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.