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 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.  


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!”


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.