In our post of February 26, 2019, we discussed a two-step process for comparing the expected present value of your lifetime essential expenses with your “floor portfolio” (investments in less risky assets) to enable you to measure the extent to which your essential expenses are funded by non-risky investments and to help you gauge the amount of risk you are assuming in your current investment strategy:
- In Step 1, we suggested multiplying the present value of future years factor determined using our default assumptions from our ABC for retiree workbooks by your estimated current expected recurring essential expenses to estimate the present value of the assets you currently need to cover those expenses for the rest of your lifetime (or the joint lifetime of you and your spouse). The present value factor in our workbook is essentially the cost of $1 of real annual lifetime income based on inflation-indexed annuity pricing assumptions.
- In Step 2, we suggested comparing that present value of your essential recurring expenses developed in Step 1 with the present value of your “floor portfolio.” The remainder of your assets, if any, would be allocated to your “upside portfolio.”
- Social Security
- Defined Benefit pensions
- Life annuities
If you are not familiar with deferred annuities or QLACs, you may wish to revisit our post of July 12, 2015 outlining the plusses and minuses of buying longevity insurance (QLACs). QLACs pay benefits for life after attainment of a specified age, and because of the benefits of risk pooling, they can provide lifetime retirement income more efficiently than other investments. Unlike other investment strategies, these insurance products can truly help you hedge your longevity and late-in-life investment risks. You may wish to read about these benefits in the article by retirement researcher Michael Finke, “Why Advisors Should Use Deferred-Income Annuities.”
Let’s see how our ABC workbook and investment in a QLAC might help our hypothetical example person, John, better manage his investment and longevity risks.
Data—John is age 65 and is unmarried. He elected to start his Social Security benefit of $20,000 per annum this year. He has $1,000,000 in accumulated savings in his 401(k) plan. His current investment allocation for these assets is 35% in bonds and 65% in equities. He has equity in his home, but plans to use his home equity to cover future long-term care expenses, so for budget purposes, we will assume that these two items net out. He has no other sources of retirement income and does not plan to work for pay in retirement.
He has no heirs that he plans to leave money to upon his demise, so he inputs a desired estate at the end of lifetime planning period of $10,000 in today’s dollars in cell D24 of our ABC for Single Retirees to cover funeral expenses. He has no expected non-recurring expenses, but he inputs $50,000 in cell D18 for the present value of his unexpected non-recurring expenses.
He uses the default assumptions to develop a total present value of his assets of $1,447,796 ($1,000,000 in accumulated savings and $447,796 from Social Security), and a total present value of non-recurring expenses of $55,694, which leaves a total present value of recurring expenses of $1,392,102. Dividing the present value of recurring expenses by the present value of future year factor of $22.3898 gives John a current year recurring expense budget of $62,176.
John estimates that his essential expenses are about $40,000 per annum and he expects these essential expenses to increase with inflation each year. As discussed above, in step one of the process to estimate the sufficiency of his floor portfolio he multiplies $40,000 by the present value of future year factor of $22.3898 to estimate the amount needed to cover (or fund) his essential expenses. This amount is $895,592.
In step two, John determines his “Floor Portfolio.” This amount equals the present value of his Social Security benefit ($447,796) plus the amount of his 401(k)-account balance invested in bonds ($350,000) for a total of $797,796. Thus, his floor portfolio is about 89% of the estimated amount to cover the estimated present value of his future recurring essential expenses.
As a result of this two-step calculation, John decides that his current investment strategy may possibly be too aggressive, and it may make sense to increase the size of his floor portfolio. He decides to look into purchasing a QLAC. He goes to a website like www.immediateannuities.com to obtain a quote for a deferred annuity commencing at age 85 with no pre-commencement death benefit. This website indicates that a $100,000 single premium will purchase fixed dollar lifetime income of $3,555 per month, or $42,660 per annum, starting at age 85 (with nothing paid if he dies prior to that age). He decides to rerun his ABC numbers assuming that he liquidates $50,000 of bonds and $50,000 of equities to make this purchase.
So, John makes two changes to his ABC workbook: 1) he changes his accumulated savings in cell D7 from $1,000,000 to $900,000 and he adds the expected annual QLAC income of $42,660 in cell F(14) with 20 year deferral in cell H(14). The results of these two changes are shown in the screen shot of the input/results tab below
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The first thing that John sees in the input/results tab of the ABC workbook is that if he purchases the QLAC, his current recurring spending budget will increase from $62,176 to $64,434, or by about 3.6%. The second thing he sees is that his floor portfolio will increase from $797,796 to $898,348 ($447,796 from Social Security, $150,552 from the QLAC and $300,000 from his reduced bond portfolio), and it would slightly exceed the estimated present value of his future recurring essential expenses of $895,592. We leave it up to you, as a home exercise, to change these results back to the original numbers to duplicate the initial $62,176 recurring spending budget.
As a result of this exercise, John decides to actually sell $50,000 of his bonds, $50,000 of his equities and purchase the QLAC. After these transactions, John calculates that his “upside portfolio” (the portfolio used to fund more discretionary future expenses) is about $600,000 and represents about 40% of his total retirement assets (excluding his home equity).
By looking at the PV Calcs tab, John notes that it costs him $100,000 in his investments to purchase $150,552 in QLAC present value. This is because the ABC assumes John will live until age 94 (the 25% probability of survival), while the actuaries who price the QLAC assume that John (or the average male purchaser who is age 65) will only live until age 88 (the 50% probability of survival). This difference illustrates the benefit of risk pooling inherent in annuity contracts discussed above.
What about future budgets?
John then looks at the Inflation-Adjusted Run-Out Tab of the ABC workbook to see how current and future withdrawals from his accumulated savings are coordinated with inflation-adjusted payments from the QLAC and Social Security to keep the real dollar total spending budget at $64,434 if all assumptions are realized. He sees that withdrawals from his accumulated savings are expected to be much higher prior to age 85 than after, but withdrawals are still expected to occur after age 85. Of course, future experience won’t be exactly as assumed, so John understands that each year, he will input revised data and recalculate a revised spending budget that will automatically coordinate his withdrawals with benefits payable under the QLAC to avoid a discontinuity at age 85 when the QLAC payments are scheduled to commence. Depending on actual experience, future spending budgets may be higher or lower than amounts shown in the run-out tab.
What makes the Actuarial Approach so special when it comes to developing a spending budget when investments include a QLAC?
Since it utilizes present values of income streams and expenses to develop a rational spending budget, the Actuarial Approach automatically handles non-linear payment (and expense) streams. By comparison, the 4% Rule, IRS RMD approach (or any other Strategic Withdrawal Plan) don’t work with QLACs (or other non-linear income sources) to provide a reasonable spending budget, as these approaches don’t coordinate spending with other sources of retirement income. And while Monte Carlo models employed by financial advisors may be able to incorporate non-linear payment streams and indicate how a QLAC may positively affect the probability of success of meeting a certain spending goal, they will generally not tell you how to adjust your spending budget each year to keep on track. Therefore, while some individuals may struggle to understand the present value concepts used in the Actuarial Approach, we continue to believe that this approach is superior to other approaches for “getting the right answer,” particularly in more complicated personal situations.
QLACs have plusses and minuses. One of the potential minuses of a QLAC is that it may be difficult to coordinate with your other sources of income. If you are thinking about purchasing a QLAC, you need to consider how you will coordinate the benefits under the contract with your other sources of income. Using the Actuarial Approach is one way to make sure this coordination takes place properly.
We have shown you how you can use our ABC tools to compare the present value of your essential expenses with your floor portfolio for the purpose of measuring how much of your essential expenses are funded with non-risky investments. If, as a result of performing this comparison, you believe that you should increase your floor portfolio, we encourage you to use our ABC workbooks to measure the impact on your current spending budget and floor portfolio of potential changes in your investment strategy. You may find the QLAC option to be an effective way for you to hedge your investment and longevity risks, but we are guessing you won’t find it particularly attractive if you plan to use it in combination with a strategic withdrawal plan like the 4% Rule or IRS RMD approach.