience (unadjusted for the current relatively high Shiller CAPE index) and a stochastic model, Mary’s financial advisor determines that if Mary invests 50% of her assets in equities and 50% in fixed income securities she has a 90% probability of being able to spend $40,000 per annum in real dollars for the rest of her life. 
Mary likes this and decides that her spending budget for recurring expenses for 2018 will be $40,000.  She determines that this amount is about $5,000 higher than her recurring spending budget for essential expenses ($35,000).  

Mary compares her spending budget of $40,000 with her ABB of $38,608 and determines that she is comfortable with the 4% difference.  She figures that her investment strategy should justify spending a little bit more than the low-investment risk strategy used to develop the ABB.  In future years, her plan is to increase her previous year spending budget by the actual rate of inflation for the previous year to obtain her new year’s spending budget, but she will continue to monitor the relationship between the resulting spending budget and the ABB to see that she doesn’t stray too far off of the actuarially balanced track. 

Because Mary has a little bit of “non-essential” spending room (but not as much as she might like) in her spending budget, Mary decides to do some scenario testing to kick the tires on her spending plan.  While her financial advisor has indicated that her investment/spending strategy has a 90% probability of success, she wonders how her new plan would fare in a bear market similar to that experienced in the U.S. in 2008/2009.  Since she is only 50% invested in equities, she assumes 2% returns on her fixed income securities and annual rebalancing and (using the assumed equity returns shown above) develops the following “actual” investment returns for modeling the next five years:

  • 2018:   -19.0%
  • 2019:    -6.5%
  • 2020:     8.5%
  • 2021:    13.5%
  • 2022:    19.0%

Mary then goes to the 5-year Projection Tab of our ABC for single retirees’ workbook.  She models three alternative spending plans under the above investment return assumptions (and assuming annual inflation of 2%):

  • Spending Plan Alternative #1:  Spending budget starts at $40,000 and is increased each year by inflation 
  • Spending Plan Alternative #2:  Spending budget equal to the ABB each year
  • Spending Plan Alternative #3:  Spending budget starts at $40,000 and is increased by inflation each year but result not greater than 110% of the ABB and not less than 90% of the ABB (our recommended smoothing algorithm discussed in our post of January 2, 2017).

The table below shows the results of Mary’s efforts.  Percentages show annual spending plan amounts as a percentage of the calculated Actuarial Budget Benchmark (ABB) amounts.  For simplicity purposes, the 5-year projection tab assumes that assumptions used to determine ABB amounts are unchanged throughout the projection period and the individual’s lifetime planning period (LPP) is reduced by one in each future year. 
(click to enlarge)


Mary notices that while the spending plan alternative #1 is at no risk of depleting her savings, she doesn’t like the fact that spending under this plan is 20% or more higher than the actuarially balanced spending levels (ABB) for some years during the projection period, and therefore somewhat off the actuarially balanced track.  On the other hand, she also notices that spending plan #2 (spending the ABB and always on track) could involve undesirable fluctuations and some years where her spending budget is actually less than her essential expense estimate of $35,000 (and she would like to avoid cutting essential expenses if possible).  She is comfortable with the alternative #3 spending plan as a compromise solution and notes that this plan could also work in situations where experience is more favorable than assumed and she might be able to increase spending, whereas this is not a subject that has come up with her financial advisor.  Therefore, Mary tentatively determines that she will follow spending plan #3 in the future and is pleased that this plan appears to weather a bear market storm that is comparable to the one experienced in 2008/2009. 

Of course, these aren’t the only alternative strategies that Mary can explore as a result of her “what if” analysis.  In addition to examining different spending strategies, she can also look at different investment strategies, such as changing her investment mix or buying annuities.  She may also want to explore spending strategies that do not anticipate increasing with inflation each year, reflecting diminished spending desires as she ages (such as front-loading travel expenses, for example), or alternatives that involve using her long-term care reserves to mitigate short term investment fluctuations.  

The primary point of this example (and post) wasn’t necessarily to argue that one alternative spending plan is better than another (or to scare you about the future), but rather to illustrate how using the Actuarial Approach and the ABB (together with whatever other approach you are currently using) can help you develop a plan of action (strategy) to deal with a range of future scenarios.  

Developing a Financial Plan using a Stochastic Model

The stochastic model used by Mary’s financial advisor tells Mary that if she invests her assets in a certain way, she has a 90% probability of being able to spend $40,000 per year for the rest of her life.  It doesn’t really give her a plan of action if her assets decrease by 30% in one year (or increase by 30%).   The model results imply that, irrespective of actual investment experience, Mary should stay the course with respect to her investment strategy and keep spending $40,000 per year come hell or high water (and not worry about the 10% failure probability).  Thus, it is more of an “implied plan.”  We believe this is a potential shortcoming for many stochastic models.  Michael Kitces addressed this shortcoming in his post of December 7, 2015, “Is Financial Planning Software Incapable of Formulating an Actual Financial Plan,” when he said, 

“virtually no financial plan today actually constitutes a real “plan” for anything. After all, the whole point of planning is to formulate the strategy of how to handle a range of possible future scenarios. If A happens, then we’ll do B. If C happens, we’ll do D instead.

Yet financial plans today, and the financial planning software that supports the process, is incapable of illustrating such scenarios and the appropriate responses! Answering a simple planning question like “how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track” cannot be easily answered with any financial planning software available today!”

Conclusion

The Actuarial Approach and ABB can help you develop a real plan and provide you with data points to help you answer questions such as, “how much do the markets have to decline before I need to cut spending and how much would I need to adjust my spending to get back on [the actuarially balanced] track.”  We encourage you to use our spreadsheets to develop these data points.  As discussed in our post of November 26, 2017, we also encourage you to periodically model deviations from assumed experience (not just assumed investment returns) so that you can better plan for situations where actual experience may punch you in the mouth.  Given the current economic environment, however, it may not be a bad idea for you to start your deviation modeling by stress testing your plan (or implied plan) for a possible bear stock market.  By suggesting that you go through this exercise, we aren’t trying to scare you--We want you to be confident that your spending and investment strategy/plan will hold up if and when stock markets go south.

Friday, April 6, 2018

Do Stochastic Models Necessarily Do A Better Job of Helping You Determine How Much You Can Safely Spend This Year?

The impetus for this post was another thought-provoking post from our friend Dirk Cotton over at The Retirement Cafe entitled, “The ‘Future’ of Retirement Planning” in which he states, “Determining how much you can safely spend this year requires a good model of the future.”  Since we are “How Much Can I Afford to Spend in Retirement,” several of our readers wanted to know what we thought about Dirk’s post.   In particular, they wanted to know whether we agreed with his implication that models that use Monte Carlo stochastic assumptions (simulations) are “much better” than models (like our simple Actuarial Budget Calculators) that use deterministic assumptions (or what Dirk calls spreadsheet models).   In this post, we will discuss where we agree with Dirk and where we agree to disagree.  

Where We Agree

We totally agree with Dirk that: 

  • “determining how much you can safely spend this year [and making other personal financial decisions] requires a good model of the future”, 
  • A model is not a plan.  A plan is an intention or decision about what to do based on the results from a model, 
  • “Of course, you can plan when outcomes are uncertain…”, 
  • A good model should not ignore sequence of return risk, and
  • A stochastic model that uses expected rates of investment return for various asset classes but adjusts for investment risk is a better model for determining safe spending levels than a deterministic model that simply utilizes expected rates of return without adjusting for investment risk, all other things being equal.
Where We Agree to Disagree

While we agree that it is important to employ a “good model” of the future when developing a retirement plan, we are not convinced that it is absolutely necessary to use a model that employs simulations.  Therefore, we will push back in this post on Dirk’s recommendation that “If you're using an online calculator, make sure it incorporates simulation”.

In our opinion, a “good model” for determining how much you can safely spend in the current year, or for making other personal financial decisions, is one that:

  • Does a reasonably good job of forecasting future experience,
  • Adequately addresses your retirement risks, and
  • Helps you to make informed financial decisions with some degree of confidence.  

We believe that such a model should:

  • Consider your personal financial situation and goals,
  • Be relatively transparent,
  • Allow you to do “what-if” scenario testing,
  • Reflect all current assets and expected amounts and timing of future assets Reflect all expected amounts and timing of current and future expected expenses,
  • Employ reasonable, or relatively conservative, assumptions with respect to:
    o   Future investment returns
    o   Future increases in expected expenses (including before and after the first death within a couple)
    o   Your (and your spouse’s) future lifetime, and
    o   Other relevant future experience
  • Develop a total spending budget for the current year, not just an amount to be withdrawn from invested assets/accumulated savings
Our point in describing the criteria for a good personal financial model is that there are quite a few conditions to satisfy to be considered “good.”  So, even if a model uses stochastic assumptions that are reasonable, this will not guarantee that such a model is necessarily a “good model” if it fails to satisfy some of the other criteria above.

Actuarial Approach with Recommended Assumptions (Actuarial Budget Benchmark)

We believe that the generalized individual actuarial model (The Actuarial Balance Equation) used in our Actuarial Budget Calculators combined with our recommended assumptions (to develop what we call the Actuarial Budget Benchmark (ABB)) will satisfy most of the above criteria to be considered a “good model” for developing retirement plans and spending budgets.

Just like most pension plan actuarial valuations, our simple Actuarial Budget Calculators (ABCs) use deterministic, not stochastic investment return assumptions.  When using these Excel workbooks, we recommend using assumptions consistent with assumptions used by insurance companies to price inflation-adjusted annuities to develop a market value (or market-priced) valuation of future spending liabilities.  While equities and other risky investments may be expected to generate higher returns than such low-risk investments over an individual’s (or couple’s) lifetime planning period, such investments carry more investment risk.  Following basic financial economics principles, the “risk-adjusted” expected returns on these more-risky investments should be approximately the same as expected returns on low-risk investments available in the market.   Thus, in applying these principles, we believe that using these low-investment risk assumptions are reasonable for the purpose of determining how much you can safely spend, and the use of stochastic modeling is not an absolute requirement for a “good model”.  

For a more detailed defense of our simple spreadsheet model, see our post of October 8, 2017, and for more discussion of the implications of using basic financial economic principles to determine the cost of retirement and thoughts from Dr. Moshe Milevsky on this subject, see our post of July 10, 2017.

Our Concerns with Monte Carlo (Stochastic) Modeling

Our concerns with Monte Carlo (stochastic) modeling may be summarized as follows:

  • Stochastic Model results are highly dependent on assumptions made for expected returns and variances for various asset classes (which are frequently built into the model, based on historical experience)
  • Stochastic Models are generally not transparent
  • Stochastic Models may not reflect all assets and spending liabilities, and
  • Stochastic Model results may not facilitate the making of good financial decisions (the primary purpose of using a model)

We discuss these concerns in more detail below. 

Model Assumptions.  Even if you are (or your financial advisor is) using a stochastic model that meets most of the above criteria to be considered to be a “good model,” you are pretty much forced into accepting the model designer’s “built-in” assumptions for expected future real investment returns and standard deviations for various classes of assets.  Therefore, the reasonableness of the results of such a model will be very dependent on the reasonableness of these built-in assumptions about the future.  You can accept these assumptions on faith, or you can question whether they are reasonable.   And unlike assumptions that can be relatively easily gleaned from current annuity market pricings, it may not be so easy to tell how reasonable these assumptions are.  You can, of course, compare them with historical results, but everyone knows that historical results don’t necessarily reflect current economic conditions and therefore are not necessarily great predictors of the future.  Alternatively, you can compare the model results of using such assumptions with the model results of using annuity-based (low-investment risk) pricing assumptions.   As discussed in our post of February 4, 2018, “Should Increasing Your Investment Risk Increase Your Current Spending Budget?,” we become concerned when we see models that suggest that you can increase current spending with little or no perceived additional risk by investing in riskier assets.  This is an indication to us that the investment return assumptions for equity investments (or other risky investments) built into a model may be too aggressive in the current market environment.

We understand that Monte Carlo modeling is fairly standard practice among financial advisors.  We also understand that most financial advisors make their living by increasing AUM (assets under management).  And while most financial advisors undoubtedly believe they are using reasonable assumptions for future investment returns and variances for various classes of assets in their models, it may be prudent for you to try to independently assess how reasonable these assumptions might be.  For example, you might want to ask your financial advisor how he or she has adjusted these assumptions for variations in the Shiller Cape 10 index (which at over 30 today would suggest lower than historical real expected rates of return in the future, all things being equal.)

Transparency and Reflection of All Assets and Spending Liabilities.  In general, stochastic models tend to be somewhat “black boxy” in nature.  Model results tend to be something like, “if you invest as follows, you will have a X% probability of being able to spend $Y per year in real dollars as long as you or your spouse is expected to live.  When using such a model, you will need to determine if all future expected expenses (such as medical expenses that are expected to increase faster than inflation, unexpected expenses, long-term care expenses, other non-recurring expenses, etc.) have been adequately reflected in the model.  

Using the Model to Make Decisions.  We like Dirk’s weather forecast analogy in his argument for using a model that develops probabilities.  If there is a 5% chance of rain today, you may decide not to bring an umbrella.  A good model is supposed to help you make more informed decisions.   Unfortunately, results of stochastic modeling tend to provide probabilities of success applicable to  long periods of time and may not facilitate good short-term decision making.  For example, a couple may become complacent after they are told that they have a 95% probability of being able to spend $X per year irrespective of actual future investment experience.  Unlike the Actuarial Approach, which encourages annual valuations, periodic scenario testing and annual thinking about the safe amount to spend (and Rainy- Day Funds to establish or use to mitigate fluctuations in spending), the results of a Monte Carlo model can encourage more of a “set-it-and-forget-it” type of behavior that could result in either significant over-spending or under-spending as time goes by. 

We are also concerned with Monte Carlo models that may lead users to invest too aggressively.   For example, if overly aggressive future real rates of investment return (or overly conservative standard deviations) are assumed for equities, some individuals who wish to increase their current spending levels may be persuaded to increase their equity holdings beyond their tolerance for risk.   

You Aren’t Required to Use Just One Model/Conclusion

There is no law that says that you have to use just one model in your retirement planning.  You should feel free to look at the results produced by several models.  We don’t think you should reject models just because they use deterministic assumptions if these models adequately address retirement risks.  We also think it is perfectly reasonable to be somewhat skeptical of models developed by model designers who have a financial stake in the decisions you may make as a result of using their model.  If you want to use a stochastic model, or your financial advisor uses a stochastic model, we encourage you to compare the results of that model with the results of our ABC model (developed by retired actuaries who have absolutely no financial stake in the decisions you make as a result of using our models) or other models.  If the different models produce significantly different results, you should try to figure out why.  This exercise will provide you with  more “data points” to help you make better informed financial/spending decisions, which is, after all, the primary purpose of modeling the future. 

Saturday, March 3, 2018

Developing a Sustainable Spending Plan (SSP) vs. Using a Systematic Withdrawal Plan (SWP)

We still see quite a bit of literature in the popular press encouraging retirees to use specific Systematic Withdrawal Plans (SWPs) to determine withdrawals from their accumulated savings.  For example, the recent article, “No Pension? You Can ‘Pensionize’ Your Savings” discusses the “Spend Safely in Retirement” strategy developed by Steve Vernon, Joe Tomlinson and Dr. Wade Pfau in collaboration with the Society of Actuaries.  The SWP advocated in their report is the IRS Required Minimum Distribution approach we discussed in our post of December 21, 2017.  In addition, we are aware that many researchers and financial advisors still advocate the use of SWPs, and some even confusingly refer to these “withdrawal plans” as “spending plans.”  Therefore, we will once again
  • attempt to draw the distinction between spending plans (and in particular Sustainable Spending Plans (SSPs)) and SWPs, and 
  • Indicate why we believe SSPs are superior to SWPs
SWPs

SWPs provide a retiree with an algorithm for withdrawing funds from their investment portfolio.  Sometimes this is also referred to as “tapping” one’s savings.   Common examples are the 4% Rule and the IRS RMD approach.  SWPs can be very simple or very complicated (with floor and ceiling adjustments, etc.) but all involve systematic withdrawals from accumulated savings.  It is generally assumed that the amount withdrawn for the particular year under the SWP plus income from other sources (IFOS) for that year will be spent by the retiree (or couple). 

A SWP isn’t coordinated with the amount or timing of income the retiree (or retired couple) may have from other sources (IFOS).  Assuming a retiree’s IFOS is reasonably constant from year to year, it is possible that adding the SWP withdrawal to the IFOS for the year may be consistent with the individual’s spending goals.  However, even assuming that this is the case, the SWP only focuses on recurring spending needs and does not consider non-recurring spending needs the retiree may have, such as unexpected expenses, long-term care costs or specific bequest motives.  As noted in the Society of Actuaries’ recent report, Shocks and the Unexpected: An Important Factor in Retirement, “Successful provision for the unexpected is critical to success in financial management during retirement.”  So, any SWP will be deficient in this regard.

SSPs

A Sustainable Spending Plan develops a spending budget that is consistent with the individual’s (or couple’s) spending goals.  Typically, these goals will include:

  • Maximizing current levels of spending without jeopardizing ability to meet future anticipated expense needs 
  • Not spending too much and not spending too little 
  • Avoiding year to year spending volatility 
  • Having spending flexibility 
  • Leaving approximately desired amounts to heirs at death
The reader will note that none of the above goals necessarily involves how much should be withdrawn from savings (or how systematic such withdrawals should be).  The focus of the SSP is on spending, not withdrawals from savings.  For example, if one member of the couple’s Social Security benefit is expected to commence at a later date than the other member, it may be very reasonable (and consistent with the couple’s spending goals) for the couple’s withdrawals from savings to be larger before the second commencement than after.  In fact, in situations where IFOS doesn’t commence at the same time or expenses are non-recurring in nature, an SSP will work much better than an SWP in meeting typical spending goals.

The Actuarial Approach advocated in this website will help you develop a SSP, not an SWP.  Under the Actuarial Approach:

  • All of your assets are considered, not just your accumulated savings 
  • All of your spending liabilities are considered, not just your recurring spending 
  • Since the amount withdrawn from savings is equal to the sustainable spending amount minus IFOS, it will automatically mitigate potential spending volatility associated with amount and timing differences that may be inherent in IFOS 
  • You can maximize current spending without jeopardizing your ability to meet expected future expenses.  For example, you can increase current real dollar spending by
o  treating travel expenses or home mortgage expense as a non-recurring expense, or
o  planning on future expenses that decrease in real dollars
  • Spending is flexible and is automatically adjusted, as a result of annual valuations, to be consistent with your goals (even if those goals change), and 
  • Periodic scenario testing will enable you to better plan for deviations from assumed future experience
Conclusion

Depending on personal situations and goals, SWPs may be OK for some individuals and couples, and may be just fine as a distribution option in a defined contribution plan or IRA, but generally you (or your financial advisor) can do better.  The Actuarial Approach will help you develop a much more robust spending budget (SSP) than can be obtained by simply adding an SWP amount to IFOS.  Will it take a little more work and number crunching?  Yes.  But, we believe it will be worth your while, and that is why we refer to our website as, “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”

Wednesday, February 28, 2018

Save More for Retirement? Nah, I’ll Just Work Longer

This post is a follow-up to our post of December 11, 2017 titled, When Can I Afford to Retire and When Should I Commence my Social Security Benefits (which was a follow-up to our posts of November 14, 2016 and April 28, 2014 touting the clear financial benefits of working longer).  In that post we included an example and concluded that:

“John’s calculations [using our Actuarial Budget Calculators] will show that if he retires and defers commencement of his Social Security benefit, he can expect his real dollar spending budget to increase by about 1% for each year of deferral (or slightly less if John is not in “excellent” health), whereas it increases by about 8% for each year that he continues to work.  Therefore, while we agree that the deferral of Social Security commencement strategy is probably “better than a poke in the eye with a sharp stick”, your decision of when to stop working is generally going to be a more significant driver of the amount of your spending budget in retirement than your decision of when to commence your Social Security benefit.’


In their recent research paper, “The Power of Working Longer,” the authors reach the same conclusion, stating, “Roughly speaking, deferring retirement by one year allows for an 8 percent higher standard of living for a couple and the subsequent survivor.”  And while it is nice to have esteemed academic scholars support the same annuity-based pricing of spending liabilities that we recommend and confirm our calculations, we have some concerns about the authors’ assumptions and methodology, which cause them to conclude that working longer may be a more attractive option for individuals and couples than increasing their savings.  While we agree that working longer is a powerful tool for increasing an individual’s or couple’s spending budget in retirement, we think it is probably a financial planning mistake to believe that you don’t have to save for retirement because you will simply work longer and rely on increased Social Security benefits, especially if you are relatively highly paid. 

Authors’ Assumptions and Calculations for Stylized Household

The authors look at a “stylized household” which consists of a 36-year-old primary earner and his or her same age spouse.  It is not clear from the example whether the spouse has the same earnings or has no earnings.  The following assumptions are made by the authors:

  • Whatever wage is being received by the household (either approximately the economy-wide average wage index by the primary earner and nothing for the spouse or two times that amount assuming they are both paid the same amount), it is assumed to remain constant until the assumed retirement age of 66 
  • Contributions of 6% of annual wage are made to their respective 401(k) plans and these contributions receive a 50% match (assuming here that the spouse actually has earnings) for a total of 9% of wage annual contributions. 
  • The assumed rate of return on accumulated savings in the 401(k) plans is 0%.  This assumption is inconsistent with the assumptions used by the authors to convert accumulated savings to lifetime income and significantly inconsistent with the approximate 6% return assumption used in Social Security law to develop actuarially equivalent adjustment factors for early and deferred retirements. 
  • Social Security benefits for the husband and wife at age 66 are assumed to be 42% of their assumed to be constant wage at age 65.  Note that the authors state that this is an average benefit payable at Social Security’s full normal retirement age, but under current law, age 66 would not be the full normal retirement age for these individuals.  No Social Security spousal or survivor benefits are considered. 
  • Social Security law is assumed to remain unchanged in the future.  This assumption includes continuation of actuarial increases of 8% per annum for each year of deferred commencement (even though increases in wages and real investment returns are assumed to be nil, and no changes in program benefits in light of significant future expected deficits. 
  • Accumulated savings are converted to an annuity at assumed retirement using fairly conservative assumptions and also assuming payment in the form of a joint and survivor annuity with 100% to be paid to the last survivor (even though the effect of survivor benefits in Social Security is to pay in the form of a joint and survivor annuity with 66.67% paid to the surviving spouse.
Using these assumptions, the authors conclude that the 9% of pay rate of savings (6% plus the 3% match) for the next thirty years will generate only about 19.4% of total expected retirement income at expected retirement at age 66 with the remainder (80.6%) coming from Social Security. 

Comparison with Our Calculations

Somewhat surprising to us, given the assumptions made by the authors, the authors’ approximate 80%/20% distribution of expected real retirement income between Social Security and accumulated savings for this stylized couple is not terribly different from the distribution obtained by using the Actuarial Budget Calculator (Pre-Retired Couple) for a 36-year-old couple currently both earning $50,000 per year and contributing 9% of pay.  For our calculations, we assumed:

  • 3% future pay increases, 
  • Economic and longevity assumptions we recommend for determining the Actuarial Budget Benchmark, 
  • a 33 1/3% reduction in desired retirement income upon the first death within the couple. 
  • Social Security benefits from The Social Security Online Quick Estimator (with adjusted future pays to be consistent with our 3% pay increase assumption) of about 47% of final year’s pay (about $55,092 per annum in future dollars). 
  • Consistent with the author’s calculations, we assumed no other non-recurring expenses or other sources of income. 
  • We also ignored the present value of expected spousal benefits from Social Security upon the first death within the couple.

Using these assumptions, we developed projected total real first year retirement (age 66) spending of $74,957 of which $60,829 was expected to come from Social Security and $14,128 from accumulated savings.  Thus, our calculations produced a 77% Social Security/ 23% accumulated savings lifetime income split for the authors’ stylized couple. 

This total first year of retirement projected spending of $74,957 represented 62.07% of projected real dollar spending for the final year of working (age 65).  Since it is less than the 85% rate that we recommend as a benchmark target, and further, since no reserves are contemplated for long-term care, unexpected expenses, rainy-day reserves, etc., we would encourage this stylized couple to consider alternatives such as increasing savings, continuing to work, taking on part-time employment, investing more aggressively, cutting back current expenses and/or not committing to funding education costs, tapping home equity, finding a rich person who will leave them an inheritance, etc.

Should You Give Up on Increasing Your Savings?

If you haven’t saved enough to date, we don’t think you should give up in your efforts to save for retirement and assume that you will just keep working and rely on Social Security.  Here are some reasons why we believe you should increase your savings if our ABC tells you that you are falling behind:

  • One very nice aspect of increasing your savings, from our point of view, is that it lowers your current spending budget and gives you a smaller spending target to replace in retirement.  If you are saving 25% of your pay and you spend 15% of your pay on work-related expenses, your replacement spending target in retirement is only going to be 64% of your pay (.75 X .85).  By comparison, if you don’t save, your replacement target will be 85% of your pay. 
  • The years just prior to your desired retirement will, in many cases, be your best opportunity to save.  You may be eligible to make “catch-up” contributions and expenses such as education costs may be reduced, 
  • Given Social Security’s financial condition, there is a non-zero probability that Social Security benefits will be reduced in the future.  These reductions may take many forms, including the possibility that Social Security’s actuarial increase factors for delayed commencement will be reduced to be more consistent with today’s low interest rates.  We call this “Social Security Reduction Risk” 
  • You (or your spouse) may not be able (or want) to continue to work at a job that will pay you the same level of earnings (or more) as you age.   Poor health, the need to take care of a family member, corporate downsizing initiatives/mergers, etc. may reduce employment opportunities.  We call this “Continued Employment Risk” 
  • If you are highly compensated, Social Security represents a smaller percentage of your overall total retirement income, so you need to save more, all things being equal. 

Conclusion

Working longer is a great solution to solving the problem of not having enough income in retirement, if you can make it work.  As the old saying goes, “Nice work if you can get it” (pun intended).  Therefore, unless you:

  • really love your job, 
  • you are quite happy with the idea of working until age 70 or longer, 
  • you believe your boss thinks you are absolutely irreplaceable and/or there is almost no chance you (or your spouse) will lose your jobs (e.g., you are a tenured college professor),
we strongly encourage you to use our calculators annually to help you develop a financial plan that considers and, if possible, reduces your Continued Employment and Social Security Reduction risks.    Sorry folks, but for many individuals, this will require increased savings.

Wednesday, February 21, 2018

Investing and Spending in Retirement is Risky Business

In our February 4, 2018 post, we cautioned our readers to be skeptical of investment or spending strategies that appeared to support higher levels of current spending than those developed under the Actuarial Budget Benchmark (ABB) with little or no perceived increase in risk that future spending would need to be reduced.  Subsequent to writing that post, we came across an excellent article on this subject that we would like to bring to your attention in this post.  The article is “What Investment Risk Is, Illustrated” by Barton Waring and Laurence B. Siegel .  Like most scholarly articles, this one involves making somewhat of an investment in time and effort to wade through, but we believe the effort and expenditure of time is worth it. 

Not surprisingly, what we really liked about this article was that the author’s conclusions are very consistent with the Actuarial Approach and the Actuarial Budget Benchmark advocated in this website.  And while there are minor differences in our recommended approaches, we both advocate:

  • Low investment-risk pricing of future spending liabilities, and
  • Developing a spending plan by periodically solving for the present value of future spending that equals the market value of assets

The authors conclude that, “Maintaining the value identity allows rules like the ARVA to maximize sensible spending at every point in time, but it means that the spend itself will have volatility.”  The “value identity” to which the authors refer is the requirement that “the present value of planned future spending must equal the present (current market) value of the assets.”  The value identity concept is equivalent to our Actuarial Balance Equation, and ARVA is the “annually recalculated virtual annuity” which is similar in concept to our Actuarial Budget Benchmark (ABB) (and initially discussed in our post of March 22, 2015).

Like us, the authors take on the 4% Rule and conclude, “the faults of the 4% rule as a spending rule always add risk relative to a multi-period CAPM [Capital Asset Pricing Model] inspired ARVA rule.” They write, “Why does the 4% rule perform so poorly? The present value of the planned future 4% spending plan at no time bears any relation to the value of the portfolio, grossly violating the equality of the present value of future spending and the asset value — implying both a greater (unintended!) bequest plan than would have been desired if had been known, as well as a tolerance for a significant possibility of spending ruin.”

The most important take-away from the author’s article, in our opinion, is that if you invest in risky assets in the hope you will achieve higher returns, you will be assuming additional risk.  And this is true whether you use the 4% Rule, the ARVA or the Actuarial Budget Benchmark to determine your spending.  In the author’s words, “Here’s the bottom line: If you take more strategic asset allocation policy risk, you might do much better either in single-period asset-only space, or in multi-period spending space. And on average, you can fairly expect to do better. But the thing is, that you might do a lot worse! You pays your money and you takes your chances. If you don’t like the risk of doing worse, reduce the risk by adopting a more conservative strategic asset allocation policy.”

Since most of us do invest in risky assets in the hope we will achieve higher returns, we encourage you to model the impact on your actuarially determined spending budget of significant deviations in investment returns by using our 5-year projection tab.   As discussed in our post of February 4, we also encourage you to consider establishing a Rainy-Day Fund to mitigate potential spending budget fluctuations. 


Friday, February 16, 2018

We Kick the Tires on Fidelity’s “Retirement Score”

We have been playing around with Fidelity’s free retirement planner, “The Fidelity Retirement Score.”  According to Fidelity, the planner will enable you to “Know where you stand for retirement in just 60 seconds. Answer 6 simple questions to get your score and additional steps to consider as you save for retirement.”  In this post, we comment on the pros and cons of Fidelity’s calculator and compare it with the Actuarial Approach using the Actuarial Budget Calculators (ABCs) for pre-retired single individuals and couples available on our website.  

Executive Summary

The Fidelity Retirement Score is not bad, and it may do a reasonably good job of telling you where you stand in your planning for retirement, particularly if you are not highly paid and you don’t have sources of retirement income other than your savings and Social Security.   We think the Fidelity calculator probably under-estimates required savings rates for more highly compensated individuals.  The analysis that we performed and discuss below, may not be all that interesting to you unless you are a real numbers geek like we are.  If you aren’t, feel free to skip the discussion below of how we kicked the tires on Fidelity’s calculator and our analysis of it. 

The Fidelity Retirement Score—What we Like About It

  • Fidelity’s calculator is sexy, quick, easy and, for many people, probably does a reasonably good job of measuring their retirement savings progress.
  • Once you have entered your data, you can see how changes in the data you entered affect your score on the scoreboard screen without having to go back through the original data entering screens.  You can also change your lifetime planning period from the default option of to age 93 on the scoreboard screen, which is helpful.
  • The calculator estimates your Social Security benefit based on the pay you enter and does not require you to calculate your own estimated benefit.  Nor does it require you to estimate your lifetime planning period (but you can change the default option if you want).
  • The calculator projects what you could spend at retirement (including Fidelity’s estimate of your Social Security) and compares that with what Fidelity thinks you’ll need based on what you input for your desired standard of living in retirement.  These amounts are shown in today’s dollars.
  • The calculator uses a fairly conservative estimate of future investment earnings (at least compared with many other calculators) and doesn’t increase your projected income at retirement if you increase your investment risk (from the balanced option) by choosing investment portfolios with higher proportions of stock. See our last post, “Should Increasing Your Investment Risk Increase Your Current Spending Budget” for discussion of why we believe this is a good attribute.
  • The Fidelity calculator is reasonably consistent with their advice to accumulate ten times your annual pay if you want to retire at age 67.  We have found that this is not a bad rule of thumb, particularly for individuals with no sources of retirement income other than Social Security and  savings. 
How We Analyzed Fidelity’s Calculator

As retired actuaries, we still like to crunch numbers.  So, we crunched some numbers for individuals earning $50,000 per year and $200,000 per year using both Fidelity’s calculator and our Actuarial Budget Calculator (ABC) for Single Pre-Retirees.  For the Fidelity calculations, we entered

  • retirement at age 67, 
  • “Spend the Same” standard of living and 
  • “Balanced” investment style,
  • Lifetime planning period ending at age 94 (vs. their default option of 93)  

For the ABC calculations, we entered our recommended assumptions (4% annual investment return, 2% annual inflation and 2% desired increases in spending after assumed retirement).   Consistent with these assumptions, we also assumed 3% annual increases in compensation.  In order to make the ABC calculations somewhat comparable to the Fidelity calculations we also assumed:

  • A lifetime planning period ending at age 94 (our recommended assumption for a 65-year old male),
  • Social Security commencement at age 67
  • No unexpected expenses, no desired estate remaining at death, no long-term care costs, no other non-recurring pre-retirement or post-retirement expenses, no other pre-retirement or post-retirement sources of income (such as annuities, matching employer contributions, income from part-time employment, proceeds from asset sales, pensions, rental income, etc.)
  • No income from spouses and no decrease in desired spending in the event of the first spouse death

For both sets of calculations, we assumed the individuals had accumulated Fidelity’s age-related recommended benchmark amounts of savings for successful retirement at age 67:

  • Age          Target Accumulated Savings as a multiple of pay
  • 35  2X
  • 40  3X
  • 45  4X
  • 50  6X
  • 55  7X
  • 60  8X
  • 66  10X

We also entered 12% of pay annual savings rates for both sets of calculations.  For the Actuarial Approach Social Security benefit amounts, we went to the Social Security Online Quick Calculator and calculated projected benefits commencing at age 67 in future (inflated) dollars using a relative growth factor in future projected earnings of -1% to be consistent with our 3% annual pay increase assumption.  We then calculated real dollar (today’s dollar) equivalent of this benefit using our 2% discount rate assumption. 

We assumed the amount that Fidelity indicates as the amount you’ll need monthly in retirement will remain constant in real dollars throughout your period of retirement.  It is not clear to us, however, how Fidelity incorporates their famous cost of healthcare in retirement estimate ($275,000 for a couple both age 65 retiring in 2017) into this amount you’ll need. 

The table below shows the results of the calculations.  Amounts are shown in today’s dollars.
(click to enlarge)



Our Analysis and Some of the Things We Don’t Like About the Fidelity Calculator

The first thing we noticed was even though the Fidelity calculator indicates that the spending target option they determine is “spend the same,” their idea of what this means is if your pay is relatively low, Fidelity believes your “spend the same” amount will be about 80% of your pay and if your pay is relatively high, your “spend the same amount” will be about 60% of your pay.  By comparison, our ABC estimates your spending before retirement by subtracting what you are saving from your estimated pay.  Thus, under our calculator, the more of your pay you save, the less of it you spend, all things being equal.  However, since your work-related expenses and your taxes will probably less in retirement, our recommended income replacement target is about 85% of your “spend the same” amount.  

The significant difference in how “spend the same” is defined in the two calculators results in significantly different spending targets and savings rates necessary to achieve retirement spending goals.  While the Fidelity calculator appears to imply that an individual earning $50,000 should be saving more than 12%, the individual earning $200,000 appears to be in good shape.   By comparison, our calculator implies that the $50,000 worker is probably ok saving 12% of pay (after adding in recommended levels of expected non-recurring expenses like long-term care costs), but the higher paid worker probably needs to save closer to 20% of pay to “spend the same” in retirement.  Highly compensated individuals using Fidelity’s calculator might find that their “on target” score over 100 may not be as “on target” as they thought. 

While Fidelity assumes that real wages will increase in the future for individuals, their calculator does not assume real Social Security benefits will increase for these individuals.   Ours does.  And while Fidelity’s calculator indicates, “your score is calculated assuming an underperforming market, so it represents a conservative estimate of how much income you could have during your retirement,” the balanced investment style appears to be expected to earn about 5% per annum and therefore would be expected to have more investment risk than the annuity-based pricing investment return assumption of 4% that we recommend.  This extra investment risk is downplayed in the Fidelity calculator.  The difference in expected returns (extra risk) is quantified by comparing the columns labeled “Projected Retirement Income @67 from Accumulated Savings.”

As discussed above, to facilitate comparison of the calculators we had to assume that the hypothetical individuals we looked at only had savings and Social Security benefits and further, they would commence Social Security at the assumed retirement age.  In this respect, the Fidelity calculator has very limited flexibility to consider other sources of retirement income or other commencement dates and does not even attempt to consider couples planning. 

Conclusion

We encourage you to use a calculator to plan for your retirement and to develop a spending/savings budget to help you achieve your retirement goals.   And, when you are planning, it is also very important to remember that whatever calculator you use is only going to provide you with a planning “data point” for you to consider along with many other factors.  For many single individuals, Fidelity’s calculator may provide a reasonably good starting data point.  By comparison, our ABC’s for pre-retired single and couples may not be as sexy as Fidelity’s Retirement Score calculator (or others available on the Internet), and you may not be able to “know where you stand for retirement in 60 seconds.”  However, we believe our calculators are more accurate and flexible in terms of considering all your potential assets and spending liabilities.   We also give you the capability of reflecting the commencement of benefits (such as Social Security) at ages other than your desired retirement age,  having increasing or decreasing patterns of real-dollar spending, and our spreadsheets can be used by individuals and couples outside the U.S.  This is why we advertise our website as “The spending budget website for intelligent retirees and pre-retirees (and their financial advisors) who aren't afraid to do a little number crunching to get the right answer.”

As we have discussed in prior posts, it is also important for you to consider the potential for deviations from expected experience as part of your planning.   For example, your employment may not continue until your desired retirement age, so you will probably want to be even more conservative in your retirement planning than indicated by any retirement calculator, at least until more-favorable-than-assumed experience emerges.