In our post of January 29, 2021, we suggested that you consider periodically stress-testing your retirement plan for unfavorable future investment experience by performing a 5-year spending budget projection assuming future assumed “crash-like” Equity returns. We included a 5-year projection example in that post for a couple who followed our Recommended Financial PlanningProcess. The couple in that example experienced no decrease in their projected Essential Expense spending during the five-year projection period, but did experience fairly significant (but presumably manageable) decreases in their discretionary spending in the initial years of the five-year projection.
In our previous post of March 11, 2021, we noted that Life Annuities can actually be worth more in your Floor Portfolio than what you pay for them, especially when compared with investment in individual bonds. Not discussed in our previous post, however, was the Risk associated with rising interest rates and rates of inflation, and the negative impact these rising rates can have on the value of fixed-dollar lifetime income assets in your Floor Portfolio.
In this post we will include an example of stress testing a retirement plan for rising interest rates and inflation. We will do this by adding 400 basis points (4%) to our current default assumptions for interest rate and inflation (3%/2%) and comparing spending budgets developed under our recommended financial planning process for the current (3%/2%) and higher interest rate / inflation (7%/6%) scenarios.
Example – Bill and Linda
The data for our example couple, Bill and Linda, are summarized below. At retirement:
- Linda had no lifetime income other than her projected Social Security benefit, which she estimated would be $18,000 per annum commencing at her Social Security Normal Retirement age of 67 (and included three years of 2% assumed future cost of living increases prior to commencement), and
- the couple had $1 million of accumulated savings.
In order to fully fund their Floor Portfolio with guaranteed income, the couple decided to spend $250,000 of their savings on an immediate life annuity of $13,440 per annum for Linda (based on annuity purchase rates used in our post of March 11), leaving approximately $750,000 to be invested in more risky investments.
To develop the data for the higher interest rate / inflation scenario, we will assume that interest rates and inflation expectations will increase by 400 basis points (4%) overnight to 7%/6%. Linda’s expected annual Social Security benefit at age 67, with 6% annual cost of living increases instead of 2%, becomes $20,202. In addition, because of calculated decreases in the present value of their fixed lifetime income annuities (shown below), the couple decides to spend an additional $200,000 (at cheaper 7% interest rates) to purchase an additional $16,686 (for a total of $30,126) of annual fixed dollar lifetime income for Linda. As shown below, this additional lifetime income is designed to fully fund their revised Floor Portfolio under the higher interest rate / inflation scenario, leaving approximately $550,000 to be invested in more risky investments.
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To simplify their calculations, Bill and Linda are assuming that their current home equity will cover their future long-term care costs and other unexpected costs, and they also assume that Social Security reform will not involve future decreases in their benefits.
Initially Bill and Linda calculated the present values of their assets using the current default assumptions and our Actuarial Budget Calculator workbooks (and assumed a 33% reduction upon the first death within the couple). As noted above, in order to approximately fully fund their Floor Portfolio under this assumption scenario, they initially decided to purchase a life annuity for Linda with $250,000 of their accumulated savings. The higher interest rate / inflation scenario below shows the effect on their Floor Portfolio assets of changing (overriding) the default assumptions from 3/2% to 7%/6% and the present value of the additional life annuity the couple purchased to once again fully fund their Floor Portfolio in the higher interest rate / inflation scenario.
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The above chart shows that the higher interest rate / inflation assumptions have almost no effect on the present value of couple’s expected Social Security benefits, as these benefits are fully indexed for inflation (under current law). However, the same is not true of the couple’s pension and life annuity income. Under the higher interest rate / inflation scenario, the value of Bill’s pension benefit is reduced by 30% and the value of Linda’s first life annuity is reduced by 36% (because of her younger age and longer Lifetime Planning Period).
Spending Budget Comparison
The two printouts below show Asset Reserves by Expense Type tabs for the current default assumption and higher interest rate / inflation assumption scenarios described above. Both scenarios anticipate full funding of the couple’s essential expenses, but with only $550,000 of Upside Portfolio assets, anticipated spending under the higher interest rate / inflation scenario is expected to be only $22,000 per year vs. $31,000 per year under the current inflation scenario (assuming such spending is spread over the couple’s anticipated lifetime planning period with annual amounts increasing by assumed inflation minus 1% per annum).
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Comparison of these printouts illustrates the interest rate / inflation risk associated with utilizing fixed dollar lifetime income investments such as pensions and life annuities to fund a Floor Portfolio. To better manage this risk, the couple may consider having Linda postpone commencement of her Social Security benefit until age 70, thereby increasing the amount of inflation-indexed annuity income available to the couple.
Conclusion
Unfortunately, for those lucky enough to have pension benefits, most of these benefits are not fully inflation indexed. In addition, inflation indexed life annuities are no longer available in the U.S. Therefore, Floor Portfolios funded with pensions and life annuities are subject to significant interest rate / inflation risk. We encourage those of you with these types of assets in your Floor Portfolios to periodically stress test your retirement plans to assess the amount of your risk and to consider taking possible actions to manage that risk.
