Sunday, February 4, 2018

Should Increasing Your Investment Risk Increase Your Current Spending Budget?

From time to time, we receive comments from readers who wonder why the recommended assumed investment return/discount rate (currently 4% per annum, or 2% in excess of our recommended annual assumed inflation rate) used to determine one’s Actuarial Budget Benchmark (ABB) is so low.  Given historical returns and the run-up in the equities markets over the past nine years, some feel that equities (or other risky assets) represent a source of consistently higher rates of return that can be expected, over sufficiently long measurement periods, to continue to outperform lower risk investments in the future.  These individuals argue that these expectations justify using higher real assumed rates of return in their budget calculations that can support higher current spending budgets than produced by the ABB, all things being equal.  Other readers wonder why we don’t link our assumed investment return/discount rate to the individual’s assumed investment mix, like most financial advisors and spending calculators do.

In this post, we will:

  • Explain why we recommend assuming a low-investment risk rate of return, irrespective of an individual’s current investment mix, at least for determining one’s ABB 
  • Discuss our concerns with budgeting approaches that imply that you can increase your current spending budget by increasing your investment risk, and 
  • Describe how we use the ABB to develop our own personal spending budgets.
Before proceeding, however, we want to remind you once again that
  1. we don’t advocate any particular investment strategy, 
  2. we don’t insist that you spend a certain amount in any given year, and 
  3. we encourage you to calculate your ABB in addition to whatever other approach you may be using to develop your spending budget, as another “data point” that you may find useful.
Why We Recommend a “Low-Investment Risk” Rate of Return Assumption for Developing Your ABB

To make the ABB a “mark-to-market” calculation, the market value of an individual’s (or couple’s) spending liability is determined using financial economics principles, by using the price of a portfolio of financial assets whose expected distributions match the individual’s anticipated spending in amount, timing and probability of payment.

We recommend using inflation-indexed life annuities as the financial assets for this purpose, and we solve for discount rates and longevity planning periods that produce about the same pricing (inflation-indexed annuity-based pricing assumptions) as for these low-investment risk investments.

While equities and other risky investments may be expected to generate higher returns than low-risk investments over an individual’s (or couple’s) lifetime planning period, such investments carry more risk and are generally not considered to be financial assets “whose expected distributions match the anticipated spending in amount, timing and probability of payment.”

It should be noted that the Actuarial Approach is a self-correcting approach.  If future experience is more favorable than assumed in the budget calculations, future spending budgets determined under the Actuarial Approach will increase relative to current spending budgets.  If future experience is less favorable than assumed, future spending budgets will decrease relative to current spending budgets.  Therefore, in this post, we are talking about when such favorable (or unfavorable) future experience is “recognized” for budget calculation purposes.  If you invest in risky assets and expect higher returns as a result, should you recognize those higher expected future returns in your current budget calculation or should you wait and recognize gains in a subsequent year’s budget calculations after they have actually occurred?  See our post of March 20, 2017 “You Can Spend It Now or You (or Your Heirs) Can Spend It Later Part II” for more discussion of this spending balancing act.

Our Concerns with Budgeting Approaches That Imply You Can Increase Your Current Spending Budget by Increasing Your Investment Risk

We are concerned about budgeting strategies (such as those that may be developed using Monte Carlo modeling, safe withdrawal approaches or even our Actuarial Approach with higher than recommended assumed real rates of return) that appear to offer higher levels of current spending at little or no perceived additional risk (of having to reduce your expected spending budget in the future).  For this reason, we recommend that you annually compare your spending budget with the ABB to quantify how much risk you are assuming with your current budget strategy.

We acknowledge that by investing in risky assets, your future investment returns may exceed those expected on low-risk investments, but we are concerned about approaches that recognize expected favorable experience in the spending budget calculation before such favorable experience has actually occurred.  We don’t believe there is a “free-lunch” to be gained by investing in equities or other risky assets.  If there were, insurance companies would want to invest more in equities rather than bonds to cover their liabilities, and it would be a “no-brainer” to leverage your investments (for example, by taking out a mortgage loan at 4% and investing the proceeds in equities expecting a 6% return). 

We are also concerned that some individuals who wish to increase their current spending levels may be persuaded to increase their equity investments beyond their tolerance for risk in order to chase higher expected returns.

How We Develop our Annual Spending Budgets

We don’t know what your future holds and we don’t know your spending goals.  As a result, we can’t tell you what the “correct” amount of your spending should be this year.  We can (and do) provide you with tools to help you perform your own calculations (with or without help from your financial advisor).  We do know that some of you use our Actuarial Budget Calculators with more optimistic investment return assumptions than the annuity-based pricing assumptions we recommend because you believe your investments will earn higher rates of return in the future and you aren’t overly concerned about the extra risk you are assuming.  And, who knows?  Your approach and assumptions may work out better for you than our recommended assumptions.

For what it is worth, we can tell you how we go about our annual budget setting process.  We invest a portion of our retirement savings in equities, and we expect to earn relatively higher rates of return on these risky assets than on our low-risk investments.  We use what we call the “ABB with Rainy-Day Fund” approach.  Under this approach, we calculate our budgets based on our recommended annuity-based pricing assumptions and in the years following years where we experience actuarial gains from more favorable than assumed experience, we park some or all of these gains in a Rainy-Day Fund, which in our spreadsheets is also called “other non-recurring expenses.”  Until we decide to use these Rainy-Day Funds, they do not enter into the calculation of our “annual (recurring) spending budget.”  If (when) we experience a poor investment year, we can dip into this Rainy-Day Fund to mitigate the resulting decrease.  Or, if the Rainy-Day fund becomes too large (which is a pleasant problem to ponder), we can use a portion of it to increase our future spending budgets.

Under this “ABB with Rainy-Day Fund” approach, we don’t recognize more favorable-than-assumed experience in our budget calculations until it actually occurs (or in some instances, not until after it actually occurs).  We feel this is a more prudent approach than one that recognizes higher return expectations before they occur, as would be the case, for example, in the common Monte Carlo model that assumes future higher rates of return when developing (or testing) a spending plan based on a given investment strategy.


We encourage you to be skeptical about spending budget approaches that appear to promise higher levels of spending if you increase your investment in risky assets, or that imply there is little extra risk associated with investment in riskier assets.  Unfortunately, developing a reasonable spending strategy in retirement is a fairly complicated and risky business.  To manage your risks, you might want to consider using the same “ABB with Rainy-Day Fund approach” that we use.  If you don’t use this approach, we encourage you to annually compare the results of the spending strategy you do use with the ABB to quantify your risks and, as discussed in our post of November, 26, 2017, we also encourage you to model potential deviations from assumed experience for the purpose of potentially mitigating your risks.