Sunday, January 21, 2018

Life Expectancy vs. Lifetime Planning Period—Part II

This post is a follow-up to our post of December 6, 2017 regarding lifetime planning period (LPP) assumptions used in financial planning.  As discussed in the December 6 post, for purposes of calculating your Actuarial Budget Benchmark (ABB), we recommend that you use the LPP (or LPPs for couples) based on the 25% chance of survival for a non-smoking male or female (as appropriate) with “excellent health” from the “Planning Horizon” section of the Actuaries Longevity Illustrator.

In this post we will address:

  • the binary nature of the mortality/longevity assumption for individuals 
  • how the LPP assumption is expected to change as one ages, 
  • the spending budget implications of continuing to survive, and 
  • general implications of planning to live longer than your life expectancy
We will also “walk back” a statement we made in the December 6 post that using the 25% chance of survival LPP would enable you to avoid actuarial losses from living too long until you reach your late 80s. 

Binary Nature of Mortality

Some retirement planners and retirement experts advocate the use of probabilities of mortality at each age for personal retirement planning, with the implication that the use of such probabilities makes the resulting spending budget more accurate than approaches that do not use such probabilities.  We are not swayed by this logic, as “pieces” of us do not die each year.  We are either alive for an entire year or we die during that year.   If we die during a particular year, we are generally not alive for any subsequent year.  The law of large numbers that may work well for pension plans with lots of participants doesn’t necessarily apply to individuals or couples.  Therefore, we have no problem developing a spending budget that assumes a specific LPP and a definite age of death at the end of that LPP.

How the LPP is Expected to Change as One Ages

There is a common misperception that your LPP decreases by one year each year that you remain alive.  It would make financial planning easier if this were true, but it isn’t.  The longer we live, the later becomes our anticipated age at death, because we have already reached a certain age.  This is best illustrated by an example.  Based on the mortality assumptions used in the Actuaries Longevity Illustrator, the life expectancy (50% chance of survival) at age 65 for a non-smoker female in excellent health is 25 years, or an expected age of death of 90.  By comparison, the life expectancy (50% chance of survival) at age 85 for a non-smoker female in excellent health is 8 years, or an expected age of death of 93, or 3 years longer.

The graph below shows the expected age at death for non-smoker females aged 65-99 in excellent health under three different lifetime planning alternatives from the Actuaries Longevity Illustrator:

  • 50% chance of survival (or more commonly known as “life expectancy”), 
  • 25% chance of survival, and 
  • 10% chance of survival
Instead of showing three horizontal lines, as would be expected if your LPP decreased by one year each year you remain alive, all three chance-of-survival lines show increasing expected ages at death as the females age, with larger total increases required for the higher percentage chances of survival.
(click to enlarge)
It should be noted that the Actuaries Longevity Illustrator calculates the expected ages at death for someone currently age 65 assuming that this individual was born in 1953, while the expected age at death for someone currently age 85 assumes that such individual was born in 1933, so we are not looking at expected ages at death for the same woman born in 1953 in this graph.  To the extent that current mortality tables anticipate mortality improvement based on year of birth, the expected age at death for a female born in 1953 when she reaches age 85 may be later than implied in this graph.

Budget Implications of Continuing to Survive

Generally, the longer the assumed LPP, the smaller the initial actuarially determined spending budget in retirement.   So, using the 50% chance of survival LPP will give you a larger initial actuarial spending budget than using the 25% chance of survival LPP, all things being equal.  The potential downside, however, of using the 50% chance of survival rather than the 25% chance of survival LPP is that you are also increasing your chances of experiencing future spending budget declines as you age (as conceptually illustrated in the graph in our post of December 6).  

Each one of the increases from the initial expected age at death shown in the three lines in the above graph represents a year when the LPP is not expected to decrease by one year from the previous year. Because the actuarially determined spending budget is calculated assuming that your LPP will decrease by one year each year, each one of these increases is expected to produce an “actuarial loss” in the year of increase.  As with any other actuarial loss recurring from experience that deviates from an assumption, this actuarial loss will decrease that year’s spending budget, all things being equal.

While we continue to recommend using the 25% chance of survival to determine your Actuarial Budget Benchmark (as the combination of the recommended discount rate and this chance of survival is roughly equal to current annuity pricing and the difference between the ABB based on the 25% chance of survival and a lower budget based on a 50% chance of survival strikes us as a reasonable cost of self-insuring one’s retirement), we do want you to be aware of the potential for actuarial losses from this source (and possible spending budget reductions) starting in your early 80s (a little bit later for males) and increasing significantly in your 90s.  Of course, if you survive into your 90s, you may be able to dip into unused funds set aside for bequest motives, long-term care costs, unexpected expenses, home sales, rainy-day funds from favorable investment returns (i.e., actuarial gains from investments), to offset these actuarial losses.  And your recurring spending needs may also be somewhat diminished at these later ages.

Alternatively, you can defer your chances for experiencing these actuarial losses from longevity until your 90s by developing your spending budget based on a 10% chance of survival.  Doing so, will produce a lower initial spending budget than using the 25% chance of survival LPP.   Or, you can scenario test your budget by inputting the higher LPPs associated with the 10% chance of survival and use the result as another “data point” in your budget setting process.

In our post of December 6 of last year, we indicated that if you used the 25% chance of survival LPP, we did not anticipate actuarial losses from longevity until you reached your late 80s.  This was based on the male mortality table we used in 2014, but is not the case with the tables currently used by the Society of Actuaries and American Academy of Actuaries in the Actuaries Longevity Illustrator, as evidenced in the graph above.

General Implications of Planning to Live Longer than Your Life Expectancy

  1. If your spending follows the Actuarial Approach, you are likely to leave money on the table when you die.  Since under this approach you are annually adjusting your LPP based on your age (and not just reducing it by one year each year to live), you are likely to die with some assets left unspent.  The amount of unspent assets should be a little higher with the 25% chance LPP than the 50% chance LPP.  For this reason, you may wish to reduce the amount you plan to leave to your heirs. 
  2. As noted above, by selecting an LPP (or LPPs) longer than your life expectancy, you are generally lowering your current spending budget and reducing the risk of subsequent declines in future spending budgets relative to a budget developed based on your life expectancy.  You will also notice that planning to live longer than your life expectancy will make certain investment strategies appear relatively more favorable.  For example, investments in annuities (either immediate or deferred) or Social Security commencement deferral strategies may appear to be more financially advantageous than if you based your LPP on your life expectancy.  We don’t necessarily have a problem with this result, as we believe that assuming a longer-than-life-expectancy LPP is just part of the cost of self-insuring one’s spending liabilities.

Sunday, January 14, 2018

Maintaining Your Principal—Another Spending Budget “Data Point”

Recently published research from BlackRock confirmed earlier research from the Society of Actuaries that retirees tend, on average, to spend just about their income each year, where income is defined as income streams from sources such as Social Security and employer provided pensions plus interest, dividends and capital appreciation on their investment portfolios.   According to the research, “The vast majority haven't been spending their retirement savings—leaving nest eggs mostly untouched and living on ready sources of income instead.”  This post will discuss this “maintain your principal” (MYP) strategy as another “data point” to be used in determining your spending budget setting strategy.

The MYP strategy has been around ever since people started to retire and wondered how they should deploy their accumulated savings.  The strategy can work reasonably well if you don’t need to rely too heavily on portfolio income for essential expenses and/or if interest and dividend payments generated by your portfolio are reasonably adequate and stable.  In the recent low-interest rate environment, it has been difficult for some retirees to make this strategy work well.  The Blackrock research appears to find, however, that many retirees have adjusted their spending to implement this strategy, even during the recent low-interest rate environment.

We at How Much Can I Afford to Spend don’t tell you how much you should spend each year.  That is your decision to make.  We do give you tools to use to provide you with additional “data points” that can supplement other data points available to you to help you make your spending decisions.  Further, even if you use our recommended Actuarial Budget Benchmark (ABB) to develop your annual spending budget, there is no requirement to actually spend that amount each year.   For example, you may feel more comfortable spending less than your ABB.

We are strong advocates of retirement planning that meets your specific financial goals.  If one of your primary goals is to maintain or grow your accumulated savings, then the MYP strategy may be more appealing to you than a spending strategy that reduces your accumulated savings over time to fund your goals for higher levels of spending.

As we have said many times in this website, we encourage you to annually calculate your ABB and compare it with whatever you are currently doing to develop your spending budget.  If the MYP strategy isn’t consistent with your long-term spending goals, you owe it to yourself to examine alternative strategies that may be.